Brexit Raises Fragmentation Risk

Shanny Basar

Eric Müller, chief executive of Eurex Clearing, Deutsche Börse’s central counterparty said the key global trend on his radar is the uncertainty from the UK’s decision to leave the European Union as the trading bloc looks set to try to retain control of euro clearing.

Müller discussed the competitive landscape with the World Federation of Exchanges following the WFE IOMA derivatives and clearing conference in Frankfurt last month.

The UK has voted to leave the European Union but approximately three-quarters of euro-denominated derivatives transactions are in London according to the Bank for International Settlements. In addition LCH, owned by the London Stock Exchange Group, is the largest global clearer of interest rate swaps. The European Central Bank has previously tried to force euro clearing to move away from London into the Eurozone but lost a court case before the EU General Court in 2015. After Brexit the UK may not have the ability to bring a similar case at the EU court.

Müller told the WFE that the one thing on everybody’s mind is the Brexit decision which has created widespread political uncertainty and requires all market participants to plan ahead.

Eric Müller, Eurex Clearing

“There’s no doubt that continental Europe will have to continue its close cooperation with the UK, the rules applicable to international markets and to competition do not change overnight,” he added. “But these rules call for new, more intelligent solutions to prevent imbalances.”

The Financial Times has reported that the EU proposal to take control of euro clearing will be made public this week.

Last September analytics and research firm Clarus Financial Technology warned that total initial margin requirements could double if clearing of Euro-denominated derivatives is forced to shift from London. Clarus calculated in a blog that initial margin could double from $83bn to $160bn if Euro clearing has to move to the Eurozone.

Clarus estimated the effect of leaving non-euro interest rate derivatives portfolios in London while moving euro-denominated business into the Eurozone using publicly available data. Clients would have to post more margin as they would not the benefit of netting euro positions against other currencies in their swap portfolio.

“When we model the LCH SwapClear portfolio as only two counterparties, we estimate that initial margin would nearly double – from $83bn to $161bn,” Clarus added. “This arises from moving a €1 trillion 12 year position from the UK into a new Eurozone clearing house.”

Müller continued that the EU has made significant progress towards co-ordinated financial market regulation and supervision, but inconsistencies have appeared in some areas such as the decision making process on CCP equivalence so capital markets remain fragmented.

“The political uncertainty generated by recent events, such as the British referendum and the US elections, emphasises the need for further European integration,” Müller said. “The decision of the UK to leave the EU leaves many questions regarding the evolution of financial regulation, market access and the future of the Capital Market Union up in the air.”

The International Capital Market Association also warned in its latest quarterly report that in Europe, the main risks of capital market fragmentation currently relate to Brexit and the future composition of the euro area.

Paul Richards, head of market practice and regulatory policy at Icma, said in the report that it is not yet clear whether the UK will be able to negotiate a bilateral free trade agreement which provides access to the EU Single Market for the UK as a third country (and vice versa).

“One approach would be to establish and maintain equivalence in capital market regulation between the UK and the EU27, with an independent third party for resolving disputes,” added Richards. “An alternative would be for firms involved across EU capital markets to be separately authorised, capitalised and staffed in both the UK and the EU27, if they are not authorised already.”

Richards warned that if the negotiations between the UK and the EU27 fail to reach an agreement this could lead to regulatory divergence, raising costs for firms operating in two separate markets; a regulatory “race to the bottom” raising financial stability concerns; and capital market fragmentation if CCPs with significant euro-denominated business are required to be located in the euro area.

He continued that CCP regulation is also not harmonised in the EU and US and research has shown that global derivatives markets have fragmented along geographic lines since the introduction of the US swap execution facility regime in 2013.

“Although Emir allows appropriately regulated third-country CCPs to operate in the EU, the US applies a different approach to authorising foreign clearers to operate in the US by requiring a full assessment by the CFTC,” said Richards.

Müller continued that other political events with the potential to create a seismic shift, such as the French elections on Sunday, are driving investors towards exchange-traded derivatives and the trend away form over-the-counter transactions is set to continue. In addition, the concentration of client risk in a limited number of risk-taking entities remains a challenge for systemic stability new  models allowing more clearing users to become direct members of a CCP, rather than using a clearing member, will become more important.

“To address this need, since summer 2016, buyside clients can become direct participants with our clearing house via our ISA Direct model, which allows them to significantly reduce their counterparty risk,” added Müller.

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