Most UK fund managers are trying to reconcile quite what leaving the Single Market – as outlined by Prime Minister Theresa May – means for their business. Single Market withdrawal means the right to unequivocally distribute funds – whether they are UCITS or AIFMs – into the 27 EU member state countries looks precarious, and this concern has understandably dominated Brexit discussions among managers at industry events. This is fair enough but a growing band of buy-side firms with heavy OTC exposures are now fretting about the impact of euro-denominated swaps clearing moving from London to the EU – possibly Paris or Frankfurt.
The vice-chairman of BlackRock recently told Reuters that he could not visualise euro-denominated clearing taking place in a non-EU jurisdiction. Any forcible resettlement of these transactions would hurt the UK, particularly as it controls around 70% of euro denominated clearing, far more than second placed Paris, which holds just 11%, according to Bank for International Settlements (BIS) data from 2013. The UK has fought off similar challenges from the ECB before – successfully – having argued in European courts that location policy went against the EU’s Single Market principles allowing for free movement of goods, people, services and capital.
As the UK has confirmed it no longer wants to be party to the Single Market and those governing principles, the ECB is naturally having another stab at redrawing the boundaries for euro-denominated clearing. Benoit Coeure, a member of the ECB’s executive board, said that euro-denominated clearing’s presence in the UK was contingent on whether the country developed a sufficiently robust regulatory framework, something he conceded would be challenging. He added the UK’s market dominance was a result of solid cooperation with the Bank of England and the ECB, which was based on a foundation of EU law under the authority of the European Court of Justice (ECJ). The rejection of the ECJ by the UK puts this at threat.
The ECB is certainly within its remit to make a play for euro-denominated clearing, but it could have negative ramifications elsewhere. Firstly, the euro – like the USD, Pound Sterling and Japanese Yen – is a global reserve currency meaning it is traded and cleared all over the world. If euros can only be cleared in mainland Europe, it could result in tit for tat reprisals, which will simply exacerbate protectionism. A land-grab for euro denominated swaps clearing by a Eurozone economy would infuriate non-Eurozone EU countries. It could also prompt legal action from aggrieved non-EU banks and CCPs. In short, any regulatory attempt to prise business away from the UK – which is clearly where the derivatives market wants to be – would be counterproductive and highly complex.
Most importantly, a protectionist OTC clearing policy by the ECB would be very costly for derivative users, particularly if markets become fragmented. The costs would not just be borne by UK asset managers, but firms and investors within the EU, and globally. Unfortunately, rational behaviour should never be taken for granted, particularly given the factitious disorder that may result through Brexit. Asset managers and their investors will face a massive rise in operating costs of euro denominated swaps clearing if the process is decentralised. The European Market Infrastructure Regulation (EMIR), which the UK has fully enacted, obliges firms to clear vanilla OTC contracts through CCPs. As part of this, fund managers need to post initial and variation margin to CCPs so that transactions are fully collateralised were a counterparty to fail. Collateral must be high quality and variation margin calls will be cash only.
A fragmented clearing set up would mean firms would have to make more margin calls to a greater number of CCPs. Obtaining collateral that is suitable for CCPs is not always easy, and it is particularly challenging during stressed markets. As such, firms would see a jump in their clearing costs to potentially unsustainable levels. The lack of a centralised clearing venue would also mean cost benefits through netting and portfolio compression could be lost. The costs may be so great that some managers exit OTCs, or worse stop hedging transactions properly. Others may simply enter OTC transactions in lesser regulated markets.
Optimists believe the UK – having implemented EMIR to the letter of the law – ought to have no problems obtaining equivalence. Even so, equivalence is far from perfect as it can be arbitrarily taken away by EU policymakers. If UK CCPs do not receive recognition, the costs of clearing will increase for European banks as they must centrally clear OTCs through qualifying CCPs or face increased capital charges. Again, this would be a major blow for Eurozone banks and may be an unsustainable stance for EU policymakers to adopt. Any challenges to the UK’s position as a centre for clearing would be hugely damaging for both UK financial institutions including asset managers, as well as those in the EU.