Once the top financial hub of the world, a post-Brexit UK is faced with new challenges from derivatives markets, as a quick EU switch in strategy from cooperation to competition has put unprecedented pressures on the UK’s financial sector.
What are Derivatives and Clearing Houses?
Derivatives are securities (i.e., a certificate with monetary value), and there are four main types: Forwards, Futures, Options, and Swaps.
They provide a higher level of safety from structural and investment risks, which is a major concern for emerging market investors.
They are the foundation of many diversified portfolios that are not dependent on standard equity investment since their value is usually derived from numerous underlying assets or the benchmark.
Once a transaction is agreed, the contract is transferred into the hands of a clearing house, which acts as an intermediary party to aid the complications of trade, ensuring stability and efficiency.
Why is this important?
Derivatives markets make up a large percentage of the UK’s financial sector, accounting for 6.9% of total economic output, 25% of London’s revenue, and ranking 9th in terms of size as a proportion of GDP.
Within the sector, banking alone makes up 3% of the UK’s GDP, behind only Japan and the US in terms of size.
Putting trade volumes into perspective, we can begin to uncover the EU’s dilemma. London Clearing House (LCH – a subsidiary of the London Stock Exchange (LSE) Group) processed more than $450tn in Swaps and Futures in 2020.
This accounts for 90% of total market activity and covers the clearing of approximately three-quarters of Euro-denominated Swaps.
Derivatives war
Considering the UK’s reliance on its financial service sector and the EU’s current reliance on LCH, it is unsurprising that the EU is in a post-Brexit fight for control.
If the EU’s goal is to bring clearing to mainland cities such as Frankfurt, Paris, Brussels, and Amsterdam, then the battle has already begun.
Due to the absence of an equivalence deal in January 2021, economic uncertainty has manifested and hit the UK disproportionately.
Firstly, London has been haemorrhaging money regardless of expectations of equivalence outcomes. In recent months, key players such as Barclays and JP Morgan shifted approximately €200bn each in assets from London into Ireland and Germany respectively, with JP Morgan also announcing plans to strengthen its Paris hub.
Secondly, through an overall decrease in trade volume due to the pandemic, the UK market share of euro-denominated swaps fell by 30% within the last 6 months, causing the entire UK derivatives market to shrink.
The mass exodus of Euro-denominated and Sterling interest rate derivatives has also shifted towards more stable destinations such as New York, whose market share for sterling swaps increased by 75% from December 2020.
Amsterdam’s stock exchange has also absorbed some of the shock, as its market share grew from single digits to 25% in the same period, overtaking the LSE for the position of number-one European leader in terms of trade volume.
The anti-UK sentiment amongst EU financial institutions has been growing for some time.
In a recent report, Erik Müller, the CEO of Eurex Clearing (a single-digit market share competitor for euro-denominated clearing), stated his disapproval of recent financial infrastructure regulations that aimed to bridge an equivalence gap, claiming they are “somewhat undermined if just one player dominates the market for OTC derivatives clearing”.
These concerns are shared by the European Commission, which has now fully opened its door to US trade in its decision to grant the US full equivalence, with the aim being to attract some traffic back to the mainland.
The London Mayor’s office predicts £9.5bn losses for every year that there is not an official trade deal, and although it appears that an equivalence deal is far from being agreed, a silver lining remains.
Temporary equivalence has still been granted to the UK which allows the same access to EU markets until mid-2022.
Thankfully, Brexit was not the cliff-dive many predicted, and temporary equivalence affords the UK some time to adapt.
Although it was granted due to a lack of European alternatives, it was for the sake of financial stability.
It’s clear that neither party is keen to damage the global economy for political gain, and therefore this transitional period could give us a glimpse into the future of financial services.
The UK Response
In response to the EU’s somewhat aggressive stance on LCH’s dominance, the UK is faced with a two-pronged strategy to allow the financial sector to adapt.
Firstly, cultivate an attractive investment climate, and secondly, look for global strategic partners elsewhere.
Whilst the UK has granted the EU equivalence, the EU has not reciprocated.
It is increasingly unlikely that they will since the UK’s plans to incentivise investment are already on a path of divergence in terms of regulatory philosophy.
This is evident in plans for financial deregulation such as removing the cap on the number of commodities contractors can hold and the removal of caps on ‘dark pools’, whereby trading is done in a private forum with little transparency.
The LSE was also quick to refocus business towards emerging markets, recently announcing a partnership with the Singapore stock exchange by introducing a range of environmental derivatives and strengthening ties with both established and emerging Asian markets.
Challenges the EU Faces
In this battle for derivatives, the EU is faced with two major problems. Firstly, European clearing houses are usually back-up options for investors whose portfolios consist of more than euro-denominated derivatives.
Secondly, LCH is a behemoth in the market. Its established economies of scale and scope have proved its advantage in the face of global recession.
If the EU shifts more traffic into European Clearing Houses, they are highly likely to disincentivise foreign investment due to higher costs.
In a letter to the commission, the ISDA predicted that the margin requirement would increase by 16-24% on average, meaning that holders would need to pay more to deposit in order to cover the credit risk.
With a greater pool of experience for cheaper prices, it is unlikely that many will look to Eurex for clearing, especially considering that 99% of their outstanding clearing is in Euros.
Conclusions
Within the current political climate, it seems highly unlikely that there will be an equivalence deal soon, if at all.
Even if one was reached, EU Law still states that equivalence can be redacted with a 30-day notice period, leaving many investors uneasy as to the long-term certainty of their investment.
There is therefore no sense in waiting for an EU hand to help the UK out of this situation.
If the UK seeks to offset the shrinking market share of euro-denominated derivatives, as is the case with all break-ups, then the UK must focus on itself.
If plans for deregulation come to fruition, could the UK regain its title as the top global finance hub?
