The future location and construct of the euro clearing industry is one of the most contentious matters within the Brexit regulation debate. Let’s look at the key issues.
In a nutshell, clearing houses sit between buyers and sellers of financial instruments, reducing trading risks by ensuring one party gets paid even if the other party goes bust before the transaction can be fully completed. Clearing houses underpin the confidence of capital markets as they reduce counterparty exposure due to trading activity. Global regulators govern clearing activity through measures like section 723 of Dodd-Frank and EMIR, each of which have made central counterparty clearing houses (CCPs) a critical part of the global capital markets infrastructure.
Clearing is a key issue within Brexit deliberations because the UK is the center of the euro clearing world. It is estimated that more than 90% of euro-denominated interest rate swaps are cleared through London-based clearing houses. There are also thousands of jobs directly linked to this activity within the UK. In the context of a Brexit divorce, euro clearing represents an area of economic activity where the UK has an outsized importance compared to the rest of the EU. Any disruption to the current model would have far reaching impact, making it a point of contention between the EU and the UK.
Location of Activities
As we recently highlighted, Brexit has triggered a review of the delegation of regulated activities to non-EU countries, known as third-countries. EU lawmakers are uncomfortable with activities such as euro clearing occurring outside of their borders and legislative framework, given the importance to the European capital markets. Currently, the Bank of England oversees this UK-based clearing activity and cooperates with the European Central Bank (ECB). With a UK move outside the EU making the UK a third country post-Brexit, Brexit negotiations will ultimately determine whether or not euro clearing remains in London.
The EU could decide that euro clearing must be conducted within an EU member state only. If that happens, the UK would lose the euro clearing business entirely. Alternatively, the EU could allow the UK to continue the activity if the UK is deemed “equivalent” to EU standards, and if disputes that arise would be resolved in EU courts.
As with most things relating to Brexit, political pressure within the EU favors pulling UK-dominated activities affecting the EU into EU member states. The ECB has already proposed changes to bring the UK under their direct supervision for clearing activity post-Brexit.
Moving clearing out of London would not be a simple or inexpensive process. It would require significant new investment from all EU clearing members and a re-papering of thousands of contracts. The process would likely increase the costs of trading on a cleared basis, result in a reduced netting of positions in multiple currencies due to resulting fragmentation, and disrupt current global collateral arrangements. Because of this, several non-EU stakeholders, such as the Monetary Authority of Singapore and the Commodity Futures Trading Commission, have weighed in on the debate. Both suggest that requiring euro clearing to move from the UK to the EU would harm the integrity and resilience of all financial markets.
History Repeating Itself
This is not the first time the EU and UK have debated the appropriate venue for clearing. In 2015, both faced off in the European Court of Justice (ECJ) where the EU argued euro clearing activity involving euro-denominated instruments should occur within the “Eurozone.” Among other things, the ECJ ruled that insisting the activity occur in a particular member state offended the principle of equality in the single market. When the UK leaves the EU, this principle will no longer apply.
What Happens Next?
All future regulatory agreements will depend on the type of Brexit that is ultimately negotiated between the EU and UK. We anticipate an agreement towards the harder end of the Brexit spectrum as the most likely outcome based on current indicators. To maintain the status quo, there will need to be a specific agreement on clearing activity. Such an agreement would likely include the UK accepting direct oversight of UK clearing houses by EU regulators and agreeing to resolve disputes in EU courts. If this comes to pass, it’s likely the UK would be granted status as “equivalent” and empowered to continue to house euro clearing in London.
If equivalent status is ultimately granted, the UK would maintain access to the EU Single Market and retain the clearing business. However, as a third-country, it would become a rule-taker, and not a rule-maker, with little or no influence in framing future clearing requirements. Those would be driven exclusively by EU policy makers.
It is difficult to predict what type of access the UK and EU will have to each other’s markets post-Brexit, but we believe asset managers should keep a watchful eye on the euro clearing debate. Its outcome will likely frame or at least influence the broader construct of reciprocal access. Concessions that both parties are willing to make on this debate will foreshadow how much material disruption of the capital markets we will see on 29 March 2019.