Is derivatives clearing the biggest Brexit issue?

5 min read

It was the Xavier Rolet show Tuesday as the polished and articulate chief executive of London Stock Exchange Group turned on the charm and transformed the UK Treasury select committee hearing on the UK’s future economic relationship with the European Union – a very broad macro subject – into a detailed and decidedly micro discussion about derivatives clearing.

Discussion about trade and business flows and jobs gave way to talk of contract novation, derivatives compression benefits (US$110trn of risk eliminated and US$25bn in regulatory capital savings), the benefits of scale, higher buyside margin requirements (€77bn higher), the headache of migrating enormous amounts of notional risk, and the dangers of fragmentation if London-based clearinghouses lose the ability to clear euro-denominated securities and derivatives.

Ever since the UK’s EU referendum result, control over derivatives clearing has weirdly become a cause célèbre, a poster-child for Brexit in the financial services industry. In the grand scheme of things, it’s a technical geeky topic. But since the EU tried and failed to force euro clearing to a eurozone location it’s become a key battleground issue. It’s undoubtedly an important subject within the financial workstream, but as a top-line macro agenda issue, surely it’s punching above its weight.

At the hearing on Tuesday, however, fellow witnesses HSBC chairman Douglas Flint and Allianz Global Investors vice chair Elizabeth Corley were reduced to long periods of silence as Rolet expounded eloquently, happily and at length on the significance of clearing to the UK’s future prospects. He was clearly in his element, dominating the three-hour proceedings and relishing the opportunity.

It was a fine performance that had it all, it must be said: chilling predictions about massive job cuts and the toxic impact on the City’s future and on the UK’s economic prospects; the UK being singled out by a vengeful Brussels; and tales of skuldugerous attempts by shady EU operatives to scare his clients into pre-emptively moving their clearing to a eurozone location ahead of the Article 50 trigger. The latter was always guaranteed to raise the hackles of the UK parliamentarians on the committee.

The same can be said for the bête noire of the ECB finally garnering power to regulate clearinghouses and forcing euro clearing conducted in the UK above a fixed cap (a cap that will be way lower than LCH’s current euro clearing volumes) to a eurozone location. The ECB leaving in place equivalence arrangements in the US and Japan also hands New York a prime opportunity to launch a landgrab for OTC derivatives clearing as hub benefits shift away.

Rolet’s interventions amounted to a slick study in making overtly political comments in a way that came across as objective and optically non-political. And he delivered it all with a smile. The global Frenchman, a highly accomplished trader through his long career working for a series of top investment banks, stylishly worked the committee with a sequence of well-worked messaging.

At its core was a call for a five-year grandfathering period (ie, Article 50 trigger plus two plus three) to be put in place to avoid otherwise potentially deleterious systemic consequences. The notion of some sort of bridging arrangement across the Brexit negotiations is pretty well supported and it seems inconceivable that negotiators wouldn’t agree on some sort of standstill.

As for the broader discussion, there’s been a lot of chatter but no real quantification or impact assessment around the long-term impact to SMEs in their financing and operations in the run-up to Article 50 and during any transitional phase and post-transition.

HSBC’s Flint spoke of the burden on smaller companies that have limited planning and financial resources but we need more discussion on this area, particularly while the Capital Markets Union project is alive and kicking and evolving in parallel.

Multinationals have the capacity and the wherewithal to deal with whatever is thrown at them but the same can’t be said about SMEs. Flint did say they would need to put in place more debt capacity and change their current arrangements around debt availability (which will inevitably become more expensive) on the basis that their financing arrangements would become more fragmented, their supply chains longer and debtor balances take longer to collect.

It strikes me that some urgent work needs to be done in this area at the very least in terms of detailed quantification of the issue, problems on the horizon and the impact on growth and jobs.