9 July 2017
Originally published by CapX.
Given the scale of Britain’s political woes, a new European Commission proposal on financial stability and systemic risk may seem the least of its troubles.
However the EU’s attempt to exert control on the “euro clearing” trade isn’t merely an arcane argument about money, or regulation. It’s a case study in the limits of government’s ability to control free markets – and their boundless capacity to screw things up when they try.
Euro clearing is a complex and rather dull topic. That’s because clearing, in the financial system, serves the same function as livers and kidneys do in our body: quietly, invisibly, cleaning out the junk and making sure things keep working. You never notice them, except when they go wrong. But when they go wrong, they go very wrong indeed.
Clearing houses, in essence, act as “the buyer to every seller and the seller to every buyer”. If I buy a futures contract based on, say, the price of oil from CapX’s Editor, I don’t have to worry about his credit, since the clearing house – known as the Central Counterparty or CCP – becomes the other side of the trade. If I meet my financial demise before the derivative expires, the clearing house pays out.
Naturally, there are many layers of safety, security and risk management built in, to ensure the CCP itself is good even when some counterparties have defaulted (think Barings or Lehman). Whole banks can go bust, but the clearing houses cope with the mess. This is also why the political-regulatory complex pushed to stop banks dealing with each other bilaterally without a clearing house being involved, as it might cause systemic problems if one of them could not meet its obligations – the Lehman scenario.
CCPs thus become huge repositories of risk – but crucially, they can offset risks between different currencies, product types and asset classes. As counterparties add more products into a particular clearing house, overall trading portfolios can be offset and thus the amount of required “margin” reduced. This is why, for instance, Australian banks clear a vast quantity of Australian dollar swaps in London (at the London Clearing House, LCH, a division of LSE Group) – because they can benefit from partial margin offset with their portfolios of trades in USD, GBP and more than a dozen other currencies.
And the other important thing to grasp is that CCPs aren’t just huge repositories of risk. They’re huge full stop. London’s euro clearing business alone handles a notional $900 billion in trades every single day. Without clearing, the engine of finance would grind to a halt. And given the volumes of trade they handle, the CCPs are actually incredibly safe.
Which brings us to the latest cunning plan that they’ve come up with in Europe.
In a post-Brexit fit of pique, suddenly high minded (and one might argue economically illiterate) EU political figures are demanding that clearing in euro-instruments must be “repatriated”. New regulations, published today, state that the European Securities and Markets Authority, an EU agency based in Paris, can declare that particular clearing houses have “specifically substantial systemic significance” and must be brought within the EU’s control, preferably via physical relocation.
So far the proposals are not as dire as they could be but they are a huge lump of protectionism at the heart of the, ahem, EU free market. Brussels wants to give ESMA the power to decide who is authorised to clear Euro denominated derivatives. In other words, a veto right which can be removed, if, for instance, London decides not to adhere to the miasma of EU regulations either now or in the future. It’s a more subtle means of deploying prescriptive red tape which can be tweaked to aid EU financial centres than a pure bludgeon of enforced repatriation.
This, as you may imagine, has less to do with proper regulation and more to do with a political desire to control a key element of a political project – that fiscal totem of European unity, the euro.
The problem is that once any convertible currency gets out into the wild of an interconnected world economy, its creators’ ability to control its destiny becomes limited. Once a baby, the euro has now become a teenager – and as all parents know, teens are generally reluctant to be corralled at home when there is a wondrous life to be enjoyed in the outside world.
So, while the actual cash runs through a system based at the ECB in Frankfurt, euro-denominated financial products enjoy all sorts of fascinating paths to market and maturity without ever having to touch the continent of Europe – let alone Brussels or Frankfurt.
There is a definitive difference, in other words, between being able to observe and understand the economic processes surrounding a currency and actually being able to control it – think meteorological observation versus King Canute. It was in fact Kennedy-era Democrats’ desire to control the dollar, via withholding taxes, which helped create a rich seam of overseas dollar trading – the “Eurodollar” market based in London, which helped turn the ailing post-imperial City of London into a global powerhouse.
At the core of Europe’s problem is that often abused marketplace for what can be termed “off balance sheet instruments” – aka derivatives. Derivatives are the neatest means known to man for transferring risk by means of hedging. And one massive area of hedging is in currency risk: which brings us neatly to the crux of the European Union’s mooted unease.
The status quo can be described simply: the UK’s generally benign, common-sense approach to regulation, as well a sound and stable rule of law on the Anglo-Saxon model, has proven vastly more popular within the financial industry than the somewhat protectionist social model beloved of many continental nations.
In terms of foreign exchange trading alone, London boasts about one third of all daily global business. It trades more US dollars daily than New York, and more euros than the EU-27 nations combined. That makes London several orders of magnitude larger than any of the other “major” EU financial centres.
London’s vast success causes a problem for the collective Euro-ego, as the eurozone’s guardians believe all euro trade ought to be located firmly within the EU.
But while this may sound plausible to a political mind, it is essentially nonsense in the more complex context of global trade.
