As Brexit negotiations continue, many are wondering what the implications will be for the clearing and settlement of euro-denominated products. The arrangements for the UK’s relationship with the European Union after Brexit are the topic of negotiation and nothing will be fixed until everything is fixed. However, if the United Kingdom ceases to be a member of the European Economic Area and loses its passporting rights in the process, the UK—as a “third party”—will need to reach and implement an agreement for European Securities and Markets Authority recognition—a process that could extend beyond 2019.
Why it matters
The UK is a big player. According to Bank of International Settlements data from 2016, the UK processes nearly 70%, by turnover, of the euro-denominated traded interest rate derivatives every day. The next four biggest players—France, Germany, Denmark and the US—account for little over 20%!
Certain regulatory control issues remain unresolved. Following the financial crisis, the European Central Bank deemed large central counterparties—defined as those that have a daily credit exposure of more than €5 billion in one of their main transaction categories—systemically important for the European Economic Area. In 2011, the Eurosystem Oversight Policy Framework called for settlement activity to be performed by institutions “legally incorporated in the euro area with full managerial and operational control” and supervised by the European Central Bank.
In 2015, following a challenge by the UK, the European Court of Justice (ECJ) ruled that the European Central Bank lacks the competence necessary to regulate the activity of securities clearing systems. The Repeal Bill, currently going through parliament, gives existing ECJ case law the same status as decisions of the UK Supreme Court. How future decisions are to be regarded remains up for consideration. In August, one UK justice minister said that Britain would have to keep “half an eye” on rulings by EU judges after the transition period.
What to expect
If the loss of passporting rights forces some, or all, of the euro-denominated clearing business to relocate from the UK to Europe, the impact on individual firms and the financial services sector could be significant.
At the firm level, we can expect to see organizations:
- Reviewing their cross-border operating models and refining their legal entity structures
- Rethinking their collateral models to accommodate the split between euro-denominated and products-denominated in other currencies
- Scaling and reorienting transferred activities and associated infrastructure
- Reviewing and potentially reworking legal documents, including thousands of contracts
At the market level, we may see:
- Direct economic impacts. A relocation of business would mean a relocation of jobs and profits from the UK to mainland Europe
- Reduced market liquidity and increased costs for investors. More limited in their ability to net euro-denominated risk exposures against exposures in other currencies, clearing members would have to put up more capital and collateral. That could reduce the liquidity and competitiveness of the European market and increase costs for European investors
While many unknowns remain, it’s never too early to start planning. Where does your firm fit into this picture? What steps are you taking to mitigate risk and prepare your business for the new world that’s emerging?
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