Finance & economics | Clearing out

The EU ponders moving euro clearing from London after Brexit

Tens of thousands of jobs are at stake in Britain

BREXIT has thrust a mundane, if crucial, bit of financial-market plumbing into the spotlight: the clearing of financial instruments. Clearing-houses sit in the middle of a securities or derivatives transaction, and ensure that deals are honoured even if one counterparty goes bust. In November a study commissioned by the London Stock Exchange (LSE) warned that if euro clearing was forced out of the City, 83,000 British jobs could be lost, and a further 232,000 affected. On May 4th the European Commission said it was looking into new rules for euro-denominated clearing. One option is relocation from London, an idea greeted in the City with a mixture of incredulity, disdain and fear.

In the wake of the financial crisis, the G20 group of big economies made it mandatory to settle most simple derivatives trades through clearing-houses. By 2016, 62% of the notional $544trn global over-the-counter derivatives market was settled in this way. Globally, London handles 37% of foreign-exchange derivatives and 39% of interest-rate derivatives, including three-quarters of those in euros (see chart). So unsurprisingly, it also dominates clearing. LCH, a clearing-house that is part of the LSE, clears over 50% of all interest-rate swaps across all currencies. Around 75% of those in euros are cleared in London.

But centralising clearing concentrates risk: the failure of a clearing-house would be disastrous. So clearing-houses require collateral from the counterparties using them, and must submit to close supervision. The European Central Bank has long worried that it has no direct control over euro-denominated clearing outside the euro area, yet any problems would embroil banks and payment systems within it. In 2015 it lost a court case against Britain over its attempt to force clearing to move. Many jurisdictions, the EU included, limit their financial institutions’ access to foreign clearing-houses. The European Securities and Markets Authority (ESMA) lets European firms use clearing-houses only in countries it has deemed “equivalent”, ie, America and a dozen others.

Brexit necessitates a new arrangement. The City has mostly been focused on obtaining “equivalence”. But the commission argues the systemic importance of British clearing-houses for the euro area may well require new, stricter oversight. So it is assessing two other options. “Enhanced supervision”—favoured by ESMA—would mean adopting the American model, in which clearing-houses that deal directly with American clients, such as the LCH, are also supervised by the American regulator. But the other option—forced relocation—has gained the support of many senior EU policymakers. Barney Reynolds of Shearman & Sterling, a law firm, insists it would not amount to much: the most the EU could do is to compel European banks to use EU-based clearing-houses. Since firms based in the EU outside Britain account for only 7% of cleared euro-denominated interest-rate derivatives at LCH, the impact could be modest for London. LCH itself claims the result would be a larger euro-denominated market outside the EU and a smaller, less-liquid euro-area market.

Since America tolerates 97% of dollar interest-rate swaps being cleared in London, it seems perverse for the EU to shift euro clearing. But Simon Puleston Jones of FIA, an industry body, points out that America is comfortable because its regime allows its regulators much greater oversight. If Brexit turns acrimonious and precludes a moderate change such as enhanced supervision, Europeans may seek blunter instruments. It is not just Brexiteers who want to take back control.

This article appeared in the Finance & economics section of the print edition under the headline "Clearing out"

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