The EU is gearing up for a campaign to seize greater control of one of the City of London’s most prized assets: its dominance over the clearing of €81tn worth of derivatives contracts that are vital for global businesses.
François Hollande fired the starting gun less than a week after the UK’s shock decision in June 2016 to leave the EU, with the French president at the time warning “the City, which thanks to the EU, was able to handle clearing operations for the eurozone, will not be able to do them”.
Five years later, the UK still controls 90 per cent of euro swaps clearing, an issue that is causing increasing angst in Brussels and across EU capitals as Britain’s financial regulations begin diverging from those in the bloc.
“We are facing a reality — the current concentration is clearly unsustainable,” a senior EU official told the FT.
Swaps are widely used by companies to protect themselves against unfavourable changes in interest rates. Brexit has also reshaped trading of euro swaps, pushing it out of the UK capital to EU cities like Paris and Amsterdam as well as across the Atlantic to Wall Street.
But London Stock Exchange Group’s LCH and ICE Clear Europe, both UK-based, have managed to hold a firm grip on clearing — a vital role in which they stand between buyers and sellers, preventing defaults from causing a chain reaction that could destabilise the broader market.
Brussels insists its primary concern relates to financial stability — that the EU cannot leave itself dependent on UK supervisors to make the right choices for Europe in a clearing house crisis.
However, national diplomats acknowledge that the issue plays into the bloc’s broader quest for strategic autonomy. Financial centres such as Paris are also keen to snatch the lucrative business away from London.
Mairead McGuinness, the EU’s financial services commissioner, said earlier this month the volumes being cleared in the City were “eye-watering” and indicated she was prepared to act if the industry did not shift activities on to the continent voluntarily.
The financial industry as a whole, however, has shown little appetite to make a substantial move across the English channel. Investment banks argue clearing is a global market and it is its clients’ choice to use London. By keeping the business in one place, they argue, banks and asset managers can consolidate all of their positions and save large sums on the amount they need to post as insurance on their trades.
Many market participants also see the UK legal system that underpins the contracts as flexible and commercially-favourable. Claims by the EU that it is too risky to allow UK authorities another currency are treated sceptically because US authorities defer primary regulation of dollar derivatives clearing to London.
“The EU wants to do this for commercial reasons, but is trying to find a way to do it through non-commercial reasons,” said a senior executive at an investment bank based in London.
As it tries to persuade the market to move, the EU has handed greater powers to the European Securities and Markets Authority, a Paris-based agency, to supervise non-EU clearing houses.
The new measures also task Esma and the European Central Bank with assessing whether clearing houses should have to shift activities within the EU to serve European customers. Such assessments for London venues are already under way.
Privately, some within the EU argue even enhanced supervisory co-operation with London would not be enough to calm concerns about the current level of reliance. The relationship with the UK should be one of “interconnectedness, not mutual dependence” when it comes to clearing, said the senior EU official.
Over the past month EU financial services officials have held two closed-door meetings with investment banks and asset managers to look at how to move thousands of open contracts without creating market instability. The sessions are part of the work of an expert group that will report its findings to McGuinness by this summer.
The meetings have mainly revealed familiar faultlines. “The banks and assets managers were of the same view that you can’t force it to move from the UK to Europe,” said one person who took part in the meetings. “The [European] Commission has realised how difficult it is to do this,” said another.
Brussels argues exposure of euro denominated derivatives to London is “excessive” but bankers say authorities have given no guidance on what level would be acceptable. EU policymakers say the industry’s arguments often boil down to concerns about extra costs, and that a price cannot be placed on financial stability.
A temporary legal permit Brussels granted to give EU banks access to UK clearing houses is set to expire in June 2022.
The EU took the step after the Bank of England and ECB warned of a threat to financial stability if access were suddenly cut off because of Brexit — something pointed to by Brussels as further evidence of the need to reduce reliance on London
Should the EU simply let the permit lapse, it could still leave up to three-quarters of the market in London, Andrew Bailey, governor of the Bank of England, has said. That is largely because most business is held by non-EU customers, who would be free to use LCH.
The LSE estimates that only six per cent of euro-denominated swaps at LCH come from EU users. Even Japan, where it is mandatory for domestic banks to clear yen swaps in Tokyo, accepts half of its market is in London.
Nonetheless, one bank executive in London summed up the industries’ fears about the EU’s intentions: “Forced relocation is the long-term goal.”