The Bank of England has issued its starkest warning yet that up to £41tn of derivatives contracts maturing after Brexit are at risk unless European officials urgently address regulatory uncertainty. The BoE said on Tuesday that clearing houses would have to tell European members such as banks to move their business or risk falling foul of European law. Ultimately EU banks would bear the cost of the disruption, the BoE warned in its quarterly statement on risks to UK financial stability, citing estimates that suggested every basis point increase in the cost of clearing interest rate swaps could cost EU businesses about €22bn a year.
The BoE estimates that EU-based companies have over-the-counter derivatives contracts with a notional value of £69tn at UK clearing houses. An increasing share of that £69tn — at £41tn — would mature after March 2019, when the UK is due to leave the EU. The BoE’s latest call to arms was echoed by the International Swaps and Derivatives Association, which lobbies for the derivatives industry. The group called on the EU to prepare new authorisation to come into force the day after Brexit.
The warnings come as preparations on both sides of the Channel step up for the possibility of a hard Brexit, where the UK crashes out of the EU with no deal and no transition period. There is increasing concern that a game of brinkmanship is being played on both sides, and as cities such as Frankfurt and Paris vie for a portion of London’s jobs and revenue. Clearing houses must give members three months notice to move their business, which is costly and complicated. This means the commission will have to make an announcement about derivatives before Christmas or clearing houses will have to start giving notice to their members. Moving business would result in banks and other holders of swaps incurring millions of dollars in extra margin payments for their derivatives positions, and in associated capital costs. In some areas, there are few alternative clearing houses in Europe.
For Brent futures, none at all. Isda has openly doubted whether it is possible to move business across the board. The BoE has consistently warned over the past year about Brexit posing legal uncertainty to vast amounts of financial contracts, from insurance policies to derivatives. But while Brussels has largely challenged its analysis, it has also acknowledged that the market for centrally cleared derivatives is a special case where there is a potential risk to financial stability. The commission has yet to reveal the short-term “contingency measures” it has said it would adopt to prevent problems.
The problem turns on EU law, which states that members such as banks must use authorised central counterparties to clear derivatives and interest-rate swaps. London-based clearing houses’ EU authorisation will lapse after Brexit. A working group of officials from the BoE and the European Central Bank, which is identifying stability threats from a no-deal Brexit, has underlined the disruption that would be caused if EU members of UK-based clearing houses needed to quickly move their business elsewhere. Mario Draghi, the ECB’s president, said last month that authorities would need to look at how “contractual positions” in the market for centrally-cleared derivatives would be regulated in the event of a “sudden . . . unprepared, hard Brexit of the sharpest kind”.
The UK government has said it would authorise European clearing houses, and give temporary permissions that would allow financial companies to continue with their current regulatory authorisations. But no parallel announcement has been forthcoming from the EU, and the vast majority of European derivatives business is in London. The ECB estimates 90 per cent of interest-rate swaps coming from the EU goes to the UK. While regulatory bodies such as the European Securities and Markets Authority have said they would enter into a series of memoranda of understanding with UK regulators, those have yet to be negotiated while political discussions continue. Clearing houses, largely run by exchanges, sit between parties in a deal and manage the impact to the market should one side default. London is the heart of the global business.
Its three clearing houses — LCH, ICE Clear Europe and LME Clear — process more than $450tn in interest-rate, credit, forex and metals-related swaps from around the world. Without access, participants face a hefty rise in trading costs — or an inability to hedge their market exposures. European banks have also started to voice their concerns about potential disruption to derivatives clearing. They say that some contracts, such as steel and some types of foreign exchange, cannot easily be moved from London to other parts of the EU because of licensing issues. The City of London Corporation welcomed the BoE’s statement, and said it was “pressing” for the EU to take action to prevent cross-border financial services being disrupted in the event of a no-deal Brexit. “Financial stability should not be jeopardised in a game of high-stakes political poker,” said Catherine McGuinness, policy chair of the corporation. “Both sides should urgently work together to address cliff-edge issues such as contract continuity and data transfers that could prevent the industry from servicing their clients.”
Source: Financial Times