Brexit Derivatives Risk: Did the City Overplay Its £38 Trillion Hand?

It’s not pretty seeing members of the financial services industry in a tizzy over the difficulties and risks of moving £38 trillion in notional amount of derivatives agreements to which EU members are a party, out of the London clearinghouse that dominates interest rate swaps, including euro-denominated ones, to someplace else. Provisions that made it seamless for EU denizens to conduct business happily in the City go poof in a crash out.

As we’ll discuss in short order, this does look like it will be quite a mess, and IMHO an unnecessary mess. This process is operationally taxing and how to do it is being sorted out at the 11th hours. At a very simplified level, first, both parties to the trade will have to agree to the novation. Second, it will be impossible to assure that the termination of the first contract and the creation of the replacement contract elsewhere will be on identical terms. Prices move and there can even be small price difference between different venues at the same time. So how do you prevent one party from profiting unfairly (whether by accident or design) from this type of mismatch? A letter to the Financial Times’ editor by Scott O’Malia, Chief Executive, International Swaps and Derivatives Association, outlines the issues:

Philip Stafford, in his Tail Risk column of June 28, correctly points out that existing derivatives contracts between UK and EU entities will not instantly become void once Brexit occurs. Firms will be able to carry out contractual obligations already agreed on cross-border contracts, like payments and settlements. But many other critical actions that take place during the life of a derivatives trade will be disrupted.

These so-called lifecycle events include material amendments to contractual terms, the rolling over of trades and trade compression. These occur on a daily basis and are vital to the efficient functioning of the derivatives market. In fact, some — like trade compression — are important risk management techniques required by EU regulation.

Firms need to be authorised in the UK and EU to conduct these activities, but may no longer have the necessary permissions in the other jurisdiction after Brexit. That means a UK-domiciled firm would no longer be able to perform these lifecycle events on existing contracts with EU counterparties, and vice versa. Without action by both EU and UK legislators, the only way these legacy contracts could continue as before would be to transfer them to a locally authorised entity.

Mr Stafford references the Bank of England’s estimate that £29tn of existing cross-border contracts would be affected and points out that the actual risk exposure would be lower.

However, the problem is not the notional figure but the substantial number of contracts that would have to be transferred and the number of counterparties that would individually have to agree to the transfer in a short period of time. A transfer of this scale has never before been attempted, and is operationally unlikely without regulatory and legislative support from the EU and the UK. This support would enable the wind-down of portfolios in an orderly fashion, without compromising the interests of end users that depend on these contracts to manage important financial and commercial risks.

Hopefully readers who are up on the specialist derivatives press or follow regulatory updates can fill in more detail, but from what I have inferred from occasional stories in the Financial Times, the late action on derivatives has at least something, and perhaps a lot, to do with it having become a political football. Recall that the morning after the Brexit vote, banks started looking into, and even in some cases applying, for licenses in places like Ireland so as to be able to set up or expand operations in the EU27. And at least one Financial Times reader, in a June 2018 comment, claimed that some banks were already on top of this issue:

‘Senior EU officials have told banks, for instance, that it is their responsibility to change the terms of relevant financial contracts signed since the June 2016 Brexit referendum’. Banks should be doing this now. The 2 US GSIBs I have best knowledge of have this problem under control.

Now admittedly one Financial Times reader won’t have as much of a view of the problem as a senior ISDA official, but the flip side is the ISDA chap is a de facto lobbyist. It’s not hard to imagine why ISDA members (dealers) would want regulatory and legislative cover. It would obviously help them operationally to have Someone Official play arbiter. But with that, one images the dealers are probably also looking for legal cover, since it’s not hard to imagine end customers thinking they were screwed in how the novation was handled and having a legal case.

A weekend story by John Dizard gives a detailed and often colorful overview of the problem:

LCH UK, which operates the London-based derivatives clearing house for interest rate swaps, let its EU members know that they could be given just three months to move £38tn in notional value of swaps contracts to other venues…

This is not simply a matter of moving data files from one location to another. Each swap contract would have to be offset with matching positions, and the new clearing houses would have to ensure they have the correct margining and netting procedures for all the new business….

To their credit, the European Securities and Markets Authority, the EU regulator, and the Financial Conduct Authority, its UK counterpart, have drawn up memos of understanding that could allow for something other than a legal, logistical and market liquidity fiasco…

Those memorandums, though, will need to be approved at the political and bureaucratic version of light speed. This requires a level of sanity and lack of posturing that has not been evident so far.

