The UK is home to both the largest “over the counter” (OTC) Euro foreign exchange transactions market and the largest OTC interest rate derivatives market in the world. Around 1 trillion euros are exchanged in the UK every day, compared with 395 billion euros in the US. In terms of interest rate derivatives, including forward rate agreements, swaps, options and other products, the UK is a clear market leader in euro-denominated transactions, with a daily turnover of 927 billion euros.
The numbers above indicate the importance of the UK as a financial center for euro-denominated transactions. At the same time, such a large share of euros being traded in a non-euro area country raises questions about the supervision and sustainability of liquidity provision, particularly if there is financial turmoil.
There are three clearing houses operating in the UK which are recognised by both the UK and the EU: CME Europe, a derivatives exchange and wholly-owned subsidiary of US-based CME group, the London Clearing House LCH Group Ltd., majority owned and operated by the London Stock Exchange Group, and the London Metal Exchange Limited.
Of the three clearing houses, LCH Ltd. has by far the biggest share of the euro-denominated market operating from the UK. Through its SwapClear service, unlike the CDSClear (credit default swaps) and part of RepoClear market located in Paris, it clears more than 50% interest rate contracts and represents 95% of the cleared OTC interest rate swap (IRS) market.
In terms of LCH’s euro-denominated transactions, interest rate swaps, forward rate agreements and oversight indexed swaps constitute the biggest share of swap transactions with 187 billion, 121 billion and 160 billion euros cleared respectively, out of the total of 479 billion euros traded daily. In the repo market the monthly clearing volume is approximately 5.8 trillion euros, although it covers a range of markets, not only euro-denominated markets.
In 2011, the ECB raised concerns over “the development of major euro financial market infrastructures that are located outside of the euro-area” in a Eurosystem Oversight Policy Framework document. In particular, the ECB stated that the development of offshore centralised counterparties (CCPs), better known as clearing houses that clear and settle large amount of euro-denominated transactions, is of systemic importance to the euro area. It argued that these settlements “should be legally incorporated in the euro area with full managerial and operational control”. The threshold was drawn at clearing houses that have a daily credit exposure of 5 billion euros in one of their main transaction categories.
In response to the ECB’s location requirement, UK government argued in September 2011 at the General Court in Luxembourg that the Overnight Policy Framework should be annulled. It contended that under the Treaty on the Functioning of the European Union (TFEU), the ECB lacks competence to impose such requirements on the clearing houses. Furthermore, by imposing location requirements ECB violates the freedom of establishment, freedom to provide services and freedom of movement of capital in the single market.
After 4 years of legal battles, in March 2015 the General Court ruled in favour of the UK, stating that the ECB lacks explicit regulatory competence with regard to the securities clearing systems. In order to obtain rights over securities clearing, the ECB would need to seek an amendment in the TFEU. Since the competence argument was enough to annul the case, the court ruled that it was unnecessary to bring the “no discrimination” argument of the single market.
If the UK votes to leave the EU and the activities of the clearing houses shift to the continent, the direct economic impact would likely be small, due to the capital intensive nature of CCPs. For instance, LCH Clearnet Group's overall operating profit for 2015 was 78 million euros, from which the UK subsidiary had an operating profit of 63 million euros, and employs around 450 people. LCH Clearnet SA (a subsidiary based in France) had an operating profit of 28.8 million euros and has 168 employees. As such, in terms of job losses the effect would be negligible.
However, from a wider perspective, the UK leaving the EU would result in significant limitations and regulatory uncertainty for the UK financial industry in general. This would impact clearing houses in particular in terms of their access to the euro market. In the event of a Brexit, the loss of “passporting” rights, exacerbated by regulatory uncertainties and delays surrounding the re-negotiation agreements in financial services, might trigger changes in the euro-denominated market of the CCPs. This includes the possibility of a gradual shift of activities to the continent. Plus, CCPs would be wary of the fact that, as a non-member, the UK has no legal means to enforce the ECB to credibly commit to the liquidity swap agreement. Such legal uncertainty would mean significant risks in an event of a liquidity crisis.
Suppose the liquidity shift does not happen and the ECB commits to maintaining a liquidity swap line, the sheer size of the euro-denominated liquidity injections necessary to offset a crisis could be destabilising for monetary policy (Armstrong 2016).
By publishing the Oversight Policy Framework, ECB has made it clear that euro-denominated activities of clearing houses are a systemic risk to functioning of the euro-area. It is impossible to know whether the ECB will attempt to impose the “location” requirement again or attempt to amend the TFEU to specifically seek competences with regard to the securities clearing systems. However, it will be much harder for the UK to influence the course of action if it is no longer a member of the EU.