The European Union and the UK do not want to demand a forced fragmentation of the market, a source told AST after Reuters reported a potential delay on the decision to allow clearing houses in London to continue clearing Euro transactions for EU-based clients.
Reuters stated that the delay is due to Britain’s plan to breach part of the Brexit divorce settlement.
The Reuters story noted the delay indicates one of the first warning shots from the EU as UK lawmakers vote on a bill that would breach parts of Britain’s Withdrawal Agreement from the bloc.
The source told AST that the EU and the UK would want to avoid fragmentation on the market because of efficiency and financial stability concerns.
It was explained that forcing European banks or participants to clear their Euro trades in continental Europe “could split up the pools of risk and make it riskier and less efficient to complete clearing”.
One clearinghouse said that it hasn’t seen any discernable change in customer behaviour. The source said the
EU Commission granted temporary equivalence previously as they recognise the importance of continuing access to London clearinghouses.
The Reuters story noted that Brussels had said it would grant Britain “time-limited” access to euro derivatives clearing from January to avoid huge disruption to markets as a unit of the London Stock Exchange (LSE) clears over 90 percent Euro-denominated swaps that are widely used by companies.
The European Commission was due to formally take that decision on Wednesday but is now expected to delay it until around the end of the month, according to the Reuters source, citing an industry meeting late last week with a European Commission official.
The commission confirmed it launched the consultation on Monday 14 September with member states due to begin the adoption process, in line with what it announced in July in its Brexit readiness announcement.
The commission declined to provide any further information at this stage as the consultation is ongoing.
Meanwhile, industry expert and consultant Tony Freeman said that the potential delay illustrates two themes: Brexit negotiations can throw up some very unexpected results and policy-makers continue to misunderstand how derivatives markets work.
Commenting on Brexit negotiations, Freeman said: “The current row between the EU and UK on the internal market bill is ostensibly about the designation of the UK as a ‘third-country’ and the free-flow of food products between the mainland UK and Northern Ireland.”
Freeman outlined that the potential delay to recognise clearinghouses in the UK has no direct connection but the timing makes it look as if it’s a retaliatory gesture.
“Throughout the whole Brexit saga the City of London has been bewildered by the lack of focus on services – especially financial services. Services account for at least 75 percent of UK GDP,” he highlighted.
According to the report issued by the House of Commons Library in 2019, Freeman noted that in 2018, the financial services sector contributed £132 billion to the UK economy, 6.9 percent of total economic output.
The sector was largest in London, where 49 percent of the sector’s output was generated.
There are 1.1 million financial services jobs in the UK, 3.1 percent of all jobs.
Exports of UK financial services were worth £60 billion in 2017 and imports were worth £15 billion, so there was a surplus in the financial services trade of £44 billion, the report found.
Additionally, the report identified 43 percent of financial services exports went to the EU and 34 percent of financial services imports came from the EU. The sector contributed £29 billion in tax in the UK in 2017/18.
Freeman explained: “Therefore a row about food in Northern Ireland (a small area that represents about 2 percent of UK GDP) threatens to de-stabilise one of the biggest segments of the UK economy. The mainstream media has very extensive coverage on fishing (below 0.5 percent of UK GDP) but doesn’t appear to even notice the much more strategic subject of financial services.”
Discussing the misunderstanding of derivatives markets, Freeman noted that policymakers in the EU continue to believe they can direct where business activity: both trading and post-trade, occur.
He said: “Derivatives contracts on London exchanges are not fungible with similar (but not identical) contracts on markets in the EU27.”
“They cannot be ‘transferred’. In the event of a legal blockage, a clearinghouse in London will have to notify clients to close its open positions – or clients can choose to voluntarily close them. They will then have to open new positions on a different exchange/clearinghouse, which could be outside the EU or achieved via over the counter contracts”, he added.
Freeman also highlighted that this may have to happen in a very short timeframe, which could introduce risks.
“Clients have chosen to use a London exchange/clearinghouse because of the benefits of a cluster: better trading liquidity and more efficient clearing (meaning lower margining costs). Both issues are beneficial to underlying clients,” Freeman outlined.
The issue about the regulatory risk of having a large amount of Euro activity outside the EU can be solved by regulatory collaboration (EU27 and UK regulators share and aggregate data for mutual benefit), Freeman affirmed.
“EU27 regulators and supervisors have the ability to visit, inspect and supervise entities in London (in the same way that US regulators oversee USD business done by US firms in the UK).”
“Nobody disputes that the EU and European Central Bank have a genuine issue in being able to monitor Euro activity. But directing where clients trade and clear their positions might not solve the problem. It could lead to fragmentation, higher costs, and, most fundamentally, increase risk”, he concluded.
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