Why the Brexit battle over London’s derivatives dominance may drag on for years

The battle for London’s trading and clearing of derivatives is heating up. But it probably won’t be settled any time soon.

The 18-month temporary equivalence agreement between the UK and EU is likely to be extended, says William Wright, founder of think tank New Financial. That’s because the EU would want enough time to ensure orderly trading until its financial hubs are sufficiently able to handle the sheer volume of some quadrillion dollars in trades.

“Currently, it’s in [The EU’s] interests to continue to grant that equivalence” to UK clearing houses including LCH Group, which is majority owned by the London Stock Exchange, Wright told Financial News. “When it is no longer in their interest or necessary” for EU banks to use UK clearing houses, “it will close down this equivalence”.

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But that may take years. Since Britain’s vote to leave the EU more than four years ago, the clearing of euro-denominated derivatives has become a key battleground. The bloc relies heavily on the UK for clearing services. According to the European Commission, the EU’s executive arm, more than 90% of euro-denominated over-the-counter interest-rate derivatives were cleared at LCH, though Deutsche Börse’s Eurex is competing for that business.

The fight appears to be getting uglier. According to a Reuters report on 23 February, the EU has asked Europe’s largest banks to explain why they shouldn’t have to shift the clearing of euro derivatives from London to the continent. Some has already shifted. An IHS Markit report on 11 February showed that the UK’s share of euro-denominated interest rate swap trading had fallen from 40% in July to around 10% as of January.

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“EU capacity in clearing won’t be robust enough to take it over” even if the bloc does succeed in cleaving away market share from London clearing houses, Wright said. Some clearing will migrate during the 18-month agreement, Wright says, but not enough that the EU decides that they don’t need the LCH anymore.

The EU has already chipped away at London’s dominance in other financial areas. The lack of a Brexit deal for financial services means European investors can no longer trade euro-denominated stocks and derivatives on UK venues, which has resulted in a pronounced shift in liquidity to continental platforms. Data from exchange operator Cboe shows that around €6bn in European share dealing moved to EU venues on 4 January.

Bank of England governor Andrew Bailey warned about the looming battle for clearing, specifically noting a potential “attempt at extra territorial legislation or an attempt to force or cajole banks and dealers to say there will be some other penalty for you, unless you move this clearing activity into the EU area,” Bailey said. “That seems to be where the debate is heading.”

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Wright added: “An additional risk is how much of the non-euro denominated business moves if a large European bank is forced to move all of its clearing to an EU clearer, how much of sterling, dollar or yen clearing will move as well.”

And some have warned that New York may be a key winner in the fight for market share. The European Union said on 27 January that it would allow US firms to provide central clearing services in the trading bloc, having determined that US central counterparties are regulated in an equivalent manner to their European peers. A survey from financial consultancy firm Duff & Phelps found that New York has continued to gain at London’s expense following the Brexit vote.

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After the 2008 financial crisis, global regulators made it mandatory to process large volumes of derivatives through clearing houses in order to reduce systemic risk. After a large default, such as the collapse of Lehman Brothers, clearing houses can step in to ensure trades complete.

Previously, large parts of the derivatives market were uncleared, with trades handled bilaterally between traders at banks.

To contact the author of this story with feedback or news, email William Canny

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