Clearing is a crucial part of the plumbing of a modern financial system. It involves a clearing house which stands between two parties to a transaction in derivatives, bonds or other financial instruments, effectively becoming counterparty to both sides of a transaction. In doing so, the clearing house guarantees completion of the transaction if one party defaults. For this service there is a fee to be paid and margin payments (depositing of funds) required of counterparties.
London dominates euro clearing
As in most European financial markets London dominates the clearing of Euro denominated transactions, despite the UK’s permanent status outside the Eurozone. London is estimated to have around a 75 per cent share of a market worth up to Euro 900bn a day and employing around 80,000 people in London. The London Clearing House (LCH) is by far the dominant player in London, reflecting the significant economies of scale available in this business.
European Commission seeks control of the market
The European Commission (EC) has just issued proposals on Euro clearing which may well be the first shot in the battle for European financial services post-Brexit. These are not part of the official Brexit negotiations due to start this week but more of a parallel move, adjusting EU law in anticipation of the UK’s departure. The EC has not adopted the direct approach of simply restricting Euro clearing to the euro area – as tried by the European Central Bank but rejected by the European Court of Justice in 2011. Instead the Commission wishes to gain greater control and ultimate sanction over UK clearing houses once we have left the single market. This time financial stability concerns are the pretext for much greater intervention and control.
Briefly, the proposal is that any clearing house deemed systemically important will become subject to regulation by the European regulatory body, the European Securities and Markets Authority (ESMA), and ECB. This control would include compliance with certain EU laws and include collateral and margin requirements. But the ultimate sanction for a clearing house considered to be of “specifically substantial systemic significance” would be a requirement to conduct business within the EU. Failure to do so would result in loss of status as a recognized clearing house, dramatically raising the cost of doing business.
Proposals would raise costs and reduce liquidity
These proposals have all the hallmarks of a political land grab dressed up as a concern over financial stability. Since the LCH guarantees transactions and is a London-based financial institution there is a financial stability issue in the UK, monitored and regulated by the UK authorities. Moreover, there is a good chance that, if enacted, these proposals will achieve the opposite of their declared intention – financial instability. By imposing potentially significant extra costs on euro clearing and especially if an attempt is made to force business within the EU the volume of business would decline along with liquidity, probably markedly so. The clearing house function allows financial institutions to lay off risks to those in a better position to accept them. Reduced clearing house activities would mean more concentrated risks and greater systemic risk in the financial system, not less.
Finance 101 – increased risk means higher margin requirements
As so often with EU regulation there is a lack of understanding as to how markets work. The LCH was criticized by European regulators for raising its margin requirements on Spanish and Irish sovereign debt during the Eurozone crisis of 2011. Talk about shooting the messenger! Given the increased risk of default during the crisis, reflected in significantly higher government bond yields, it would have been negligent of the LCH if they had not increased margin requirements. Counterparty risk had increased so margins increased – as they did following the collapse of Lehman Brothers in 2008.
The euro clearing proposals now begin a long journey through the European Parliament and European Council: details may be amended, the spirit will not be. Some regulatory oversight in this area is inevitable. Good regulation addresses a market failure – here it is the classic systemic risk argument – that the collapse of one financial institution could have serious consequences for the wider financial system and that this risk is not fully reflected in the actions of private institutions. Hence there is a need for regulatory oversight and capital adequacy requirements. The EC proposals appear to have less to do with addressing market failure and more to do with the failure of any other EU city to develop a financial centre anywhere near comparable to the City of London.