Perhaps I am too jaded, but I am finding it hard to have much sympathy for the latest round of big bank whinging, as summarized in EU under pressure to extend access to London clearing houses in the Financial Times.
To simplify a long story, the EU has long wanted to pry the clearing of Euro derivatives away from London to the Continent. The European Central Bank had sought to do so, but the UK successfully contested the move. In 2015, the European Court of Justice ruled that the ECB could not discriminate against an EU members that way.
The logic of that ruling meant that as soon as Brexit was in motion, it was clear the ECB could and would revive the idea of relocating derivatives trading. The EU gave London a waiver and let them continue to clear under “equivalence” rules, but only on an interim basis.
Now that the EU has set a drop-dead date of mid 2025 to move a big chunk of this activity eastward, banks, including many top European derivative players, are sounding alarms that this switch would be risky, might hurt vaunted market efficiency, and would cost them money. Extracts from the pink paper:
The EU is coming under mounting pressure from Europe’s biggest derivatives houses to radically rethink its plans for wresting euro-denominated clearing from the City of London.
Clearing houses — which reduce market risk by standing between two parties in a trade — have been a key battleground since Brexit, with the EU intent on moving the clearing of strategically important European trades to the continent as soon as it is practical to do so.
The latest deadline, which the EU has vowed will be the final cut-off, is June 2025. But finance bosses have warned of the grave risk to financial stability which Brussels’ blueprint poses.
Europe’s biggest derivatives houses, including BNP Paribas, Deutsche Bank and Société Générale, vehemently oppose the EU’s plans, fearing extra costs and less efficient clearing, while London’s clearing house LCH, which stands to lose lucrative business, has also pushed for a rethink.
Banks, LCH and their lobby groups stepped up efforts to overturn the European Commission’s plans in recent weeks, warning that Brussels’ proposals to bring the activity onshore are not workable and could wreak havoc with European markets.
What bothers me about this article is that, as in the last paragraph, it featues assertions that the EU plans are bad, without giving a single example of what is wrong about their scheme (I hope Colonel Smithers will weigh in in comments; this should be right up his alley). Instead, the article gives the strong impression that the beef really is that they are having to do this at all. I doubt that this is anywhere near as difficult to do as they suggest. You build a parallel system, road test it very hard on realistic volumes, and then move the trades over.
What I suspect is doing it right would cost way more than they want to spend and cutting corners to bring costs down to an acceptable level would indeed produce risks of blowups (and blowups at high volumes are like a tire going out in a Formula 1 race: all sorts of bad things happen, such a spin-out that hits other cars). So they are establishing their own facts on the ground: by not doing much preparation, they are making it impossible to meet the deadline.
We see some support for that reading. Again from the Financial Times:
People familiar with the EU’s position said Brussels was not entertaining an extension now and that any changes would fall to the next commission, which takes over in late 2024.
The commission said its decision last February to extend equivalence for UK clearing houses “ensures the EU’s financial stability in the short-term. There are currently no plans to amend this decision.”
“There is an inconsistency between the message at political level and the reality on the ground,” another person involved in the industry discussions told the Financial Times. “We almost take it as a given that equivalence will be extended.”…
Now it is very likely true that there are some things wrong with the EU’s current requirements. Schemes like this usually need a lot of back and forth to hammer out details.
But what makes me suspect the issue is that the beef is about this plan moving forward at all is the lack of any examples of deficiencies in the EU plan that need to be fixed.
Moreover, I am bothered that the banker claim that less efficient derivatives clearing is a bad thing gets a free pass. We’ve repeatedly argued that highly efficient trading is a bad thing because it encourages speculation, pulling resources away from productive real economy activity. Derivatives are the poster child of that sort of thing. The highly profitable derivatives are used almost entirely for socially destructive activities like money laundering, tax evasion, and accounting gaming. Yes, those derivatives are for the most part bespoke and thus likely not centrally cleared. But the bank that writes that trade will need to hedge it. That would entail the use of centrally cleared derivatives. Make hedging more costly and fewer of those bad-behavior-enabling derivatives will be written.
Readers are encouraged to tell me I’m all wet, there are X really bad provisions in the EU proposal that will result in Y bad outcomes. But absent getting more specifics about what is wrong with the details of the relocation plan, I’m sticking to my guns that the real beef is that this is being done at all, and most of these complaints are a rearguard action to hold off the transition as long as humanely possible.
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Thank you, Yves, including for the shout-out.
First, a caveat. My speciality is corporate banking, not markets, but I am familiar with the concepts, rules and issues, technical and political, surrounding derivatives clearing.
As often, Yves’ pithy introduction summarises matters well.
Firstly, these rules have been operating EU (28 and 27) wide for many years, so there’s no new regulatory obligation to implement and get used to, and, had it not been for covid, on shoring by the ECB may have happened earlier. The industry had been warned many times. The mid 2020s was always the likely cut off date, though, as the EU needed to get its regulators up to speed.
There are no capital and liquidity issues for the European derivatives houses as, whether they trade from London Branch or head office, it’s the same legal entity and pot of money to cover activities, including losses arising. Branch structures often facilitate smoke and mirrors, but that discussion is for another occasion.
