Hello from London, where relaxing lockdown rules means we can enjoy a pint in the pub and contemplate the biggest post-Brexit battle in financial services. It’s a high stakes game of poker for billions of dollars of capital and a miscalculation could have unintended consequences.
We’ll have more on one specific aspect of that battle — control over clearing euro-denominated derivatives — in today’s main piece. Tall Tales looks at the latest goings-on with the Ever Given container ship.
Why market dynamics mean clearing will not shift
After the 2016 Brexit referendum result, it was clear that Europe’s financial and economic landscape would shift. Within days of the vote, EU political leaders had signalled where their overriding preoccupation would lie. Not jobs, but ending London’s stranglehold on the clearing of interest rate swaps denominated in euros.
An odd focus in the circumstances, but it goes to the heart of the euro currency and its stability. Five years on and London’s grip on this market is tighter than ever, turning the issue into a battle between political will and market practice.
A clearing house stands between two parties in a trade, acting as a counterparty and ensuring one side is paid if someone defaults on payment, and the effect spreads through the market.
They shot to the forefront of global regulators’ attention after the 2008 financial crisis, as officials sought to design tougher rules to stabilise markets. The biggest and most systemic clearing house is the UK’s LCH, controlled by London Stock Exchange Group. It handles 90 per cent of all euro denominated derivatives, with a notional value of €81tn, or $97tn.
EU authorities have never been happy about the business being congregated in London with the UK out of the single currency, but Brexit has made the situation intolerable in their eyes. The EU wants to make itself less reliant on London and fears UK regulators would not have the stability of the eurozone as their top priority.
Whether derivatives clearing contributes to potential instability is a question rarely asked (it’s highly debatable). Even so, Brussels wants the market to reduce its “excessive exposures” in London and build up capacity in the eurozone.
The rapid shift of euro denominated shares from London in January has heightened sensitivities on both sides of the Channel. But that made sense — EU shares were only really traded in London because the UK was in the single market. Swaps clearing has a different dynamic and a split in the liquidity, or depth, of the market is rare.
Clearing is not especially lucrative; what matters are the billions of dollars of margin and collateral that users are required to post to support trades that can be open for months or years. Positions are netted down in a clearing house to offset that heavy burden, saving users millions of dollars. Splitting the pool of liquidity would raise costs because there are fewer positions to net.
Other factors illustrate the radical nature of the EU’s plan. Clearing is a global market. EU institutions’ euro volumes are only 6 per cent of all interest rate swaps cleared at LCH. Most of London’s business comes from the US. LCH also clears 90 per cent of the world’s dollar derivatives, with a notional value of $129tn. London is a strategic offshore financial hub — but for US interests.
The market also likes the UK’s flexible and commercially minded bankruptcy laws, a critical concern if things were to go badly wrong. EU watchdogs have little collective experience in overseeing clearing of swaps, raising concerns among bankers.
For example Brussels has given little guidance as to what is an acceptable level, nor even how it is has determined what “exposure” is. Derivatives markets tend to use notional numbers, to show the extent of trading activity. It reflects the value of the contract and creates those dizzying numbers. However, they are very poor measures of the level of risk in a derivatives portfolio because positions are netted down. A contract with a notional amount of $1tn does not mean someone may lose $1tn. The real “at risk” number is usually measured in low-digit billions at most.
UK officials have also argued that splitting the market would not make it safer when prices gyrate wildly, because the market is global and concentrated. Market participants suddenly need funds that can be used to plug leaks that have sprung. Demands from clearing houses for initial margin, held to cover potential losses from a default, doubled to $343bn in the pandemic-induced volatility of the first quarter last year, for instance.
That means finding ways for banks to access cheap funding, and is best supplied by central bank currency swap lines already in place between the Bank of England and the European Central Bank or the repo market, where banks can temporarily exchange assets for collateral.
These issues are cutting little ice in Brussels. EU policymakers say the industry’s arguments often boil down to concerns about extra costs, and that a price cannot be placed on its financial stability.
A temporary permit, known as equivalence, allows EU institutions to use London right now, but it runs out in June next year. After that, Brussels could opt for permanent equivalence, a continuation of the status quo. But that seems unlikely unless a deal is struck between the UK and EU.
Brussels could let the permit lapse and perhaps a quarter of cleared euro swaps would move to the bloc, according to Bank of England governor Andrew Bailey. The rest are held by non-EU institutions, and could well remain in London, putting EU banks, cut off from LCH, at a cost disadvantage. Or the EU may order all global euro clearing takes place in the bloc — the nuclear option Brussels is very hesitant to use.
The ultimate problem the EU has is that cost is inseparable from the market. Charges associated with clearing are not one-offs, as setting up an EU office might be. And while Brussels may effectuate a split, US banks are the main players in this market and there’s no guarantee EU users won’t look at ways of channelling deals to London, probably via the US, in an effort to lower costs. As politics and money collide, trying to find a balance is no easy matter.
Tall tales of trade
Will the Ever Given ever escape the Suez Canal? The huge container ship that made an unplanned berth last month that left it blocking one of the arteries of world trade for more than a week is being held by the Egyptian authorities.
An Egyptian court ordered the container ship to be seized while talks continue between the Suez Canal Authority and the ship’s Japanese owner and its insurers. The blockage affected just under 80 container ships, transporting goods with a retail value just over $80bn, according to project44, a logistics data provider.
The authority earlier this month made a $916m claim for damages, a sum which amounts to $152.7m for each day the canal was blocked. That, as one FT reader put it, makes it “the most expensive parking ticket ever”.
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