Investment banks are shifting nearly a trillion euros of assets into EU entities in preparation for Brexit. But will the traders responsible for many of those assets have to follow? Perhaps not, with many banks hopeful that the lion’s share of their trading operations will remain in London in the years to come.
Much remains up in the air - not least because of the considerable uncertainty overshadowing the UK’s attempts to leave the EU. And some banks aren’t taking any chances and plan to shift a more significant proportion of traders to mainland Europe.
Nonetheless, most are hopeful that regulators will follow the same playbook as their decision over the location of central clearing for the US$481trn interest-rate derivatives market - which looks increasingly likely to stay in London - due to concerns over splintering liquidity (See Box story). That may mean banks will only have to relocate a relatively small amount of trading operations in the coming years.
“If it feels like a core European product, where most of the liquidity, buyers and sellers are going to be in the EU, that is more likely to have to move,” said Patrick Hunt, a partner at consultancy Oliver Wyman.
Banks have come up with different answers on whether to move other asset classes like credit, equities and foreign exchange, said Hunt. “But in general there is much more of a case to maintain it in the UK and back-to-back the business there because of the cost of capital efficiencies,” he said.
The stakes for banks are high. Many are already spending hundreds of millions of euros to move assets as well as staff from sales, operations and risk to the continent. New Financial, a capital markets think tank, estimates banks are shifting at least around €800bn in assets to mainland Europe as a result of Brexit.
PUSHING UP COSTS
Splitting up trading desks will push up costs even further because keeping trading in one place allows banks to offset clients’ positions, reducing the capital needed to be held against trading books.
“The biggest risk is fragmenting trading operations - that’s what everyone wants to avoid,” said one senior trader.
Citigroup, Deutsche Bank, Goldman Sachs, JP Morgan and Nomura are among the banks understood to be planning to keep the bulk of their trading operations in London for the time being, although most are relocating some traders to Europe. Citigroup, for instance, which already has a large presence in mainland Europe, only plans to move 45 traders to the continent.
Others believe European regulators simply won’t be comfortable allowing a large amount of European capital markets activity to take place outside of their jurisdiction over the longer term. Bank of America, for instance, plans to create a 500-strong trading unit in Paris. Societe Generale has established a clearing broker there too, while it is understood Morgan Stanley also plans to have a more substantial presence in mainland Europe.
“I think a lot of people have been in denial for a long time,” said the head of regulatory affairs at one investment bank. “You have to work your way over the stages of grief that you’re no longer in the single market, and that has consequences.”
London has long been the region’s pre-eminent trading hub thanks to its location straddling Asian, European and American time zones, along with its language, reliable legal system and abundance of support services.
On average, US$1.2trn of interest rate derivatives change hands in the UK every day, according to the Bank for International Settlement’s most recent survey. France was the EU’s next largest centre at US$141bn, while Germany had just US$31bn. A large chunk of that overall number is the euro swap market, which trades US$641bn per day.
The UK is by far the biggest FX hub, accounting for 37% of global currency trading with US$2.4trn in daily volume. London is also the major trading centre for the US$8.6trn credit-default swap market.
“There is a reason why everything was done in one place - for productivity, for efficiency,” said the head of one investment bank’s trading unit.
Euro swaps are the most likely product to head overseas, but even that decision is not straightforward. Three quarters of the US$138trn of euro swaps LCH cleared in the first half of 2018 didn’t involve an EU-based client, according to the London-based clearing house.
For its part, the ECB has said it wants appropriate operations on the ground when banks are servicing EU clients to manage all material risks, including front office staff and risk management.
“If the counterparty is European, that contract needs to be papered in the EU,” said Frederic Ponzo, managing partner at financial consultancy GreySpark Partners.
How many staff have to move to Europe, though, is “really a question bank by bank of where the bulk of [their] counterparties” is based, he added.
NO CLIFF EDGE
In the short-term, bankers are relieved given the considerable political uncertainty that supervisors won’t take a cliff-edge approach to regulation in the post-Brexit world.
As to their longer-term Brexit strategy, discussions with regulators are ongoing and attitudes could change - not least because of the shape of the final Brexit deal that is agreed.
One crucial issue is whether regulators will permit banks to house most of their trading operations in a London-based branch of their EU entity - a popular structure many are exploring.
Another area of contention is whether regulators will allow arrangements where back-to-back trades are done into London to persist over the longer term.
Some senior executives are encouraged that regulators such as the Bank of England have generally argued against dividing up pools of liquidity over financial stability concerns, noting the example of derivatives clearing staying in London.
“It’s very much the hope that we see similar approaches” for trading, said another investment bank’s head of regulatory affairs.
London wins derivatives clearing battle – for now
When judging how much trading activity could migrate to the EU after the UK leaves, many market participants look to the recent turf war over one of the most vital parts of financial markets’ plumbing: central clearing of derivatives.
Clearing houses play a crucial role in reducing systemic risk by standing in the middle of derivatives trades between counterparties and so limiting the fallout if one of them goes bust
Even before the Brexit referendum, the ECB tried in vain to move euro interest rate swaps clearing out of London to mainland Europe. Naturally, the UK’s vote to leave the EU in 2016 provided a pretext for European politicians and regulators to make another land grab.
But after extensive lobbying from the financial sector – and arguments from the Bank of England, which regulates the activity in the UK – clearing for the US$481trn interest rate swap market looks set to stay in London for the time being.
Benoit Couere, an executive board member of the ECB, outlined in a February speech the case for cross-border supervision of central clearing. While noting that the ECB would need appropriate safeguards, including adequate information on the risk management of clearing houses, Couere said the ECB would not look to supersede supervisors in the EU or other countries.
“Their primary responsibility to guarantee the resilience of [clearing houses], and more broadly the stability of our financial system, cannot and should not be questioned,” he said.
One of the main concerns of moving clearing activities to the EU was the risks to financial stability posed by splitting up liquidity in derivatives markets. LCH, which clears the vast majority of the interest rate swap market in London, has said it has no intention of shifting its clearing operations to Continental Europe.
“We are very much aligned with the G20 view here. LCH are not in the business of fragmenting liquidity,” said Daniel Maguire, chief executive of LCH Group.
“We seek to keep efficient and effective markets together, at the same time ensuring all the relevant authorities have the right and proportional level of visibility, supervision and oversight that makes them comfortable.”
The European Securities and Markets Authority will take over primary EU supervision of clearing houses next year and many participants are hopeful that it will continue to endorse clearing staying in London.
In the meantime, Eurex Clearing, the Frankfurt-based clearing house operated by Deutsche Boerse, has seen an increase in clients signing up to its clearing service as well as an uptick in volumes of short-dated forward contracts, albeit from a low base.