Europe makes contingency plans for clearing-houses after Brexit

 

AS THEY PREPARE for Brexit, many of London’s financial firms have begun to move some staff, or operations, to the continent. But financial contracts, notably derivatives, are difficult to uproot. London’s clearing-houses, which ensure that a contract is honoured even if one side goes bust, are globally important. As fears of an acrimonious Brexit have risen, so too have those of havoc. Now European Union regulators have unveiled contingency plans.

Clearing-houses have grown vastly in significance since the financial crisis, after which the G20 group of economies made it mandatory to settle most simple derivatives trades through them. London’s three big clearing-houses handle vast amounts of derivatives, and much of the trading cannot be done elsewhere. LCH, London’s largest clearing-house, clears interest-rate swaps with a notional value of over $ 340trn, making up 95% of the world’s total. LME Clear (part of the London Metal Exchange) is near-irreplaceable for precious-metals traders. ICE Clear Europe handles half of the world’s oil-futures contracts, and is typically the only place to go for those linked to the Brent benchmark.

EU rules state that European firms can only do business with, or be members of, clearing-houses that are either within the union, or recognised by it as “equivalent”. Without action, in the event of a no-deal Brexit, Britain’s clearing-houses risked being in neither camp. That would have been a particular problem for EU-based “clearing members”: banks or broker-dealers that have direct access, and through which other market participants interact with the clearing-house. Of the LCH’s 100-odd members, over a third are based in the other 27 EU countries. And because clearing-houses require 90 days’ notice to end membership, the deadline that mattered was not March 29th, Brexit day, but three months before. That lent the quandary some urgency.

For months EU authorities did nothing to intervene, even though Britain had promised a temporary permissions regime allowing British banks and broker-dealers to be members of EU clearing-houses. The Bank of England warned in October that no deal would put £41trn-worth ($ 53trn) of derivatives in clearing-houses at risk. Market participants, though worried, were loth to start the gargantuan, expensive task of transferring their positions.

As it became clear that LCH would soon serve cancellation notices, the European Securities and Markets Authority (ESMA) and the European Commission were compelled to act. On November 13th the commission agreed that EU action on clearing was needed, and for the first time said that existing equivalence rules could be applied. On November 23rd ESMAsaid it was preparing to recognise British clearing-houses temporarily as of March 30th.

Although this provides a reprieve for market participants, it is not a lasting solution. EU authorities have not yet specified how long their temporary recognition will last. Under the existing equivalence rules, recognition is decided unilaterally by the EU and can be revoked at any time. The move does not alter the EU’s medium-term goal of coaxing business to relocate. Indeed, argues one London lawyer, it merely allows the EU to do so in a “managed and controlled”, rather than chaotic, way.

Some European officials have made their intentions very clear. On November 23rd François Villeroy de Galhau, the governor of the Banque de France, said that any temporary recognition of British clearing-houses should not last more than a year. In the same speech he hoped that Paris could become a new “market hub”.

Businesses, too, are chipping away at London’s lead. In January Frankfurt-based Eurex Clearing started to share profits with member banks. Its interest-rate-swap clearing business has since grown steadily, to nearly €10trn ($ 11trn). It now handles about 15% of the European market. Last month it announced plans to extend its profit-sharing scheme to foreign-exchange derivatives and repurchase agreements. Chaos may be avoided. But Britain’s clearing-houses are still under threat.

This article appeared in the Finance and economics section of the print edition under the headline “The future of contracts”