The European Central Bank (ECB) fired the first real salvo in its fight to claw back from London the lucrative business of clearing euro-denominated derivatives. And, typical for a central bank announcing bad news, it did it on a summer Friday, when the holiday spirit takes over London's hard-working bankers (especially as the U.K. has just gone through its hottest June day in 40 years).
On June 23, 2017, exactly one year after the Brexit vote, the ECB published a recommendation it made to the European Parliament and the European Council to give it the right to make regulations regarding the clearing of financial instruments "within the Union and with other countries."
Readers probably remember that in 2015 the European Court of Justice stopped short an attempt by the ECB to wrest control of euro-denominated derivatives clearing from London, arguing that the ECB did not have the authority to request such a thing. Now, the ECB is making sure it will have that authority.
There are 17 central counterparties (CCPs), as clearing houses are officially known, which are authorized to offer clearing services in the European Union. Of these, four are in the U.K. under the supervision of the Bank of England: LCH Ltd., CME Clearing Europe Ltd., LME Clear Ltd., and ICE Clear Europe.
At present, London clears about two-thirds of all existing euro-denominated derivatives. When it comes specifically to euro-denominated interest rate swaps, LCH Ltd. clears $84.3 trillion, or 97% of them, according to data from the European Commission quoted by Bloomberg.
Because not all CCPs are authorized to clear all derivatives, London's role is even more prominent. For example, of the two CCPs that are authorized to clear credit derivatives, one -- ICE Clear Europe -- is situated in London (the other one is Paris-based LCH SA). Of the two CCPs that can clear derivatives based on inflation, one, LCH Ltd., is in London; the other is Eurex Clearing AG, based in Germany.
The ECB makes clear that as the issuer of the euro currency, it is uneasy that after Brexit these important CCPs will be out of its jurisdiction so it will not be able to supervise them.
"A substantial volume of euro-denominated derivatives transactions (and other transactions subject to the EU clearing obligation) is currently cleared in CCPs located in the United Kingdom," the ECB said in its recommendation.
"When the United Kingdom exits the EU, there will therefore be a distinct shift in the proportion of such transactions being cleared in CCPs outside the EU's jurisdiction ... This implies significant challenges for safeguarding financial stability in the EU that need to be addressed."
Among the dangers of such clearing happening outside its jurisdiction, the central bank highlighted the risk that certain practices or changes in risk management models could go undetected, which could hurt financial stability in the EU.
There is also a potential conflict between the non-EU supervisor's objectives and those of the ECB, with each supervisor seeking to ensure financial stability on its own turf. A big risk the EU fears is the potential relaxation of regulation in the U.K. post-Brexit, which would lead to an unlevel playing field with the EU as investors would choose the market with the laxest regulations.
"There is currently no mechanism to ensure that the EU is informed automatically of such changes and can take appropriate measures," the ECB said.
The ECB's recommendation shows it is taking the issue extremely seriously and will not stop until it ensures it has control over London's clearing businesses. Whether this will force CCPs to give up on euro-denominated clearing altogether or move some operations to the eurozone will depend on what the U.K. negotiates with the EU. But London-based banks will be increasingly worried.
At a meeting of London-based bankers last October, euro-denominated derivatives clearing emerged as one of their biggest fears when it comes to the effects of Brexit. Losing such lucrative business would damage the City, but it will be death by a thousand cuts rather than a sudden shock.
One likely scenario is that, if euro derivatives clearing gradually leaves London, other bits of business will follow. Banks already are setting up headquarters in EU cities such as Dublin and Frankfurt in anticipation of the U.K.'s withdrawal from the EU. Their clients, accustomed to all their business under one roof, likely would demand that all connected services be done in those centers.
Little by little, other businesses would follow -- among them legal services, administrative support and public relations firms -- that are part of the myriad of small but dynamic businesses that currently are an important part of London's thriving financial sector.
Of course, not all financial services and connected firms will leave London, not even most of them. But the British capital, and indeed the U.K. as a whole, depends so much on this industry that the closure of a significant part of these businesses would be a major blow.