The FT reported yesterday on the intensifying staring match between the EU and the UK over financial services.
London has for some time been in danger of losing its position as the world’s clearing center for euro-denominated derivatives. The city’s clearing houses handle up to three-quarters of the global euro-denominated derivatives market.
The European Central Bank (ECB) has long argued that oversight of euro clearing services would be easier if they were relocated to within the Eurozone, and in 2011 issued a policy reflecting this. The UK took the case to the European Court, which eventually sided with the UK. The reason given was not because geographical restrictions would discriminate against some member states (the UK’s main argument), but because the ECB’s role is to supervise payment systems, not securities settlement. The ECB still alleges that settlement oversight is essential for payment system stability.
Now that Britain will soon no longer be an EU member, the battle lines are shifting. The European Commission (EC) is preparing legislation for June that will impose geographical restrictions on euro-based clearing. An interesting twist is that the EC is not waiting until Brexit becomes a reality.
The policy, due for publication tomorrow, moves to extend the ECB’s role to include supervision of clearing houses if they provide “critical capital market functions” (such as derivatives swaps). If this goes ahead, it will mean that either the activity needs to relocate, or the UK has to allow ECB supervision on British territory (which it’s unlikely to be happy with).
If the activity has to relocate, the fallout will be considerable, and the impact could be felt around the world. Euro-denominated derivatives clearing accounts for about one third of the global interest rate swaps market.
It’s probable that some clearing houses will prefer to wind down than move (CME Group recently decided to pull out of London due to lack of profitability). The larger ones may find that they lose clients. Either would be enough to contract medium-term liquidity in the market.
Short-term, the potential problem is more serious. Clearing houses reduce liquidity risk in financial markets by standing between two traders in a transaction. They also increase transparency by being in a position to publish the price at which a trade executed.
Disrupt those functions, or even temporarily interrupt them, and you increase systemic risk. You also increase the cost of clearing, as economies of scale are reduced.
Some clearing houses are looking into blockchain applications as a way to reduce costs and enhance liquidity. In 2015 a group including settlement giants CME Group, Euroclear and LCH.Clearnet formed a working body to discuss how the technology might be used to settle transactions. The Depository Trust & Clearing Corporation (DTCC) in the US is specifically looking at credit derivatives settlement.
So, there is movement to seek greater efficiencies in settlement, reduce dependence on clearing houses and reinforce transparency. But it’s happening slowly.
Understandably so. Blockchain technology is still new and relatively untested in financial applications. And systemic market infrastructure is not something you play around with.
However, the clock is ticking. And heavy investment in new systems that perpetuate current inefficiencies and are not future-proof will end up adding even more pressure to financial services firms’ already squeezed margins.
Now we can add political pressure to the list motivating factors.