Alarm bells are ringing in both Westminster and the City as Brussels intends to explore how to impose EU control over London’s dominance of the euro clearing business.
Ever since the EU allowed London to clear euro-denominated swaps — despite not being in the EU — in the late 1990s, the issue has irked Brussels. Equally, few forecast how the business would mushroom in the 21st century, nor how big London would become.
Now, as Brexit negotiations beckon and already appear fraught, here are the key questions for the City and policy officials.
What is the debate about?
The controversy is less about jobs and income from financial services and more about being able to monitor and intervene so as to prevent systemic shocks.
The EU is concerned that clearing houses — also known as central counterparties, or CCPs — may pose significant systemic risk to the broader financial system. Therefore, a regulator must have the ability to step in and calm markets, either through increased supervision or via a funding backstop.
The problem is that most euro-denominated derivatives are cleared at the London-based LCH, which will be outside of the EU once Brexit is completed.
The role of CCPs came under the microscope in the eurozone crisis in 2011, when LCH unnerved markets by raising margins on Irish and Portuguese government bonds.
The European Central Bank in 2011 suggested clearing houses should be based in the eurozone if they handled more than five per cent of a euro-denominated product. The European Court of Justice subsequently ruled the European Commission and European Securities and Markets Authority had clearing house oversight, not the ECB.
How does the EU regulate clearing houses?
Europe runs a two-tier system. Clearing houses in the 28-country bloc are overseen by a college of regulators, which consists of the CCP’s national authority, plus other interested authorities. The college composition varies, but each would typically include two regulators and at least one central bank.
But it cannot have representation from a body outside the EU, so, for example, the US Federal Reserve or the Commodity Futures Trading Commission, the main derivatives regulator, do not have a voice.
For clearing houses beyond its jurisdiction, the EU allows the home country to be the principal regulator, so long as the country’s laws are deemed equivalent to the bloc. The EU has equivalence rulings with all the major derivatives clearing jurisdictions, including Japan, Singapore and the US.
Once the UK has left the EU, it will be eligible to be recognised as a third country and it already operates under EU rules. But “the political mood prevailing at the time could convert what should be a straightforward exercise into a protracted negotiation”, the FSN Forum, a UK lobby group, noted in January.
How does the US oversee London clearing houses?
The US approach is starkly different. It demands that entities overseeing US-denominated activities which are traded by US customers are directly registered with its agencies. It does not matter if the entity is not domiciled in America.
London clearers such as LCH and Intercontinental Exchange are registered with the CFTC and are regularly inspected by them, in the same way a domestic clearer would be. In this context, the UK’s departure from the EU makes no difference.
Whether the EU wants to relocate euro-denominated business or switch its regulation to a US-style oversight of clearing houses will be one of the key issues from the commission’s proposals.