In particular, one reason London is so popular for trading is its openness to multi-currency dealing. LCH daily clears some 18 currencies. The result is a huge growth in positions which may have offsetting risk profiles. The pointy-headed geniuses in clearing houses use tricky maths to resolve the risk factors and effect a form of alchemy. At a CCP, owning oil derivatives in one currency can be offset with being short gas derivatives in a different currency.
Where pricing relationships are relatively stable, a process called “netting” delivers a huge collateral benefit to banks and counterparties. In other words, when banks place lots of positions in one clearing house, the CCP itself can give them a relative discount on how much “margin” they must keep as a security deposit against potential losses. Banks can use the money freed up to lend to SMEs and individuals, thus helping the economy grow.
If the euro component of clearing were to be forced out of its natural home in London, to the essentially mono-currency silos of the EU, then banks would have to lodge more collateral for their euro trades (and separately, for their other positions in London). That would reduce the amount of money on their balance sheets which which to lend.
Thus the victory for Europe in “taking back control” of currency clearing would look somewhat pyrrhic, as the banking system had to scale down its real-economy activities. Conservative bank estimates here suggest a 20 per cent increase in cost. Derivatives associations reckon it could be a near doubling of collateral from $83 billion to $160 billion. In other words, up to $77 billion might be cocooned in a politicised rump of financial plumbing as opposed to circulating in the real economy.
But that is only the tip of the iceberg. The truth is that not that much of the business in euro derivatives is actually “pure eurozone”. Even if you stretch your definition from the 19 members of the single currency to the EU as a whole, pure EU27 to EU27 bank trading at the major clearing houses is estimated to be barely 7-10 per cent of the total.
In other words, fully 90 per cent of euro-denominated swaps would be very difficult, if not downright impossible, for the EU to actually force into clearing on the Continent. So repatriating the eurozone CCP market would simply bifurcate the process, making for a fragmented and less efficient marketplace. Indeed, a European pension fund being “forced” to clear Euro-denominated assets within the EU would fall foul of customer “best execution” rules which have been (over-)prescribed in meticulous details by various rounds of EU laws for years, leaving their collateral wedged between a rock and a hard place.
So while the ECB could deploy some specialist levers from the black arts of central banking to help encourage EU27 banks to clear their positions on the Continent, it would require extra regulations to force corporations or investment funds to forcibly move their clearing. And the backlash would likely be considerable, as they tried to force conflicting rule books on the counterparties.
The next huge problem is that there isn’t actually anyone on the Continent who could realistically process such a huge volume of transactions. Clearing, given the hundreds of billions of pounds involved, requires a lot of collateral – nobody wants to entrust their swaps portfolio to the financial equivalent of a tobacconist’s kiosk.
While the CCP clearing houses themselves can cope, their clearing agents (generally large banks) cannot. Of all the top 20 clearing agents listed by the US regulator, only Deutsche Bank manages to squeak into the top 10. Only two European names make the top 15.
In other words, given the concentration of clearing in the largest names, the EU has insufficient banking power to actually process the transactions its politicians haughtily proclaim are theirs to control. Of course, Deutsche Bank could always raise more capital – but given its multiple travails in other departments, adding derivatives clearing reserves to satisfy the whim of the EU’s political classes may prove tricky.
As if that wasn’t enough of an obstacle, there’s a further problem too: forcing EU27 banks to clear within the eurozone is not going to pass muster with the rest of the world. The chairman-elect of the CFTC, the US regulator, issued a diplomatic threat of “MOAB” proportions when he spoke at the leading derivatives association’s AGM in Lisbon during May. The EU has proposed what amounts to perfect grounds for a trade war.
At the extremes, by protecting where transactions are cleared, the euro could be deemed non-convertible – which would reduce the currency to little more than a footnote in monetary terms. It would certainly induce other central banks to dump the currency. The US government could also retaliate by seeking to protect trade in US dollars from taking place in Europe. We’re not talking about chaos at airport forex bureaus here, but catastrophe for ports like Rotterdam and Hamburg where vast bulks of coffee, sugar and cocoa nestle in silos – and are priced in dollars, as virtually all commodities are.
Europe cannot target London, in other words, without targeting the rest of the world. That would vastly damage the reputation, and the fiscal stability, of the EU27.
Instead, the EU and the ECB need to be pragmatic and sensible about the way forward. There is a vast difference between control (which seems to be the EU’s political desire at all times) and mutual access to data. There is a pragmatic agreement to be had that enables clearing houses to share information and assist the ECB – and ESMA – with the best ways to understand flows and manage any risks or crises that may occur. Such agreements already work well across the Atlantic with regard to dollar-denominated derivatives.
The old-fashioned protectionist bludgeon, by contrast, is a suicidal strategy for the EU – and one which would backfire. London built the best mousetrap for clearing, which is what helped make it the biggest international financial centre in the world. Let euro derivatives be cleared alongside the Australian dollar, the yen, the Polish zloty and all the others, and both Europe and Britain will be better off.
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