Blog Post

Brexit and the UK’s Euro-denominated market: the role of clearing houses

Clearing houses in the UK operate an extremely sizable market in euro-denominated transactions. However, even though the numbers are big in value terms, in substance, clearing houses shifting to the continent will not make a big difference to the UK economy and employment. Arguably, there is a case for the ECB to claim that euro area business of clearing houses be relocated.

By: Date: June 7, 2016 Topic: European Macroeconomics & Governance

The UK is home to both the largest “over the counter” (OTC) Euro foreign exchange transactions market and the largest OTC interest rate derivatives market in the world. Around 1 trillion euros are exchanged in the UK every day, compared with 395 billion euros in the US. In terms of interest rate derivatives, including forward rate agreements, swaps, options and other products, the UK is a clear market leader in euro-denominated transactions, with a daily turnover of 927 billion euros.

The numbers above indicate the importance of the UK as a financial center for euro-denominated transactions. At the same time, such a large share of euros being traded in a non-euro area country raises questions about the supervision and sustainability of liquidity provision, particularly if there is financial turmoil.

There are three clearing houses operating in the UK which are recognised by both the UK and the EU: CME Europe, a derivatives exchange and wholly-owned subsidiary of US-based CME group, the London Clearing House LCH Group Ltd., majority owned and operated by the London Stock Exchange Group, and the London Metal Exchange Limited.

Of the three clearing houses, LCH Ltd. has by far the biggest share of the euro-denominated market operating from the UK. Through its SwapClear service, unlike the CDSClear (credit default swaps) and part of RepoClear market located in Paris, it clears more than 50% interest rate contracts and represents 95% of the cleared OTC interest rate swap (IRS) market.

In terms of LCH’s euro-denominated transactions, interest rate swaps, forward rate agreements and oversight indexed swaps constitute the biggest share of swap transactions with 187 billion, 121 billion and 160 billion euros cleared respectively, out of the total of 479 billion euros traded daily. In the repo market the monthly clearing volume is approximately 5.8 trillion euros, although it covers a range of markets, not only euro-denominated markets.

In 2011, the ECB raised concerns over “the development of major euro financial market infrastructures that are located outside of the euro-area” in a Eurosystem Oversight Policy Framework document. In particular, the ECB stated that the development of offshore centralised counterparties (CCPs), better known as  clearing houses that clear and settle large amount of euro-denominated transactions, is of systemic importance to the euro area. It argued that these settlements “should be legally incorporated in the euro area with full managerial and operational control”. The threshold was drawn at clearing houses that have a daily credit exposure of 5 billion euros in one of their main transaction categories.

In response to the ECB’s location requirement, UK government argued in September 2011 at the General Court in Luxembourg that the Overnight Policy Framework should be annulled. It contended that under the Treaty on the Functioning of the European Union (TFEU), the ECB lacks competence to impose such requirements on the clearing houses. Furthermore, by imposing location requirements ECB violates the freedom of establishment, freedom to provide services and freedom of movement of capital in the single market.

After 4 years of legal battles, in March 2015 the General Court ruled in favour of the UK, stating that the ECB lacks explicit regulatory competence with regard to the securities clearing systems. In order to obtain rights over securities clearing, the ECB would need to seek an amendment in the TFEU. Since the competence argument was enough to annul the case, the court ruled that it was unnecessary to bring the “no discrimination” argument of the single market.

If the UK votes to leave the EU and the activities of the clearing houses shift to the continent, the direct economic impact would likely be small, due to the capital intensive nature of CCPs. For instance, LCH Clearnet Group’s overall operating profit for 2015 was 78 million euros, from which the UK subsidiary had an operating profit of 63 million euros, and employs around 450 people. LCH Clearnet SA (a subsidiary based in France) had an operating profit of 28.8 million euros and has 168 employees. As such, in terms of job losses the effect would be negligible.

However, from a wider perspective, the UK leaving the EU would result in significant limitations and regulatory uncertainty for the UK financial industry in general. This would impact clearing houses in particular in terms of their access to the euro market. In the event of a Brexit, the loss of “passporting” rights, exacerbated by regulatory uncertainties and delays surrounding the re-negotiation agreements in financial services, might trigger changes in the euro-denominated market of the CCPs. This includes the possibility of a gradual shift of activities to the continent. Plus, CCPs would be wary of the fact that, as a non-member, the UK has no legal means to enforce the ECB to credibly commit to the liquidity swap agreement. Such legal uncertainty would mean significant risks in an event of a liquidity crisis.

Suppose the liquidity shift does not happen and the ECB commits to maintaining a liquidity swap line, the sheer size of the euro-denominated liquidity injections necessary to offset a crisis could be destabilising for monetary policy (Armstrong 2016).

