London has dominated European swaps and futures clearing, and clearing houses, such as LCH, ICE Clear Europe and LME Clear, are key institutions in the financial system. Scale has been key in the long process through which this dominant position was achieved. Markets, though, need and demand certainty, and the process of Brexit has done anything but deliver it.
UBS has estimated that LCH, the London clearing house owned by the London Stock Exchange, is likely to lose at least 25% of its euro clearing volumes as a result of Brexit. Deutsche Bank, Barclays, and HSBC have all moved some of their euro-denominated clearing business to the continent. Will this fragmentation continue? What will the derivatives clearing industry look like in five 10 ten years time?
The equivalence path
London has benefited from its access to the European Economic Area (EEA). By using a UK licence as a European “passport”, foreign firms can offer services throughout the EEA. A disorderly Brexit would risk the loss of UK “passporting” rights and access to these clearing systems. FIA, the trade organisation for the futures, options and centrally cleared derivatives markets, has warned that the reciprocal loss of derivatives market access for businesses based in the UK and the EU in a no-deal scenario could lead to a significant increase in costs for pension funds, asset managers, insurers and corporates.
The Bank of England (BoE) estimates that EU-based companies have over-the-counter derivatives contracts with a notional value of £69 trillion at UK clearing houses. The BoE warned last October that derivatives contracts maturing after Brexit would be at risk unless regulatory certainty was addressed. The nightmare scenarios seem to have been avoided, at least for the moment. The European Commission’s decision in December to agree a temporary one-year equivalence for UK central counterparty clearing houses (CCPs) has reduced the immediate risks.
Clearing houses are meant to reduce the risk of a domino effect of defaults if party to a contract fails to pay. They have grown in importance since the 2008 financial crisis, after which the G20 made it mandatory to settle most derivatives trades through them.
Rafael Plata, secretary general of the European Association of CCP Clearing Houses (EACH), which represents 19 central counterparty clearing houses (CCPs) in Europe, believes the one-year equivalence measure is “a step forward for financial stability and very much welcomed.” But, he says, it’s only a first step.
The next step is recognition by the European Securities and Markets Authority (ESMA) for UK CCPs. ESMA has recently granted recognition for LCH, ICE Clear Europe and LME Clear in the case of a no-deal Brexit. Clearing houses, Plata stresses, can’t function without mutual recognition. A disorderly Brexit and lack of permanent mutual recognition would be “especially difficult” for ongoing derivatives contracts, as marking to market would be much harder, and contracts might come to be seen as unsafe. Plata wants ESMA to provide temporary recognition for UK CCPs, which ESMA has a mandate from the European Union to do. He stresses that the UK also needs to provide recognition to EU CCPs. “It’s a two-way street,” he adds.
Shifting rationales
According to Marc Giannoccaro, head of development, execution and clearing at CACEIS Investor Services in Paris, the heavy defeat of Theresa May’s Brexit plan in parliament in January has left a situation of “complete uncertainty. The number of possible scenarios for Brexit is very large.” The one-year equivalency, Giannoccaro argues, is in itself a source of uncertainty. He says that it would be “absurd” if permanent equivalency was not the ultimate result of negotiations.
Giannoccaro doesn’t expect dramatic short-term changes in derivatives clearing. In the case of interest-rate swaps, he says, France has found that there are many technical and liquidity problems involved in creating new capabilities and transferring existing positions. “It’s not as easy as that to build from scratch. Listed derivatives are a silo as they have to be cleared on the spot,” Giannoccaro notes
However, the economic rationale for euro-area institutions offering derivatives clearing in the UK will start to change. To be able to continue to offer listed derivative clearing services in the UK, CACEIS is obliged to study the creation of a new funded unit in the UK for which there is little or no economic or industrial rationale. This would mean more systems and personnel would be needed, and the risk for the industry as a whole is that costs for the client will increase. “Access to the UK market will become more expensive. There is a risk that clients will decide to invest elsewhere,” explains Giannoccaro.