Dizard then went on to discuss how derivatives clearinghouses hadn’t necessarily solved the problem they were supposed to, that of ending too big to fail risk, and instead shifted it to clearinghouses, which could be politically more tetchy to bail out. While it is unquestionably true that clearinghouses are themselves potential or actual TBTFs, it is also true that having central counterparties does at least somewhat reduce risk by standardizing contracts and reducing the complexity of exposures. He then proceeds to discussing the issues that arise if a central clearing house blows through its customer margin, its reserves, and its equity. Dizard depicted the alternatives as having customers who had profits in their accounts pay off losers, or a capital call to members, or a rescue.

A problem with his otherwise informative piece is that by putting these topics together, Dizard gives the impression that the Great Swaps Transfer, if it takes place, could bankrupt a clearinghouse. Yet he doesn’t give any reason to believe that, not even a dire quote from an expert. Normally I take Dizard at face value, but some mavens popped up in comments to take issue with his article. For instance:

There are lots of learned papers published by Risk Magazine on CCP recovery and resolution that the author has failed to read. In extremis, at the end of the default waterfall, a CCP can tear up derivatives contracts so that they cease to exist and share this burden amongst all participants. It is not at all like a single RBS running out of liquidity and being bailed out by the state as the author purports.

Nevertheless, you could expect large, even wild, currency and interest rate movements if a crash out starts to look inevitable, and that in turn could produce losses as contracts were novated. But those would be losses to the counterparties and not the exchange unless there was a customer default.

To put it more simply, this derivatives event would be a nasty and unnecessary addition to the disruption of a crashout.

As indicated earlier, this issue became politicized, with Bank of England governor Mark Carney complaining about the EU’s failure take hard/crash out Brexit risk seriously enough as far as financial services industry risks were concerned. The wee problem is that while Carney was raising a legitimate issue, his solution was to pump for UK firms to be able to continue to provide services on the Continent, which is inconsistent with Brexit and could be managed only in the context of a EU/UK services agreement. Derivatives were the scariest part of this problem due to the large notional amounts. From the Financial Times in June:

Having put in place a scheme to allow European financial services companies to continue to serve UK clients after a hard Brexit, Mr Carney said the UK now had a “rock solid solution” to potential disruption to derivative and insurance contracts, but said he was still waiting to see similar solutions on the EU27 side…

The central bank’s one domestic concern about the financial stability consequences of a hard Brexit was the lack of continuity of derivative contracts, which it said needed action by governments on both sides of the English Channel. Only then would £29tn of derivatives, such as interest rate swaps, be guaranteed not to be disrupted after a hard Brexit.

It has since become clear that these contracts are overwhelmingly with the London clearinghouse LCH. So the bigger risk was UK financial services companies not being able to serve EU clients after a Brexit, and a remedy for that problem would have the convenient side effect of keeping business in the City. I find it hard to believe that Carney’s proposal wasn’t symmetrical, that the provisions he put forward for EU financial services firms to operate in the UK would apply to UK financial firms with EU clients.

And this sort of disingenuousness would sit particularly poorly with EU financial regulators, since the ECB, along with France, had tried to require that Euro derivatives clearing take place on the Continent, only to lose the case in an ECJ ruling, because the EU is not allowed to discriminate among members in the manner the ECB was pushing.

So with that history, Carney’s proposal probably came off as yet more UK special pleading to hang on to Euro and other derivatives clearing.

So it should come as no surprise that that the EU was of the view that this matter didn’t require official intervention. From the Financial Times in July:

The European Commission has downplayed warnings from the Bank of England that the validity of vast numbers of financial services contracts could be put at risk if regulators do not put special measures in place before Brexit, saying the market should be able to deal with most of the problems itself….

He said that Brussels had studied the potential impact on both insurance and derivatives contracts, and that “current analysis . . . suggests that preparedness by market participants can go a long way to mitigate the impact of Brexit”.

The assurances run directly counter to fears expressed by the BoE that the validity of some £29tn of derivatives, such as interest rate swaps, could be called into question after a hard Brexit unless EU and UK authorities act to legally ensure their continuity….

The BoE’s governor, Mark Carney, complained….“This cannot be solved by the private sector,…It will not be possible, ahead of March 2019, for private financial institutions on their own to mitigate fully the risks of disruption to financial services.”

So as I read this, Carney tried muscling the EU on behalf of the City and both side have sat pat until events have forced action…perhaps too late to avoid a mess. But the one bit of solace is that despite the scary big notional value, the economic value of plain vanilla instruments like interest rate swaps is vastly lower. The fact that the ISDA official thought that the sheer volume of trades is a bigger problem than their magnitude is also somewhat reassuring.

