In the days since the UK electorate's emotive decision on European Union membership, financial commentators have been speculating about the fate of euro-denominated clearing in the City of London. Will the major UK central counterparties (CCPs) such as LCH have to move all euro clearing into the eurozone?
French president François Hollande then added fuel to the fire. "The City, which thanks to the EU was able to handle clearing operations for the eurozone, will not be able to do them," he declared after an EU summit meeting on Tuesday (June 28).
That sounds categorical – and it wouldn't be the first time Europe had sought to put obstacles in the way of UK-based clearers – but the reality is more complicated.
The dispute goes back to July 2011, when the European Central Bank (ECB) published its Eurosystem policy oversight framework. This posited that financial market infrastructures handling euro transactions should "be legally incorporated in the euro area, with full managerial and operational control and responsibility over all core functions for processing euro-denominated transactions, exercised from within the euro area".
The ECB's reasoning was that CCPs can pose a systemic risk, especially to market liquidity, and it must therefore be possible for the central bank to ensure emergency liquidity provision to major euro-clearing facilities.
The Bank of England (BoE) tacitly recognised the logic of this concern. In March 2015, it signed an enhanced information-exchange agreement with the ECB, covering UK CCPs with substantial euro-denominated activities. It also extended its bilateral currency swap arrangement with the ECB to enable multi-currency liquidity support to UK CCPs. Bilateral swap arrangements have become common among central banks since the financial crisis and there is no reason to think they are contingent on the UK's continued membership of the EU.
The General Court holds that the ECB lacks the competence necessary to regulate the activity of securities clearing systems as its competence is limited to payment systems alone
European Court of Justice
In any case, in September 2011, the UK government initiated a lawsuit against the ECB at the European Court of Justice (ECJ). Its complaints included the fact that the ECB has no authority to determine the location of CCPs, that it breached the rules of the single market – requiring firms to be treated equally in every member state – and there were less intrusive ways to resolve financial stability concerns (which the subsequent ECB/BoE agreement demonstrated).
In March 2015, the ECJ found in the UK's favour on the very first point. To quote directly from the judgement: "The General Court holds that the ECB lacks the competence necessary to regulate the activity of securities clearing systems as its competence is limited to payment systems alone by Article 127(2) of the FEU [Functioning of the EU] Treaty."
In other words, the ECB does not have the authority to regulate CCPs under EU treaty law. That power rests with the European Commission and European Securities and Markets Authority. Having overruled the ECB on this basis, the ECJ did not even consider the other UK complaints, so the exact legal position on them is still unknown.
Given this judgement, there is no legal basis for the ECB to renew its euro-clearing land grab simply because the UK leaves the EU. To do so would require one of two alternative courses of action.
First, broaden the ECB's powers under Article 127(2) of the FEU Treaty. This requires unanimous support from member states, and the UK, of course, would no longer be at the negotiating table to object. Or secondly, the European Commission could start the process of a new regulation to change the rules on the location of CCPs – perhaps an amendment to the European Market Infrastructure Regulation. This would be subject to the usual majority voting in the Council and Parliament of the EU, and subsequent trialogue negotiations.
Both of these courses of action are fraught with difficulty. Fundamentally, any decision that euro clearing can only be conducted inside the eurozone terminates the single market for clearing services. Will Sweden's Nasdaq OMX Clearing also be forbidden to clear euro transactions? And, for that matter, will eurozone CCPs such as Eurex be forbidden to clear in the Swedish krona or Polish zloty?
Such a path seems likely to face objections from the remaining EU members, especially those outside the eurozone. Indeed, if the UK chooses to join the European Economic Area, it will remain in the single market, so it could potentially reactivate its own lawsuit against the ECB on the grounds that the restriction on CCPs would infringe the single market. A long political and legal argument over the esoteric matter of clearing regulation seems unlikely to be a top political focus for the EU in the present circumstances.
Question of equivalence
If the UK chooses to leave the single market, then the clearing question becomes a different one altogether: a question of equivalence for UK CCPs generally, rather than a debate about euro clearing specifically.
Today, the regulation of UK clearing houses is not just equivalent to the EU. It is identical. And the UK Financial Conduct Authority hinted the day after the referendum that it would like to keep things that way. Political tempers may be running high at the moment, but after a period of calmer negotiation it would be a very perverse outcome if UK CCPs did not receive full EU equivalence.
It would also be counterproductive for the EU. For reasons of language and the convenience of UK financial contract law, it seems likely that London will remain a major centre for US dollar clearing in the European timezone. Refusing to grant equivalence would cut off EU institutions from that facility.
Clearing is, by its very nature, a global cross-border business. There has been much sabre rattling in recent years between the EU and the US over CCP equivalence. But, in the end, the EC has repeatedly postponed punitive capital requirements on EU banks facing US clearing houses, pending an equivalence deal to avoid imposing those capital charges. There seems little reason to think the same logic will not apply in the case of the UK: it is the EC and Esma that will determine whether UK CCPs are equivalent, not the French president.
Suffice it to say, LCH and its peers are unlikely to have to think about moving their euro-clearing facilities out of London any time soon.