Clearing and the challenge of ‘taking back control’ in financial services

Sarah Hall | Oct 2021

The UK government has been clear that one of the advantages of Brexit, as it sees it, is the ability of the UK to ‘take back control’. In financial services, the focus for such control lies in developing a regulatory approach that “better suits our [UK] markets” as Rishi Sunak set out in his July 2021 blueprint for post Brexit financial services.

At the same time, the EU is developing its own approach to ‘strategic autonomy’ in financial services. This aims to develop an open, but resilient, financial services sector within the EU. The challenge comes when the deep networks of cross-border UK-EU trade in financial services mean that whilst the politics of Brexit supports taking back control in financial services, the economics reveals the trade-offs involved for both the UK and the EU.

This is most apparent currently in the seemingly technical world of derivatives clearing. Derivatives clearing is a vital infrastructure in contemporary financial markets. Clearing houses sit between two parties in derivatives trading and supports transactions in the event of defaults. In order to do this most efficiently, it is most efficient for clearing houses to be located where there are large active financial markets.

The depth and international focus of market liquidity in London has meant that the City has dominated the market for Euro dominated derivatives clearing, despite the fact that the UK was never a member of the Euro zone.

The bulk of this market is cleared through clearing houses in London. This has continued after the implementation of the Brexit trade deal in January 2021 because the EU granted the UK a time limited equivalence decision for UK clearing activities, meaning that EU clearing members can continue to use UK based services.

The key question is what happens when this equivalence decision ends in June 2022. The EU had granted equivalence in part to make time for the development of domestic capacity in this area. The European Securities and Markets Authority is currently assessing the risks to financial stability posed by having clearing activities located outside the EU. This review includes an analysis of the risks and opportunities associated with relocating activity into the EU. This builds on longstanding and understandable concerns about the risks associated with having an important aspect of financial market infrastructure located outside of the euro area.

In the meantime, the rate of domestic growth appears limited within the EU. In February this year, Andrew Bailey responded to reports that suggested the EU make seek to require European banks to onshore their euro denominated trading activity, stating that this would be resisted ‘very firmly’.

There are also economic reasons that prevent an easy, business led relocation of euro denominated clearing activity from the UK to the EU. These reasons reflect the locational advantages of financial market clustering in London. London is the global leader in over the counter interest rate derivatives trading. There are benefits for Euro clearing to be co-located with other derivatives markets in London in terms of access to infrastructure and labour markets. This acts as a magnet, making relocating euro denominated clearing activity to the EU less commercially attractive.

The EU could look to force the onshoring of euro derivatives clearing into the single market by not extending the equivalence determination. However, it is possible that if equivalence is not extended, business may choose to relocate to the US rather than the EU in order to try to replicate these economic advantages of co-locating derivatives markets.

In this scenario, the EU would not only fail to take euro derivatives clearing into its regulatory orbit but could also see the relative importance of Europe as a financial market decline in relative terms. Research has recently suggested that financial markets are growing more rapidly outside of the UK and the EU, particularly in places like Singapore. In this scenario, both the UK and the EU could lose out, relative to growing financial market activity elsewhere.

On the UK side, recent months have seen a greater focus on the possibilities, post Brexit, for increasing trade with non-EU states and growing digital and green finance. These priorities do not necessarily preclude continuing equivalence with the EU on clearing. However, in his Mansion House Speech this summer, Rishi Sunak appeared to confirm that the UK would prioritise regulatory freedom over securing single market access. This is likely to make a permanent equivalence decision for UK clearing politically impossible for the EU. For both the UK and the EU then, the politics of ‘taking back control’ in financial services does not always sit easily with the economics.