Mixed motives threaten messy outcome in euro clearing row

In the long-running debate about the post-Brexit status of London’s LCH, what happens next depends to a large extent on why it is happening at all.

If you take proposals issued by the European Commission (EC) in June at face value, then it’s all about systemic risk – LCH would only be denied recognition if it posed an unmanageable risk to EU financial stability.

The argument has shades of the location policy laid out in 2011 by the eurozone central banks: offshore central counterparties (CCPs) should be “legally incorporated in the euro area” if their net daily exposure in euro-denominated products breached a threshold of €5 billion.

If that is why everyone has been talking about LCH for the past year, then the end result seems obvious. The EC’s proposals would allow the European Securities and Markets Authority (Esma) as well as the “relevant central banks” – those in whose currencies the cleared products are denominated – to recommend a CCP should not be recognised.

Given the chance, it’s hard to imagine the Eurosystem central banks not using that power to revive the location policy, which was blocked by the European Court of Justice in 2015.

There are other ways to explain the fuss about LCH – for example, it could have more to do with French dreams of making Paris a genuine international finance hub

But there are other ways to explain the fuss about LCH – for example, it could have more to do with French dreams of making Paris a genuine international finance hub. In 2009, a report compiled by a French working group, with members drawn from the government, the central bank and the big French dealers, concluded clearing was of strategic importance to the eurozone – and to Paris.

Those convictions are still held today. When the EC published its June proposals, it was no surprise that they mirrored a white paper issued by the French securities regulator in May.

If this is what it’s all about, then the outcome might be quite different – an expansion of LCH’s subsidiary in Paris might be enough to stave off a broader derecognition.

Or maybe there’s something else at work. A former employee of LCH claims European animus towards the London-based clearer has less to do with the systemic risks of offshore euro-denominated clearing and more to do with a decision by LCH’s repo clearing service to apply haircuts to major eurozone government bonds during the region’s debt crisis – a step that may have contributed to a drop in demand for the paper.

“It’s not about swaps clearing. Moving that to the eurozone doesn’t solve much of a problem for anyone. The thing that poisoned the well was repo clearing,” he says.

There is some support for this view in the EC proposals, which call for EU central banks to affirm that each systemically important CCP complies with the banks’ monetary policy requirements. These might include “the level of any ‘haircuts’ applied to collateral”.

If this is the problem, a deal could be done that would move LCH RepoClear to Paris. At that point, says the former clearing house employee, “everyone gets back in their box and carries on as usual”.

A final possibility is that it’s less about systemic risk, nationalism or monetary policy, and more about oversight – when the UK’s membership runs out, EU bodies such as Esma will lose access to LCH. This problem could be remedied through a framework of enhanced supervision, which the London-based clearer has endorsed in principle.

The truth, of course, is that LCH is under attack for multiple reasons. Given the varied arguments arrayed against the CCP – and the opacity of the UK’s exit terms – it’s no surprise some of its EU customers are now looking at how and whether to transfer their positions to a venue with a more settled future.

LCH’s foes may not see this as a bad thing – an extended period of uncertainty could see euro-denominated trades moving to the eurozone voluntarily. The danger is that instead of a managed migration, the market gets a dangerous stampede.