The EU Puts London in the Last Chance Saloon: or Does It?

Tony Freeman explains why European banks are unlikely to move away from clearing trades through London absent a regulatory mandate.

The mundane and low-profile business of clearing is back in the news. The EU’s financial services chief Mairead McGuinness has granted non-EU CCPs a further three years of equivalence until 30 June 2025.

Reuters reported the story as:EU says Britain’s euro clearing extension will be its last”. An anonymous EU official said, “It’s clearly the end of the road, there will be no extension after those three years.” A four-week consultation has been launched. So, we’re back in the Brexit bunker again.

One of the least understood aspects of Brexit is that it’s a process as much as an event. Whilst the UK formally left the EU a year ago, the long-term structural impacts will take many years to crystallise. And financial services is at the forefront of this issue.

After 45 years of membership, the UK and its fellow EU member states became hugely intertwined in their trading relationships. The origins of London’s dominance as Europe’s financial centre go back to the 1980s but the trend was turbocharged by the creation of the single market in 1993. This allowed any EU regulated business to operate freely across the bloc and contributed to the breakdown of regional barriers. In the post-trade segment, clearing has been a prime example.

Following the 2016 referendum decision, there was a clamour of commentary about the dominance of London in clearing – especially in the OTC derivatives area. London has long been the biggest global centre for the trading of OTC derivatives – especially swaps – and it is, therefore, a natural by-product that London should also do the post-trade clearing and risk-management process.

LCH (formerly known as London Clearing House) is the centre of this activity. It is a broad business covering many products and currencies, and its ability to streamline processes and manage a netted position is very attractive to the biggest clients. Clearing benefits greatly from the network effect – the bigger the network the greater the benefit to all members. Every new member adds value for me, and growth begets growth. Concentration, despite being disliked by policymakers, is inevitable.

But why does this matter and why do European politicians care so much about the issue?

There are two reasons: politics and systemic risk. The political issue is easy to see: it is not a good look for the vast majority of Euro swap clearing to happen outside the EU. This may be an issue of vanity or pride, but the risk issue is very real. When the next crisis happens (which is inevitable – it’s many years overdue) policymakers and central banks in the Eurozone need to be able to make policy decisions about their currency. If the crisis occurs in the vast OTC derivatives market the issue is magnified.

Derivatives, unlike equities and bonds, create leverage. It is easy to see this in action – in 2020, an obscure so-called family office called Archegos generated losses of more than USD 10 billion. The losses were contained, but if a large European bank got into the same type of trouble the losses could be far greater and potentially systemic. It could induce a crisis. But with LCH being outside their jurisdictional territory the freedom to act is constrained.

So, the issue is real. But will the remedy work? Right now, we don’t know.

The consultation, which is only open for 4 weeks, raises a multitude of policy options. The expectation (or hope) is that EU-based CCPs will become more attractive, and the market will voluntarily move. But, based on the behaviour of the market since this issue arose, this would appear to be an unrealistically optimistic viewpoint.

Banks use CCPs because of their value proposition and cost. An individual bank is not going to move away from London into an EU CCP because it will please bureaucrats and politicians. Its netting rate would fall, its costs would rise, its service to its clients would be worsened, and the transition would generate substantial operational risk. Absent a regulatory mandate it’s just not going to happen.

The EU has stated that it intends to publish a legislative proposal by the end of the year. There’s a huge amount of lobbying to be done before then, but the most likely outcome is onerous new regulations. Let’s hope not.

Tony Freeman is a freelance communications consultant. He spent more than 30 years working in the City of London. He worked at Omgeo & DTCC from 2004 to 2020. He focuses on financial technology and operations.

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