By publishing the Oversight Policy Framework, ECB has made it clear that euro-denominated activities of clearing houses are a systemic risk to functioning of the euro-area. It is impossible to know whether the ECB will attempt to impose the “location” requirement again or attempt to amend the TFEU to specifically seek competences with regard to the securities clearing systems. However, it will be much harder for the UK to influence the course of action if it is no longer a member of the EU.

 

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Opinion

A Brexit deal is still not achieved

The UK paper should be seriously considered. While it breaks a number of European red-lines, it is also an attempt to solve some issues. The question is whether the EU will be ready to seriously negotiate. Geostrategic considerations suggest that it is time for the EU to do so.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 13, 2018
Read about event More on this topic

Past Event

Past Event

Designing a new institutional framework for UK-EU relations

Finding the right way forward for the EU and the UK.

Speakers: Raphael Hogarth, Jill Rutter and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 13, 2018
Read article

Blog Post

Trading invisibles: Exposure of countries to GDPR

This blog post identifies provisions of the EU’s General Data Protection Regulation (GDPR) that affect foreign companies, and discusses implications for trade in services with the EU. The authors provide a novel mapping of countries’ relative exposure to these regulations by a) measuring the digital maturity of their service exports to the EU; and b) the share of these exports in national GDP.

By: Sonali Chowdhry and Nicolas Moës Topic: European Macroeconomics & Governance, Global Economics & Governance Date: June 28, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: The drama of the EU and euro area

Bruegel's director, Guntram Wolff, is joined by Ashoka Mody, visiting professor in international economic policy at Princeton University to discuss topics from his latest book, Euro tragedy: a drama in nine acts.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: June 27, 2018
Read about event More on this topic

Past Event

Past Event

Euro tragedy: a drama in nine acts

This event will feature a presentation by Ashoka Mody of his new book, which argues that the Euro is at the root of the problems the European Union faces today.

Speakers: Maria Demertzis, Ashoka Mody and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 27, 2018
Read article More by this author

Parliamentary Testimony

European Parliament

The potential impact of Brexit on ICT policy

Testimony before the European Parliament's Committee on Industry, Research and Energy (ITRE).

By: J. Scott Marcus Topic: European Parliament, Innovation & Competition Policy, Testimonies Date: June 27, 2018
Read article Download PDF More on this topic More by this author

Working Paper

EU financial services policy since 2007: crisis, responses and prospects

This paper presents a holistic overview and assessment of the European Union (EU)’s financial services policy since the start of its financial crisis in mid-2007. Its emphasis is on public policy initiatives and developments at the European level, including those specific to the euro area.

By: Nicolas Véron Topic: Finance & Financial Regulation Date: June 21, 2018
Read article More on this topic

Blog Post

Is the ECB collateral framework compromising the safe-asset status of euro-area sovereign bonds?

Central banks’ collateral frameworks play an important role in defining what is considered as a safe asset. However, the ECB’s framework is unsatisfactory because it is overly reliant on pro-cyclical ratings from credit rating agencies, and because the differences in haircuts between the different ECB credit quality steps are not sufficiently gradual. In this note, the authors propose how the ECB could solve these problems and improve its collateral framework to protect its balance sheet without putting at risk the safe status of sovereign bonds of the euro area.

By: Grégory Claeys and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: June 8, 2018
Read about event

Past Event

Past Event

Financial services after Brexit - what path for the EU27 and the UK?

How will the European financial services industry develop after Brexit?

Speakers: Dashiell Caldwell, Richard Knox and Francesco Papadia Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 30, 2018
Read article Download PDF

External Publication

The changing fortunes of central banking

What are the major challenges of central banks today? This book discusses the developing role of central banks and the policies they pursue in seeking monetary and financial stabilisation, while also giving suggestions for model strategies.

By: Philipp Hartmann, Haizhou Huang and Dirk Schoenmaker Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: May 29, 2018
Read article More on this topic More by this author

Opinion

La PAC n’est pas taboue

Dans cette chronique, l'auteur estime qu’une renationalisation graduelle de certaines politiques pourrait utilement contribuer à la nécessaire redéfinition du modèle agricole français..

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: May 28, 2018
Read article More on this topic More by this author

Blog Post

Are SBBS really the safe asset the euro area is looking for?

The European Commission is pushing to create a synthetic euro-area-wide safe asset in the form of sovereign bond-backed securities (SBBS). However, SBBS do not fully fulfil their original promises. If introduced on a massive scale, they might increase the supply of safe assets in good times and loosen the link between sovereigns and banks. But they will not give governments a means to maintain market access during crises, they might change incentives for governments to default, and they could pose a problem to individual bonds not included in SBBS if, in the end, they are put at a regulatory advantage vis-à-vis individual bonds.

By: Grégory Claeys Topic: Finance & Financial Regulation Date: May 28, 2018
Load more posts