In other words, the UK side has incentives to make this derivatives problem sound like a potential comet about to wipe out the dinosaurs, since the City comes out the loser. And it will be a massive challenge to get this sorted out and have the markets not suffer a loss of liquidity. But since this issue is now belatedly being addressed, we should have a better idea in the coming weeks just how bad this could wind up being.

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  1. Colonel Smithers

    Thank you, Yves.

    Having worked on such matters in previous lives and over a decade, I think the City is overplaying its hand, not helped by politicians and hacks who have their own agendas and / or don’t understand what how the industry works. It’s not just Carney who went into bat on behalf of the City. Andrew Bailey and Paul Tucker, both with an eye on their futures as with Carney, do so, too. Carney and Bailey have former colleagues as advisers. Their advisers know better than that and say so, but their advice is ignored.

    City lobbyists have been told by the EU about this since at least 2013, but have not taken any notice. It does not help that the better / wiser lobbyists moved on from 2012 – 3 onwards and were replaced often by political party officials on the make, young civil servants demoralised by Osborne’s catamites etc., few of whom spoke another language or made an attempt to understand the EU. In my case, my boss, a former minister, was replaced by associates of Boris Johnson.

  2. tegnost

    what are the chances of global contagion? It seems to me that the disaster captalists mouths may be watering…

  3. vlade

    TBH, I think it’s a massive operational problem, but I don’t think the novations would be problematic (moving off-the-market swaps from one CCP to another is BAU, but of course BAU is not counting on having to move squillions of contract by the end of next week to exagerate a bit). The margining provisions, which do impact on the contract costs, do change between CCP, but not so much that overall it would be

    It’s really the new trades which are a problem – as whole processes assumed something, but will end up with something entirely else.

    Also, where it can blow things up is more in having to spread collateral. TLDR; – some counterparties may have to find collateral they didn’t need before, even if technically their positions are neutral.

    1. Lambert Strether

      OK, I’ll bite. Here’s what Wikipedia, quelle horreur, has to say about novation:

      Novation, in contract law and business law,[1] is the act of:

      1. replacing an obligation to perform with another obligation; or
      2. adding an obligation to perform; or
      3. replacing a party to an agreement with a new par


      Novation is also used in futures and options trading to describe a special situation where the central clearing house interposes itself between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of the clearing house defaulting. In this context, novation is considered a form of risk management.

      The term is also used in markets that lack a centralized clearing system, such as swap trading and certain over-the-counter (OTC) derivatives, where “novation” refers to the process where one party to a contract may assign its role to another, who is described as “stepping into” the contract. This is analogous to selling a future contract.

      Yes? No?

      1. Clive



        The “but” being this is all a theoretical exercise which we can run from the comfort of our armchairs without risking a dime of our own money. That’s fine, but not what the real decision-makers are staking their careers on.

        The proposition we’re in the luxurious position of having someone else go through with it is something like:

        “Hmm. What shall I do today for a change? Oh, I know. I’ll roll over a $1bn contract. Into a completely different jurisdiction. With an untested legal position. While having a foothold left behind in the prior contract’s jurisdictional reach. Where there’s no case law to guide anyone. On law that isn’t well settled anyway. With two different legal systems in play (common law and civil law). With the new contract’s governing court not known for having any regard for decisions of other jurisprudence’s courts’ decisions even though it can look perverse as a result. Into which the contracting parties have recourse to both national and supranational legal systems. Where the supranational court’s bench does have a bit of a reputation for leaning more towards favouring certain big governments and certain big governments’ pet big business interests over others. Between country A and trading block B who are, ah-hem, not currently on the best of terms following a somewhat acrimonious decoupling process. And which are still in the midsts of sorting out how this will all work in the long term. Yeah, sure, why not? What could possibly go wrong…”

      2. Redlife2017

        Yes that is the OTC meaning, but hardly analogous to selling a future contract. I’ve worked with the impacts of just novating one client on a few occasions (with hundreds to upwards of over a thousand contracts). It’s straightforward in a legal sense (albeit tons of work). But NOT in a BAU sense. It doesn’t seem to me that many places built their IT systems to be able to handle novations, so manual cranking / data massaging is often involved including getting the pricing right/ agreed. Every time it happened when I was involved it was a [family-blog] show. And we have tons of these contracts. This is purely “the how” in an IT / Data Architecture sense. Not really the legal sense.

        And if you saw what a mess MRUD (Margin Requirements for Un-cleared Derivatives) made in early 2017, you would definitely be cautious about this.

