Magazine Issues » October 2019

Clearing & settlement: A UK horror story

PumpkinsLondon and Frankfurt clearing houses are battling for post-Brexit euro derivatives business. Nicholas Pratt considers where UK asset managers may be putting their flows.

If there is one thing that is neither cleared nor settled, it is Brexit. The UK’s parliamentary process is in chaos, negotiations with the EU remain unresolved and the spectre of a no-deal exit on Halloween looms ever larger.

Meanwhile, within the financial services sector, there is an ongoing Brexit-based battle between Frankfurt and London regarding the clearing of euro-denominated derivatives, a business worth some $660 trillion (€603 trillion).

Asset managers are large users of derivatives for portfolio management purposes and managing risks such as currency exposure.

Ever since the creation of the euro in 1992, London’s clearing houses – LCH, ICE Clear Europe and LME Clear – have dominated the clearing of any euro-denominated derivatives, by virtue of London’s pre-eminent position as a foreign exchange centre. But its hold on the lucrative business has become more tenuous since the UK’s referendum result in 2016.

European venues, namely Deutsche Boerse’s derivatives arm Eurex Clearing, have ramped up their efforts to encourage both EU and UK-based market participants to switch their business from London to the continent, including a recent offer to waive the additional booking fee imposed on any participant that relocates its derivatives trading business.

For asset managers and other buy-side firms, the concern is whether they will become collateral damage in this battle. Will the competition between clearing houses lead to splits in liquidity, which in turn will increase execution costs and decrease post-trade efficiency?

Will the derivatives market be affected by the same political uncertainty around the timing and manner of the UK’s departure from Europe that has worried so many other sectors? And beyond the ‘temporary equivalence’ that the EU has awarded to London’s clearing houses in the event of a no-deal Brexit, what measures, if any, are in place for the long term?

Business as usual, for now
The reality is that the legal position has not changed since March 2019 when the EU granted the three UK clearing houses “a temporary and conditional equivalence for a fixed, limited period for 12 months to ensure that there will be no immediate disruption in the central clearing of derivatives”.

This equivalence allows the UK clearing houses to continue to offer all clearing services for all products and services to all members in the event of a no-deal scenario.

However, this equivalence is still due to expire in March 2020, despite the delays to a withdrawal, and would last just five months should the UK exit the EU on October 31 with or without a deal. Furthermore, the EU’s financial regulation chief Valdis Dombrovskis has since urged banks and brokers to prepare for a no-deal Brexit rather than take it for granted that they can look to Brussels for help via a further transition period.

This stance has in turn led the UK’s watchdog, the Financial Conduct Authority (FCA), to seek further assurances. In September, the FCA’s chief executive Andrew Bailey urged the EU not to “sacrifice open financial markets” and to extend equivalence to ensure market access post-Brexit.

In specific reference to the clearing of EU derivatives, Bailey has asked for permanent recognition for the UK’s clearing houses. “Without greater clarity on the regulatory status of UK CCPs [central counterparties] after this date, the contracts that EU members clear with UK CCPs will need to be closed out or transferred by then,” he said. “This process would need to begin by the end of this year, and would impose significant costs on EU firms, as well as potentially straining market capacity.”

The European Central Bank and the EU have clearly articulated since the UK’s Brexit decision that they feel uncomfortable if a large chunk of euro-denominated derivatives are cleared outside of the EU 27 and beyond the jurisdiction of the European Courts of Justice. It is very important from a monetary policy perspective and in terms of systemic risk.

However, the hope is that any migration will be market-led. “No one in the market wants forced relocation of clearing from the UK to an EU 27 venue. We see a superior path in a voluntary and market-led migration,” says Matthias Graulich, Eurex Clearing executive board member.

Eurex Clearing has worked hard to incentivise market participants to relocate their derivatives clearing from the UK and venues such as LCH. In early 2018, the Frankfurt-based clearing house launched the Eurex Partnership Program to try and develop a liquid OTC [over-the-counter] clearing alternative to London-based venues.

“A lot of end-clients in and out of the EU have put a second pipe with us in place,” says Graulich. “We have onboarded more than 100 new clients this year and now have a total of around 250 clients in swap clearing. Some have decided to do all new euro denominated business with us. Others are still sitting on the fence.”

The LCH remains pugnacious in the face of the challenge from Eurex Clearing. Appearing before a UK parliamentary select committee in February, its chief executive Daniel Maguire said: “We have seen no discernible change in behaviour of customers, banks and asset managers.

“If you look at market share, volume and facts, there hasn’t been a material shift in volumes. What we have seen is discernible change in marketing. Competitors are definitely leveraging Brexit uncertainty to find their competitive aspirations.”

As of the end of August, Eurex Clearing has processed around €13 trillion, but the majority of this has been in low-margin deals rather than the more lucrative swaps business. In contrast, LCH has processed more than €195 trillion in euro-denominated swaps so far this year.

One of the barriers to relocation was the fear that it would lead to a fragmentation of liquidity in OTC derivatives, which would in turn lead to wider bid/spread offers and higher trading costs. However, Eurex Clearing is confident that euro swap location prices at its venue are now in line with those offered by LCH. Graulich believes this will encourage more market participants to switch their business from the UK to Germany. At present, it is still a minority and predominantly selected banks, pension funds, asset managers and insurance companies from the EU 27.

In addition, Eurex Clearing has a euro-focused offering, says Graulich, as opposed to the multi-currency approach of the LCH. “We offer futures, swaps, repos and sec lending denominated in euros, bringing different products in the same currency together,” he says. “We are convinced that this approach will deliver higher efficiencies for most market participants.”

Graulich is also convinced that Eurex Clearing’s offering will be successful in attracting people regardless of Brexit – because, he says, people always wanted an alternative for clearing that generates competition and fosters innovation. “Eurex has a strong proposition, a broad collateral range, reduced funding costs because of cross-margining, and tailored access models for the buy-side,” he adds. “We have been continuously improving our offering over the last 18 months and I am convinced that we will be successful.”

Working in parallel
The appetite for competitive clearing among asset managers is a moot point. While all participants will welcome reduced fees, the greatest efficiency comes from being able to clear multiple products in a single venue rather than having different instruments sent to different venues in different countries with potentially different rules.

Regardless of what form the UK’s withdrawal from the EU takes, if any, market participants have had to spend considerable sums on new arrangements. According to estimates from EY, UK financial services firms have so far spent £1.3 billion (€1.5 billion) on Brexit relocation and planning costs and have allocated a further £2.6 billion for new entities abroad and an estimated 7,000 job moves – all with the objective of maintaining access to their EU clients.

Similarly, trading venues have had to make their own alternative arrangements, establishing new operations within the EU 27 as well as their UK venues.

Tradeweb, an electronic trading venue for derivatives, received authorisation from the Dutch regulator for its Amsterdam operation in January 2019. “We have been ready since early March with our Amsterdam venue and have had the two venues (Amsterdam and London) working in parallel since January,” says Enrico Bruni, head of Europe and Asia at the firm.

One of the biggest issues related to a no-deal Brexit from a trading perspective relates to derivative trade obligations, says Bruni. “This is really affecting EU banks conducting their derivatives trading through a UK branch. They could end up under a dual trading obligation.”

For Tradeweb, the concern is with trading and clearing workflows. The asset managers’ preparedness is quite high, says Bruni. The education efforts have been thorough, although there are still some open questions. And while the larger managers have a bigger budget for their Brexit preparations, they have all had to plan for a worst-case scenario. “The cost to the system from the preparations is high.”

The next and as yet unanswered question is who is going to bear these costs.

©2019 funds europe