The European Central Bank (“ECB”) has warned that Brexit will mean that it will be difficult for the UK to retain its dominant role in Euro-denominated derivatives clearing. London currently is the world’s largest centre for Euro-denominated derivatives clearing, handling three-quarters of all transactions, with an average daily value of $573bn according to a recent Intercontinental Exchange (ICE) paper. The Bank of England oversees this Euro-denominated clearing activity, but the ECB cooperates on regulation through its participating in European “colleges” of regulators.
Clearing houses, or “central counterparties”, are an integral part of the financial system and intermediate between buyers and sellers of financial instruments to reduce the chances of settlement risks by ensuring one side gets paid if the other fails. Clearing involves the matching of all buy and sell orders in respect of financial instruments (including derivatives, bonds, equities), while settlement (undertaken by settlement systems) involves processing the related exchanges of currencies or value.
Although most attention has been focusing on the clearing of Euro-denominated derivatives transactions, the issue of the UK’s role in ‘Euro-clearing’ is a wider consideration that includes London’s prominent role in clearing Euro-denominated bond and equity trading. A serious disruption to derivatives, bond or equity clearing houses or settlement systems could cause significant systemic problems requiring liquidity support from central banks. Post Brexit, the ECB and other EU institutions appear uncomfortable that such level of Euro-denominated clearing can continue, not only outside the Eurozone, but entirely outside the jurisdiction of the EU’s courts.
The UK could seek to continue to provide Euro-clearing post Brexit if it were to develop a system of regulation for UK based clearing houses that satisfies European “equivalency” requirements, however, the task in doing so has been described by Benoît Coeuré of the ECB’s executive board as “challenging”. Steven Maijoor, chairman of the European Securities and Markets Authority (“ESMA”), recently noted that unintended consequences had arisen in some of the 22 non-EU clearing houses currently recognised by ESMA as “equivalent”, and suggested that the equivalence system itself may need to be revisited.
Even before the UK’s Brexit vote in June 2016, the ECB had expressed its concerns regarding the clearing and settlement of Euro-denominated transactions outside the single currency area. Mario Draghi, president of the ECB, has stated that with the UK in the EU, the ECB has broad powers to oversee and supervise UK clearing houses to ensure financial stability in the Eurozone. It has been reported that Mario Draghi, in a letter to a MEP, stated that, post Brexit the UK’s regulation of Euro-clearing must at least preserve, or ideally enhance, the current level of supervision and oversight of the ECB. Achieving this will be difficult in practice.
In 2015 the UK won a case in the EU’s General Court against an ECB proposal that would have required UK based securities settlement systems and clearing houses to relocate to the Eurozone in order to clear or settle Euro-denominated transactions in relation to securities or derivatives (the proposed ‘location rule’). The UK’s position is now considerably different as a result of the Brexit vote, making the ECB much more likely to win any legal challenge on the basis that the clearing and settlement of Euro-denominated transactions is a critical piece of market infrastructure that EU institutions should oversee for the financial stability of the EU.
In the 2015 case the EU court rejected the ECB’s argument that without the Eurozone location rule, the ECB would not be able to sufficiently influence a settlement system or clearing house, potentially endangering payment systems and clearing inside the Eurozone area. The court accepted the UK’s argument that the ECB’s proposed location rule would unduly hinder the free movement of capital and services and ruled that the ECB could not impose a Eurozone location requirement on clearing houses or settlement systems. However, the court did not consider whether the ECB could impose a location rule requiring Euro-clearing to take place in the EU.
Political pressure appears to be again mounting to require this activity to take place in a Eurozone jurisdiction (or at least an EU jurisdiction) under the direct control of EU institutions. Many commentators are taking this possibility seriously, including one senior international industry speaker, who stated at the European Financial Forum in Dublin this January that he did not see how such high levels of Euro-denominated clearing could stay outside the EU.
Given the perceived importance of providing financial regulators with the necessary tools to support the stability of the Eurozone and the EU, EU regulators may once again seek to impose a location rule or other requirements to directly or indirectly discourage Euro-denominated clearing outside the EU. For example, it would not be very surprising to see more onerous credit risk related regulatory capital charges being imposed where EU financial institutions have exposures to non-EU clearing houses compared to EU clearing houses.
Moving clearing from London would involve significant new investment by clearing members, a reduced ability to net positions in multiple currencies and greater aggregate collateral requirements. Any attempt by the EU to force clearing out of London may undermine the basis on which existing third-country clearing houses benefit from equivalence rulings and could lead to a fracturing of market operations along geographical lines, ultimately harming the integrity and resilience of the market in a manner that could be harmful to EU financial markets. However, it remains to be seen whether all of this will ultimately amount to anything more than a war of words in a rapidly evolving political landscape.