        1. vlade

          Whether one client novation is or is not BAU really depends on the size of the client. Most reasonably sized banks will do high tens/low hundreds of novations a day, literally as BAU. But if you have to novate even high thousands (on a day), it’s likely that things will start getting awry. Especially, if the contracts are in systems that are old, and tend to rely on some “fun” side-effects. Techically, you can always novate by a zero-cost-buyout of existing contract + a new off-the-market contract, although residual payments, if any, can be nightmare (well, you can deal with it via the buyout mechanism, but the whole thing tends to throw up too many exceptions).
          Banks very regulary (now for at least a decade plus) run a process called “compression”. Basically, a lot of banks subjects

          CCP migration has specific problems, which include:
          – not all products can be migrated between CCP. That’s true on both high-level (like Eurex clearing only JPY and USD of the non-european currencies, and not even all european currencies ), and low-level (daycounts, inflation interpolation/lagging etc.. Most of the stuff I deal with is non-CCP, so don’t take my word on exact details here)
          – different collateral rules
          – calculation (most are similar, but as usual, devil is in the detail)
          – collateral eligibility (if the CCP doesn’t clear AUD, it’s unlikely to accept AUD collateral)
          – haircuts (even it if may accept AUD collatera, it may not give you the same haircut)
          – becuse of the above, you may not be able to migrate whole portfolios. Which means your low-risk portfolio gets split into two high-but-opposite risk portfolios, meaning you’ll have to find more collateral. Which means more costs. Which you may or may not be able to pass to the client.

          Really, what I would be worried over across all EU derivatives, not just clearing, is what Clive sort of indirectly mentions above. Most of the derivatives in the world are under English or NYC law.

          ISDA is fundamentally English-law. There is a German-law ISDA (which Eurex uses), but the case law, the lawyer/judge experience just doesn’t exist. Now imagine that you’re a SocGen. Your client has some clearable derivatives, which will go via Eurex, under German law. But then you may have some unclearable derivatives with the same client. I doubt that SG or the client would like to have those under German law, more likely French one. Woohoo! I think derivative EU lawyers with knowledge (or pretence of)of more than one jurisdiction will be in dire demand, if a lot of the derivative contracts gets moved. TBH, I’m wondering how it will work with insurance as well.

          The EU might find that one thing that the UK provided and no-one in the EU valued was a common business law. For example, I know a lot of startups got re-incorporated in the UK, as investors didn’t really want to hire a professional translator they could trust, and a lawyer they could trust, and a … in every country they operated.

          An alternative (which I’m surprised no-one of the Baltics or small states came up with), is that one of the EU states will take the hit for the benefit of the others (hahaha) – comes up with a full-package law, and an exchange to support that, and persuades everyone to use that. Sort of try to replace English law with, I don’t know Latvian one (as they would be also inclined to put a clause there that it can be written in any language, like English.. )

          1. vlade

            Noticed now I forgot to continue the compression stuff:

            Basically, banks have vast portfolios with other market participants (mostly banks). That’s like a stuff that just accumulates in the attic… Some time ago, somoene had a smart idea, that you could clean up the attic – or, in this case, reduce the number of trades. What happens there is that the particiapants submit data on their portfolios, something goes through it, and comes up with simplified portfolios that keep the same risks.
            This includes trade full or partial buyouts (i.e. terminating the trades, a final payment amount may or may not be involved, usually it’s 0 in these situations though), trade novations, and in some cases also creating new trades. So a fairly complex process that can’t run on daily basis. Trade compression is actually a regulatory requirement for larger parties, which means you have to be able to handle stuff like this regularly (i.e. BAU)

            But again, all of the above assumes that you’re working in the same solution space. Moving into a new solution space (which is not only about novations) is an entirely different kettle of fish.

  4. begob

    Is this relevant?

    European Central Bank reportedly wants to crack down on a practice known as “back-to-back” booking after Brexit.
    The process effectively sees banks and other institutions carry out business in one market, but book that activity in another.
    Many in the City believed the continued use of back-to-back booking would have helped London retain its European financial crown after Brexit.

  5. Tim Smyth

    The real story is not the future Euro denominated swaps in the City of London but the future of US Dollar dominated swaps in the City of London i.e. if Euro swaps are pulled from City then what is the rationale to keep US Dollar swaps there as well instead of repatriating these activities back to the US. Now the US has not been nearly as picky or concerned with having all this US dollar swap activity offshore unlike the continental Europeans however, since early 2017 CME Group which is the primary albeit much smaller US “onshore” swaps clearinghouse now has direct access to the Chicago Fed and Fed liquidity while the main City of London clearinghouse LCH does NOT. Thus while the US has been silent on the future of US swaps in London it is obvious that in a systemic crisis LCH will been in a huge disadvantage compared to CME especially once it loses ECB liquidity post Brexit.

