By Paul Lirette, Senior Economist, CASE
The vote for the UK to withdraw from the EU has created speculation surrounding the fate of London’s prized euro clearing business. Will the European hub for swap trading remain in London or will major UK central counterparties be forced to set up shop in the Eurozone?
London has been the center for European financial services since the inception of the EU. According to the latest BIS’s Triennial Central Bank Survey, the UK houses the largest “over the counter” (OTC) Euro foreign exchange transactions market and the largest OTC interest rate derivatives market in the world, exchanging nearly 1 trillion euros per day.
London based central counterparties (also known as clearing houses) play a key role in managing financial risk stemming from payment defaults in these markets. The largest of which, London Clearing House, cleared roughly 430 billion euros worth of transactions, daily, saving the industry billions in margin and capital requirements.
All other things being equal, once Brexit occurs, the majority of euro denominated clearing will be performed outside of the Eurozone. The ECB is determined to restrict this clearing to EU based firms, given that during periods of significant systemic risk its ability to intervene (where appropriate) in the provisions of euro-clearing services would be limited. However, this determination, often echoed by French President Françeois Hollande, has been unsuccessfully put into action even before the Brexit referendum.
Ultimately, the future of the UK’s passporting rights, which allow UK businesses to provide financial services anywhere in the EU, will determine the impact on UK financial services. A Brexit that remains “in” or re-joins the European Economic Area (EEA) would maintain current passporting rights and allow for business to continue as usual.
Outside of retaining EEA membership, the UK could negotiate some level of bilateral agreement (as exists with Switzerland) or proceed without any agreement, each option potentially jeopardizing the UK’s ability to provide these financial services to the EEA. PWC estimates that a loss of euro denominated clearing houses in the UK could decrease financial sector gross value add by 1.8%-4.0% and decrease domestic GDP by as much as 3.5% by 2030, which would lead to substantial job loss (and surely impact EU external demand).
Whether or not these economic and financial realities will outweigh political will to punish bad behavior remains to be seen. Given that both sides of the English Channel has significant skin in the game, a joint approach (as outlined by the Financial Service Negotiation Forum earlier this week) as opposed to a tit-for-tat style retaliation could be the best outcome for all.