Sometimes, trading with a client is by way of a capital markets subsidiary, but that subsidiary soon trades back to back with the parent (or local branch).
Contracts tend to be written according to English law, so novating them to another governing law and in a different language even IS an issue. A complication arising from that is local terminology may be different and not address what an English document stated and intended. The possibility arises that positions are not covered and, should something bad happen, more capital may have to be set aside. There are firm and wider system concerns. This said, firms ought to have contemplated the risks and addressed them.
Yves’ conclusion is on balance the right one. Having invested so much in London, moving out is painful, but staying put was never on. The weakness / thinness of the argument put forward says a lot. If I was still at a trade association, I would be embarrassed by that and not say anything. Lobbying by way of a story planted in the FT allows financial institutions to avoid explaining to the authorities in person. Been there. Done that. Worn the t-shirt.
It’s not even a question of EU27 regulators not having the expertise. UK regulators are struggling, too, and no longer able to share the burden with EU colleagues. There aren’t enough UK regulators, let alone older and wiser heads, and the limited head count is having to come up with deviations from EU rules just because. Sometimes, deviation is justifiable and appropriate, but not always. Politics trumps everything else.
Thank you Colonel and Yves.
It would be interesting to know what is going on behind the scenes. To my mind the obvious solution would be for LCH to set up a separate entity in the EU so that they keep the business in their empire. I wonder if there are negotiations going on to try to bring that about amicably. Ultimately, if they do not, I think the EU have to find a way to create the necessary clearing in the EU if they are to have effective oversight of the clearing of euro derivatives trading.
As you say, politics trumps so I wonder if some of the problems lie with governments. Are there discussions among EU member states as to where the clearing ends up? I can imagine Frankfurt and Paris putting in a shout. Maybe others? Dublin? Amsterdam? I can’t see the UK authorities falling over themselves to be helpful here as it presumably loses some revenue to the UK and raises the possibility, for efficiency’s sake, of sterling clearing moving to a EU location.
All part of the sunlit uplands of course.
Being total ignorant in the matter and interpreting Yves’ Col Smithers’ words in my limited way I suspect that the derivative clearing activities might not be as clear as supposed and if the (somehow desperate?) call to keep all them in London is a call to keep the underlying mess under the carpet.
Just asking
Thank you, Ignacio. That’s not impossible.
Thank you.
Your first paragraph is spot on. Setting up in the EU costs money and takes up time and resources, but Lloyd’s insurance market got on with it and set up in Luxembourg. LCH cant expect the EU to neglect its regulatory responsibilities. I am stunned that Deutsche, my former parish, and the big French banks, all with political links, think that is tenable, especially as Brexit will feature in the forthcoming UK elections and the withdrawal agreement is up for review soon after.
I am not aware of discussions at EU Council level and between member states on a limited basis. The issue is of interest to the member states you have specified plus, say, Italy.
UK regulators do act as blockers, not just on this matter, but the shift of investment services (MiFID) and (allied) commercial banking from London. UK regulators want to know if such moves are in the interests of clients, without specifying what good customer service looks like.
I hope to e-mail Yves some tidbits about Whitehall soon and hope Aurelien / David, Harry (formerly Bank of England) and your good self pipe up.
Being a bit of a cynic, could the reason for all this be as mundane as those Eurobanks and the City of London have some very cozy, lucrative relations and they want to keep them going as long as possible? So here it would be a case of follow the – undeclared – money. Moving to the EU would mean upsetting this particular cart and those Eurobanks would know that the EU leadership would be standing by for their little ‘gifts’ once this move was made. By this I mean that for example, the EU leadership wants all future arms deals made in Brussels and not each individual nation so they would get the largess from those arms companies and not those individual countries. If all those transactions were done in the EU, I could see the very same EU leadership wanting their cut. Just a theory mind.
Most likely, as from this outsiders perspective it seems like UK is the perfect place to run eternal accounting games in.
After all, some of the places most preferred for parking money are British Overseas Territories. Internally self-governed, but can call on Westminster any time foreigners get uppity.
And i have the impression that from day one UK favored the City above all else upon joining EU.
Not sure why there is no mention of the lax financial regulation in the UK that makes money laundering so much easier, something all the banks are fond of.
A language problem? Yes, English is the language used and it always has been and is used internationally, the idea that shifting out of London will somehow stop those pesky bilingual multilingual foreigners from coping is just silly.
The language problem is a legal terminology and jurisdiction problem, rather than a simple understanding issue. The contracts would state that the jurisdiction is that of the English courts and the law to be interpreted is common law. Concepts, terms, legislation, and cases that would be taken into account while drafting the contract and would be material to its functioning would all be null and void should the contract be transferred to a European jurisdiction. Wholly new contracts would be required to be drafted.
As I understand it, this is a regulatory control issue as far as the ECB is concerned, they don’t care if it leads to pain (at least the slight pain that is the most plausible form of pain) they want to run it. This goes back to the Greek euro drama I believe when the ECB was restrained from acting, so I supremely doubt there will be any extensions. Pretty sure there is substantial backing from euro goverments too, if there weren’t thr ecb wouldn’t have tried to get at it in 2015 to begin with.