    The rumor I have heard is that the Brits and LCH are moving heaven and earth to get the US Fed to provide the same type of US dollar swaps liquidity to LCH in London as they are providing to CME in Chicago. However, to date due to longstanding regulatory restraints and specific language in DF the Fed is unwilling to extend this same backstop to a “foreign” swaps clearinghouse no matter how long the Brits drone on about the special relationship.

    The main thing the Brits and LCH have going for them is most of the sell side banks don’t have good relations with the two “onshore” Euro and USD swaps clearinghouse Eurex in Frankfurt and CME in Chicago. Thus the Brits and the Bank of England seem to be hoping for some type of capital strike on the part of the big TBTF sell side banks against moving their swaps activities onshore to the US and continental Europe.

  6. blennylips

    Someone here recommended Jack London’s “The People of the Abyss” recently.

    It has been urged that the criticism I have passed on things as they are in England is too pessimistic. I must say, in extenuation, that of optimists I am the most optimistic. But I measure manhood less by political aggregations than by individuals. Society grows, while political machines rack to pieces and become “scrap.” For the English, so far as manhood and womanhood and health and happiness go, I see a broad and smiling future. But for a great deal of the political machinery, which at present mismanages for them, I see nothing else than the scrap heap.

    Excerpt from the author’s forward.

    Get an e-it here:

    Riveting read so far, thanks to whomever!

  7. Susan the other

    How amazing. Financial meltdown in a time of global devastation. When it becomes apparent that there is no such thing as “insurance”. Only regulation and good faith. This little summary was so interesting; makes all the pieces fall into place. Theresa May’s pointless grandstanding just like Cameron’s. It’s almost all about the City of London’s demise. A standoff if I ever saw one. In a funny twist of irony, the very miserable state of the planet, caused by aggressive profiteering basically, will now come to our rescue because everyone is in agreement it will take many trillions to save the planet and probably so many trillions that a few swaps contracts that lack proper handling will seem like mosquitos.


    Why does a government allow interest rate swaps and other financial derivatives? I know why corporations and banks use them; but with the trillions of dollars involved, I would think a government would put a stop to them.

    1. JTMcPhee

      I am glad that YOU know why corps and banks play the derivatives casino game. It makes no sense to me at all. Is the key word “profit,” hiding behind “insurance” and “hedging” and “rationality?”

      And in the sense that trillions of “notional dollars” are somehow created, and get priced into “the political economy” and produce bonuses and “value” that the “traders” can spend for their benefit, which have been backstopped as I understand it by “full faith and credit” dips into the US treasury (standing aside from the MMT/taxes confusion), it looks like massive counterfeiting to this not so smart mope. Diluting and debasing the currency by intent.

      I and my friends and family and people of my “class” have apparently paid off most of the casino markers the Banksters and these really smart City slickers have off-loaded onto us back in the GFC. Though clearly these creatures have run up another huge stack of Funny Munny wagers and markers that once again seem about to totter and fall — on us mopes, of course. No benefit to us (especially as the activities that derivatives are part of now bid fair to kill us all off, retail and wholesale, via extraction and combustion consumption “trade” and “market economics”).

      Why should we mopes care a whit (especially in the face of the hand-waving about “disruptions” that we are told we must FEAR and must remedy) whether the whole Rube Goldberg mess comes crashing down, like one of those “auto-destructive art” abstractions of Gustav MEtzger, or the many videos in youtube showing all kinds of complex machines tearing themselves apart due to some flaw or miscalculation or mischance? One example, due to a failed brake and regulator:

      I bet a lot more people, as the complexity and vulnerability linkages and dysfunctions become more apparent, will be saying “Screw it,” and start throwing gasoline on the fire and shooting any moving target. Some of those West Coast wildfires were reportedly started by anomic a$$holes looking for thrills. “A Clockwork Orange” meets “Heller-Skelter” riffs off My Lai and Hiroshima-Nagasaki… And those twits in their bespoke suits with their £300,000 “wrist chronographs?” Maybe they should burn too, along with the rest of us…

  9. DSP

    On the 4th.Oct. Open the Podbay Doors HAL posted an interview with a Prof.Werner in the last few seconds of which the Prof. mentioned that the City of London is not part of the UK,nor is it part of the EU either.
    How will this affect the financial situation of Brexit?

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