Philip Forkan head of derivatives, clearing and collateral management at WSNGC, a consultancy for banks and brokers, agrees that Brexit uncertainty has created concerns about bottlenecks. The one-year equivalence agreement, he says, “gives more of a window” and will help to ensure that the cliff edge is avoided.
“UK-domiciled funds, are currently experiencing outflows which are going into euros and dollars instead. The need for portfolio rebalancing means that the uncertainty is leading to an increase in derivatives volumes,” Forkan says.
Forkan doesn’t anticipate that Brexit will lead to market disruption. “Derivatives markets are quite robust,” he says, but what the markets need though is “certainty and clarity – even if it’s not good news.”
He does predict a long-term process of fragmentation which could become self-reinforcing. “Clearing will be more regionally than centrally-based. Once fragmentation starts, it becomes easier to break down existing positions,” Forkan adds. Many countries, for example the US, may want to claw back clearing in their own currencies. US institutions such as ICE, he says, are “looking at this very intently.”
Behaviour changes
One company that hopes to benefit from Brexit is Eurex, the derivatives exchange owned by Deutsche Börse. Eurex has targeted a 25% share of euro-denominated swaps by the end of 2019. It remains difficult to say exactly when the target will be reached, says Matthias Graulich, a member of Eurex Clearing Executive Board. “There is nothing natural about a year-end when a new market is being built.”
However, Graulich explains the euro-denominated swaps business is progressing well, and Eurex now has a market share of 11%. January was a record month with average daily volumes of about ¤140 billion, compared with ¤50 billion in 2018. Long-dated swaps also saw their largest-ever average daily volumes in January. “There is also a significant pipeline of new pension fund, asset management and hedge fund clients who are coming on board,” Graulich says.
The Eurex programme, under which derivatives clearing profits are shared with the users, has definitely helped in achieving this. The profit-sharing programme has helped to make bid-offer spreads on Eurex fully competitive with those on LCH, Graulich argues. Brexit also helped, which he adds has “stimulated a thought process about what to do in case of a hard Brexit.”
The Brexit process brought to the fore underlying issues which had lurked in the background, such as risk diversification and the need for greater competitiveness, he says. “Brexit required people to take action.” This process has now become independent of the specific final outcome of Brexit. “It’s clearly good from an overall systemic risk perspective,” says Graulich.
Political brinkmanship over derivatives clearing is likely to continue, and even if the politicians tacitly agree that the worst scenarios will be avoided, markets are unlikely to be willing to tolerate indefinite uncertainty.
Karel Lannoo, chief executive of the Centre for European Policy Studies in Europe, sees signs of financial behaviour already changing, with LCH moving business back to Paris. For derivatives clearing, he expects “more fragmentation overall, and hence more cost. For 20 years the UK has played the game of economy of scale, and they risk losing it.” While Lannoo has no doubt that London will remain the most important European financial centre, he expects that there will be a process of attrition through the prolonged uncertainty, and that in three years time, derivatives clearing in London will be “scaled down from today.”
“There is a business logic to pooling products in the same currency,” argues Graulich. Eurex has sought to position itself as the incumbent for euro-denominated products, and, in the long term, Graulich expects this logic to triumph regardless of Brexit’s final form. “People will see that these efficiencies are superior,” says Graulich, and expects Eurex will take a significant portion of post-Brexit derivatives clearing as a result. By the same logic, he says, dollar-denominated swaps may in the future be increasingly cleared in the US.
The EU knows that derivatives clearing is not going to move overnight, Lannoo says. Complex combinations of infrastructure and expertise that are hard to find in the euro area would need to be assembled. Derivatives markets can only thrive in the presence of a range of accompanying markets, he notes. But much bigger movement of derivatives business is possible over a longer timeframe of 10 years, and the EU and US both could stand to become the beneficiaries of this.