Large clearing houses in London must expect they will no longer be able to process euro derivatives trading from the City after Britain leaves the European Union, according to a draft for a new market infrastructure regulation that the European Commission presented Tuesday.
Under the proposed rule, a clearing house with “significant systemic importance” for monetary policy and the European financial market can lose its approval to conduct transactions in the EU if it operates from a third country. The Paris-based European Securities and Markets Authority, or ESMA, will decide which companies will be affected after consulting with central banks. This will essentially force clearing houses to relocate from London to the European Union, the nuclear option in the European Commission’s arsenal.
Clearing houses are the central counterparty between the buyer and the seller in securities transactions, stepping in when a party fails. The clearing houses themselves became a risk as their significance for the financial market increased. With these new measures, Brussels wants to ensure that this risk is adequately controlled after Britain leaves the EU. “As we are facing the exit of the largest financial center in the EU, we have to make certain adjustments to our rules,” said Valdis Dombrovskis, European Commissioner for the Euro and Social Dialogue.
Under the new regulation, clearing houses in third countries will be divided into three categories. Category one consists of clearing houses with no systemic importance for the European financial market; nothing changes for them. Category two encompasses systemically significant clearing houses that will only be permitted to operate outside the EU if they meet stringent supervisory and regulatory requirements. Among other things, they must provide ESMA with all relevant information about their business and allow on-site inspections. The clearing houses in category three pose such great risks to the EU’s monetary policy and financial market that they can no longer operate from a third country, even if they meet all of EU’s requirements. EU Commissioners are unwilling to reveal which of the London clearing houses this will affect. ESMA will apparently make this decision after thorough examination.
The most important criterion is likely the clearing house’s turnover volume, which means London clearing house LCH is in danger of falling into category 3. The majority of euro-denominated interest rate swaps used to hedge interest rate risks are cleared through LCH.
The Commission is still keeping its options open with the draft directive. Some industry representatives had expected Brussels to use a quota system to move some of the businesses to the continent. This would have hurt London firms while boosting clearing houses on the continent, including the clearing house operated by Deutsche Börse, Eurex Clearing.
“The plans do not sound like the worst-case scenario,” a London financial insider said, suggesting that ESMA would be given a certain amount of leeway to make decisions. “It isn’t clear yet what the disadvantages will ultimately be for London.”
Simon Gleeson, a partner at the international law firm Clifford Chance, also cautions against alarmism. None of the announced rules, he points out, will come into effect before Britain has left the EU. “As a result, there is no evidence that clearing that is currently taking place in Great Britain will be forced to move,” he said. “The question is whether and to what extent the EU wants to prevent banks from engaging in euro clearing outside the European Union.”
“The plans do not sound like the worst-case scenario.”
This could become a problem for banks. For instance, the FIA Principal Traders Group, which represents major trading houses in the Americas, warned there would be additional costs for market participants in the event of a compulsory relocation of the clearing system. The FIA suggests a move out of London could double total collateral requirements, from around $83 billion to $160 billion, citing a study by financial data provider Clarus FT. Other observers assume the amount would be much lower.
Mr. Gleeson does not believe Brussels wants to impose costs on banks in the euro zone. “I think that this is essentially about the EU wanting to create a means of pressure.” This would give them more influence when negotiating the regulation of clearing deals in London in the Brexit talks, which are scheduled to begin Monday. But they could be delayed, since Prime Minister Theresa May now needs more time to set her Brexit course after the election debacle.
The future of London euro clearing is anything but clarified.
Michael Brächer is a financial editor in Handelsblatt’s investment team in Frankfurt. Ruth Berschens has been Handelsblatt’s bureau chief in Brussels since 2009. Katharina Slodczyk works at the London Bureau of Handelsblatt. You can contact the authors at firstname.lastname@example.org, email@example.com and firstname.lastname@example.org