As negotiations over the UK’s exit from the EU grow more urgent, another critical battle is playing out with ramifications for global markets.
Clearing interest rate derivatives is not glamorous nor does it have much resonance beyond London’s Square Mile, but control of this important industry is up for grabs thanks to Brexit.
The fight over whether London will remain the global heart of the $482tn industry following Brexit pivots around three major figures. Xavier Rolet, the French chief executive of the London Stock Exchange Group, is the staunch defender of the City’s status against Carsten Kengeter, the Anglophile head of Deutsche Börse, who is trying to wrestle some of the clearing business to the continent.
Observing this tussle and trying to assert US interests is Christopher Giancarlo, the new head of the Commodity Futures Trading Commission, the US derivatives regulator.
The stakes are high and no player can afford to overplay their hand. After the financial crisis, regulators designated clearing as the solution for taming the risk associated with derivatives trading. That catapulted what was an arcane business to the front line of safeguarding the financial system.
Clearing works effectively when vast amounts of trades are pooled together with losses and gains across the market for equities, swaps and repo cancelling each other out. In times of market stress, a stable clearing house means the threat of contagion igniting the type of crisis seen after the demise of Lehman Brothers in 2008 can be contained.
The risk from a brutal Brexit divorce is that clearing fragments between London, Europe and New York. Not only would it diminish its effectiveness in mitigating trading risk, it could fracture a hard-won harmony between regulators.
“This is not a just a UK and EU matter. Preventing this market from fragmenting is important for us all,” says Scott Hill, chief financial officer of Intercontinental Exchange, the US markets operator worth $40bn.
While the European Commission, the EU’s executive arm, has stepped back from demanding relocation of the clearing of euro derivatives, it has kept the threat in reserve. Such a move would strike at London’s LCH, majority owned by the LSE. As the world’s pre-eminent clearing house, it has cleared a notional €174tn of euro-denominated derivatives this year, around 75 per cent of that market.
The possibility of forced relocation alarms banks that trade derivatives because they prefer clearing to be concentrated in just a few locations. For now, the ECB has proposed powers for more direct oversight of overseas clearing houses.
With LCH controlled by the LSE, it has made Mr Rolet the most vocal advocate of London keeping an industry it has dominated for 20 years. Mr Rolet, who is stepping down next year, holds an honorary knighthood and is impeccably connected. Philip Hammond, UK chancellor of the exchequer, spoke at the LSE’s annual lunch in December.
Mr Rolet wants a transition deal from March 2019 agreed by Christmas to stave off worries. And the grinding Brexit talks are intensifying concern. “My wish is that in the UK [there is] a greater sense of realisation of the efforts that are needed to make global co-operation, global flows, work,“ the 57-year-old Mr Rolet told a conference last week. “That has also benefited the UK since joining the EU.”
As the complicated political negotiations yield limited progress, Mr Kengeter, who studied and lives in London, is making his push for that euro interest rate derivatives business. Deutsche Börse’s Frankfurt-based Eurex Clearing is the only clearing house in the eurozone licensed to process it.
A former swaps trader and senior UBS banker, he is one of the few senior executives who has been at the industry’s sharp end, and is well connected with the banks.
Eurex wants to share the profits it makes from clearing with its main users. Three of the largest market players — US trio Citi, JPMorgan and Morgan Stanley — are among five banks interested.
“It’s about not having our eggs in one basket,” says the head of OTC Clearing at one bank considering signing up.
However, Mr Kengeter — who at the start of the year was trying to engineer a €29bn merger with the LSE — faces his own problems. German regulators are probing whether Mr Kengeter bought shares in Deutsche Börse while having extensive talks with Mr Rolet about the merger. A court in Frankfurt, Germany, on Monday night refused to approve a settlement between Mr Kengetter and criminal prosecutors over alleged insider trading.
As they compete, a third force is exerting influence: Mr Giancarlo, who was appointed as head of the CFTC by the Trump administration in August.
Well versed in swaps market, having worked at an interdealer broker before joining government in 2014, Mr Giancarlo has set red lines on the EU proposals to either force relocation or demand direct oversight of euro clearing. The 58-year-old was last week withering about the battle over clearing that Brexit has unleashed.
“I feel as if the United States are being treated as the children of a divorcing couple,” he told the House Agriculture Committee.
He says EU proposals mean EU law and ECB oversight could be applied to American clearing houses because euro-denominated derivatives are also cleared in the US.
“This is something unprecedented. Our Federal Reserve has no role in clearing houses offshore. When you fragment ecosystems, you weaken and harm [them].”
The uncertainty Brexit has created in the global clearing industry follows three years of sometimes fractious talks that ended in 2016 with the EU and the US agreeing a deal over the joint supervision of clearing houses. Mr Giancarlo is not keen to return to it. “Where I come from, a deal is a deal. We reached a deal,” he cautioned. “Concessions were made to reach that deal.”
Mr Rolet has warned New York could emerge as the main victor from Brexit if LCH moves its business to the US. Privately, that is an outcome that worries US officials happy to see the business in London.
Joe Cassidy, head of market infrastructure in KPMG’s Capital Markets team says London’s legal framework and timezone makes it an ideal offshore location to manage default risks by offsetting dollar-euro swap deals while US markets are closed.
“The vast majority of transactions have a dollar risk,” says Mr Cassidy. “The dollar is at the heart of the City. The US looks at the dollar as a reserve currency of the world. It’s an expression of soft power. People learned from 2008 that a crisis is borderless.”
The CFTC, conscious of the Brexit uncertainty, is more comfortable with the business moving to Frankfurt from London via Deutsche Börse’s market-led initiative rather than EU regulatory decree, according to two executives who have held discussions with the US.
The banks, if they move, are likely to move in concert, to pool their trades. “It’s not going to be something you do yourself. It needs to be a discussion in the industry,” says Sylvie Matherat, chief regulatory officer at Deutsche Bank.
As the Europeans squabble, Mr Giancarlo’s message is clear: don’t forget the US. “We’re a sovereign nation . . . We are certainly recognised as the world’s leader in derivatives regulation. The United States is a rulemaker not a rule-taker.”