The UK government is wrong to claim London could not be quickly stripped of its right to clear euro-denominated derivatives, according to lawyers and derivatives market experts. The issue has become one of the flashpoints of the post-referendum period, with European politicians claiming the business will be relocated to the eurozone.
In 2015, the UK prevailed in a legal dispute with the European Central Bank (ECB) over the location of euro-denominated clearing – and an attempt to reverse that decision would take time, the UK chancellor, Philip Hammond, said in an interview earlier this month.
But there may be faster ways to achieve the same outcome. Simon Puleston Jones, head of Europe at derivatives industry association FIA, says the European Commission's review of the European Market Infrastructure Regulation (Emir) could provide an opportunity for the European Union to renew its claim to euro-denominated clearing.
Puleston Jones says that while the ECB is not part of Brexit negotiations or the Emir review process, "politics being what it is, it could be fixed with one sentence, and that one sentence would say: in order to meet your mandatory clearing obligation for any derivative denominated in euros, you will only meet the clearing obligation if you clear it on an authorised central counterparty (CCP). That way, you wouldn't meet your clearing obligation if you cleared that euro-denominated derivative on a CCP in London or in the US, or anywhere else outside of Europe."
That scenario would make use of a distinction in Emir between authorised CCPs, which are directly supervised by EU authorities, and recognised CCPs, which reside in third countries deemed to have equivalent supervision to those in the EU. Following Brexit, UK-based clearing houses are likely to end up in the latter group.
To meet your mandatory clearing obligation for any derivative denominated in euros, you will only meet the clearing obligation if you clear it on an authorised central counterparty
Simon Puleston Jones, FIA Europe
The EC's Emir review will focus on the issues raised during a public consultation in the summer of 2015 and the call for evidence early this year. The review report is scheduled for the end of 2016, with a possible legislative proposal in early 2017.
A spokesperson for the EC declined to comment on the review, saying it is "far too early to speculate" on possible outcomes.
Michael Thomas, a London-based partner at law firm Hogan Lovells, says the change described by Puleston Jones could, in theory, be made in the Emir review by altering the so-called Level 1 text – the original legislation – but doing so would not just punish the UK. Other third-country CCPs that clear euro-denominated trades would also be hit.
A second possibility that would disqualify London as a centre for euro clearing would be if UK clearing houses were not immediately recognised as qualifying third-country CCPs following Brexit. Next year, the UK government intends to repeal the act that took Britain into what is now the EU. It will then transpose EU law into British law before later deciding which EU laws to keep and which to discard. In theory, British law will be commensurate with EU laws such as Emir, but importantly, that will be for the EC to decide.
London-based Mark Kelly, professional services director at regulatory reporting business Abide Financial, says: "It is quite possible that post-Brexit, the UK will be put on a slow track to getting equivalence as a vindictive retribution."
Thomas at Hogan Lovells says the timetable for achieving equivalence is uncertain: "If the UK needs to be equivalent and its CCPs recognised under the third-country regime, what's the process for that happening? Does the assessment of equivalence happen prior to Brexit, or does Brexit take effect followed by a hiatus, assessments undertaken and any application for recognition processed with Esma? That could take two years or more."
Suddenly, the CCPs will cease to be recognised within the meaning of Emir and the Capital Requirements Regulation
Michael Thomas at Hogan Lovells
Unless European institutions come to an advance agreement on CCPs that would also allow European firms to continue trading in the UK market, clearing house members could face a step change in regulation.
"Suddenly, the CCPs will cease to be recognised within the meaning of Emir and the Capital Requirements Regulation, and the capital requirements for all European clearing banks linked into UK CCPs will shoot through the roof," says Thomas.
The FIA's Puleston Jones agrees, urging: "If equivalence is not possible on day one [following Brexit] we need to think about grandfathering arrangements that protect the status quo."
Speaking at The UK Financial Services Brexit Summit in London last week, Anthony Browne, chief executive of the British Bankers' Association, was concerned about the impact on the derivatives market, of which 30% is traded in London: "Banks need transitional arrangements. To suddenly cut off markets traded in London... would have major financial stability implications. No doubt we will get a deal negotiated that is very complicated with lots of brinkmanship, with nothing agreed until everything is agreed – and it will be agreed at 3am with people storming out and tearing their hair."
The UK Treasury did not respond to a request for comment on what it is doing to demonstrate to the EC ahead of time that UK rules will be equivalent to Emir immediately after Brexit.
Also speaking at the London conference, Robert Rooney, chief executive of Morgan Stanley International, voiced concern at the potential for international banks to have to adapt to two different regimes in Europe post-Brexit: "It's a much less efficient way for us to operate, with two sets of ring-fenced capital, two sets of ring-fenced liquidity, two sets of organisations governing these entities. Over time, if all euro currency business is primarily executed somewhere else, you could see a shift in the weightings of those legal entities."
Analytics firm Clarus Financial Technology estimates the impact from moving euro clearing out of the UK as a result of Brexit could lead to a near doubling in initial margin, from $83 billion to $160 billion, for the industry – an increase of $77 billion. The analysis suggests that if euro clearing were to leave LCH in London, the net effect would be to move more than €1 trillion of swaps with an overall average maturity of 12 years to a new clearing location in the eurozone, bifurcating interest rate derivatives portfolios and leaving non-euro business in London.
In 2015, the UK won a case at the European Court of Justice (ECJ) that annulled moves by the ECB to limit the clearing of euros outside the eurozone. The ECB has concerns about the financial stability implications of a euro liquidity squeeze at a CCP outside the eurozone.
The ECJ judgement, in which Sweden was named as a party alongside the UK, found the ECB does not have the competence necessary to regulate the activity of securities clearing systems, annulling the ECB's 2011 Eurosystem Oversight Policy Framework, "in so far as it sets a requirement to be located within a member state party to the eurosystem for central counterparties involved in the clearing of securities".
What we did in the EU to try to protect ourselves will come back to shoot ourselves in the foot [with] Brexit
Rob Moulton, Ashurst
Thomas says it is "not beyond the realms of possibility" that the ECB could subsequently be empowered to impose a location policy for euro-denominated instruments.
However, once Brexit occurs and the UK is outside the EU, the ECJ judgement will be turned against the UK, according to Rob Moulton, a London-based partner at law firm Ashurst.
Moulton says: "What we did in the EU to try to protect ourselves will come back to shoot ourselves in the foot [with] Brexit, because we have already argued before the European courts that you cannot discriminate within the EU to clear euro-denominated securities. But we're about to become a third country. The ECJ has said the ECB does not have the power to decide who can and cannot clear euro-denominated securities, but the Commission does, and it can use our own arguments against us."
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