Why Brexit could hurt UK clearing

The City dominates euro-denominated clearing but the European Union is looking to take back control after Brexit. This could hurt the City and cause job losses, says Simon Wilson.

What is a clearing house?

It’s a vital bit of financial market “plumbing”, designed to make particularly risky transactions – such as trading in financial derivatives – a bit safer. A clearing house is not the same as an exchange, which is a marketplace for trading securities. An exchange’s main role is to facilitate fair and orderly trading between a pair of willing counterparties.

The clearing house, on the other hand, acts as a single centralised counterparty (CCP) to all parties in a trade, so it’s on the hook if one or other counterparty in a deal defaults on their side of the bargain. As a result, the clearing house also holds collateral (or “margin”) in the form of cash or bonds, against the risk of each counterparty defaulting.

Why is this a good thing?

It cuts the risk to all parties, and enables complicated deals to be done, because everyone is dealing with one trusted counterparty. In other words, it’s a way of mitigating the risks involved in trading foreign-exchange derivatives, interest-rate swaps and other financial products. Following the global financial crisis, all of the G20 economies made it mandatory to settle most simple derivative trades through clearing houses, as a way to increase transparency and stability.

As a result, 62% of the over-the-counter derivatives market – involving transactions worth a notional $544trn – were settled in this way in 2016, according to The Economist. Xavier Rolet, the chief executive of the London Stock Exchange (which controls LCH, the world’s largest clearing house), says that clearing “underpins the global financial system, ensuring millions of daily trades are settled in a safe, transparent and highly regulated manner”.

And London dominates?

Yes. Clearing is, by its nature, an area where the benefits to market participants increase if one clearing house, or one location, dominates. That’s because the more parties there are using one clearing system, the more effectively the risks can be pooled and mitigated, and the less collateral each party needs to stump up to mitigate them. The City of London handles 37% of the global trade in foreign-exchange derivatives and 39% of interest-rate derivatives. So perhaps it is not surprising that it also dominates clearing.

In particular, LCH clears 90% of global interest-rate swaps, 28% of which are denominated in euros. Overall, the City processes around 75% of global euro-denominated derivatives, clearing transactions worth a notional 850bn every day. By contrast, only 13% are cleared in France and 2% in Germany, the biggest euro economies.

What’s this got to do with Brexit?

Some in Europe think that it’s time they had a much bigger slice of this business, and were able to keep a closer eye on it – especially with the UK set to leave the European Union. The EU is due to make specific proposals on the matter within the next few weeks. But last month it spooked the City by briefing that it would be necessary, post-Brexit, for firms that “play a systemic role for EU financial markets” (such as London clearing houses) to be subject to “safeguards provided by the EU legal framework. This includes, where necessary, enhanced supervision at the EU level and/or location requirements”.

What ostensibly worries the EU is that if a clearing house handling lots of euro transactions were to run into financial trouble, then the European Central Bank (ECB) would have to rush in to backstop it – not necessarily easily done if that clearing house is outside its jurisdiction. Enhanced supervision isn’t an issue: US regulators have oversight over UK-based clearing houses that clear dollar-denominated instruments (see below); once the UK leaves the EU, the City would expect a similar deal. But the “location requirements” have the City worried.

What’s the worst-case scenario?

That the EU insists euro derivatives must be cleared within the eurozone. The ECB previously tried to push this through in 2011 (partly because, during the eurozone debt crisis, LCH raised margin requirements for clearing Spanish, Irish and Portuguese government debt – understandable, but unwelcome when the ECB and eurozone governments were struggling to resolve the crisis). That case rumbled on for several years before the European Court of Justice ruled against it in 2015. But with Britain out of the EU, things may change.

The exact consequences for the City are unclear – the London Stock Exchange argues that it would result in 83,000 job losses, but as LCH stands to lose the most from any such shift, this is clearly a partisan view. It wouldn’t kill off London as a dominant clearing player – far from it. London clears derivatives in 18 currencies in total, including 97% of global dollar interest-rate swaps. But it would put a big dent in a crucial and growing slice of the City’s business, and the fragmenting of financial services would make banks think twice about where to locate jobs in the future.

Will it happen?

London Stock Exchange boss Xavier Rolet reckons that if euro clearing was taken out of London, it would drive up trading costs by €100bn over five years, due mainly to the loss of economies of scale. The financial centre most likely to benefit would be New York, rather than Frankfurt or Paris. So any move by the EU to wrest back euro clearing would hurt European capital markets and the real economy.

Equally, as Christopher Giancarlo, chairman of the US derivatives regulator, noted pointedly, America has no problem with dollar clearing being located in London: “[The US] has not deemed a body of water – even as large as the Atlantic Ocean – as an impediment to effective supervision”. That’s not to say it won’t happen – motivations range from “punishing” Britain for Brexit, to enjoying more direct control over financial markets in case of future eurozone crises, to winning business for European financial firms – but if clearing moves, it’ll be for political reasons, not practical ones.