Before the Brexit talks have even begun, Brussels is preparing for life with the City of London outside the EU.
The European Commission will on Tuesday say what it plans to do about London’s lucrative euro clearing market — the envy of financial centres on the continent.
This is a critical part of London’s financial services sector and the volume of business can exceed a notional $900bn a day. It centres on the processing of euro-denominated derivatives contracts by clearing houses such as the London Stock Exchange’s LCH.
Brussels’ proposal, seen by the FT, will be that EU regulators should be given powers to vet overseas clearing houses. Those assessed to pose a “systemic risk” to Europe’s financial stability will face a range of requirements if they want to maintain smooth access to the EU market.
In extreme cases, they could be told to relocate to Europe if they want to retain regulatory approvals that help them do business.
What is euro clearing?
The unheralded world of clearing has become a pillar for global financial market stability since the 2008 financial crisis. A clearing house, such as LCH or Deutsche Börse’s Eurex, stands between two parties in a deal, insulating the rest of the market if a trader defaults on payment.
The City is the dominant global location for clearing derivatives contracts that are denominated in euros even though the UK has never been in or intended to join the eurozone.
What is Brussels worried about?
The problem is simple. Current rules would leave the EU with little say over how clearing houses in the UK are policed once Britain leaves the single market.
This is an acute concern because the operations or failure of a UK-based clearing house could have massive ramifications for the EU.
For example, an often heard complaint for European regulators is that LCH aggravated the eurozone’s sovereign debt crisis in 2011 by raising its margin requirements — the amount that market participants needed to post as collateral — on debt for Spain and Ireland.
The EU’s proposal is about addressing this lack of control.
What does the EU want to do?
The EU will propose giving the European Securities and Markets Authority, an EU agency based in Paris, powers to assess the systemic risks posed by overseas clearing houses.
It would look at their size, structure and how much of their business is in EU currencies. Its assessments could lead to clearing houses facing new requirements.
What extra rules could clearing houses face?
For those not deemed to pose a potentially systemic risk, nothing would change. But those judged systemic would have to meet special conditions, among them compliance with an EU law for the sector known as the European Market Infrastructure Regulation, and accepting policies put in place by EU central banks, for example when it comes to collateral management.
Refusing to do so would mean a clearing house would not be “recognised” by the Esma. It would become far more expensive for European banks to use the clearing house — the amount of capital they would have to set aside to underpin transactions would rise dramatically.
Esma and the central banks could also deem a clearing house to have “specifically substantial systemic significance” for the financial system. In such cases, Brussels could decide to make Esma “recognition” conditional on the clearing house shifting activities to the EU. It is likely that LCH is particularly at risk from that judgment, because of its large market share.
How is this linked to the formal Brexit negotiations?
Legally, not at all. What the commission is putting on the table is a proposal to amend EU law — entirely outside the Brexit talks.
But it shows how Brussels is already moving to adjust to life without the UK, and that it does not want to rely on the exit talks to settle all questions of Britain’s future access to the EU financial services market.
What does this mean for the City?
One thing Tuesday’s announcement from Brussels will not give the City is certainty.
This is the start of a long process involving the European Parliament and the European Council, which represents national governments. They have the power to amend the plans.
Nevertheless it is unlikely that the market will move much of its euro-denominated business until it is formally told to. There are tremendous cost efficiencies for banks and other market participants in having large, and fewer, capital pools and LCH is the biggest by some distance.
Indeed since last summer LCH has taken on even more business. Its owner, the London Stock Exchange Group, on Monday predicted double-digit growth for the next two years.
Is this all just about the UK?
No, the proposals are likely to be scrutinised closely in the US. Its clearing houses will also go through the vetting process to assess the systemic risks they pose.
Brussels is likely to argue that much of what it is proposing mirrors powers that US regulators, such as the Commodity Futures Trading Commission, have long enjoyed, but which up to now have not been available to the EU.