At the centre of London lies a paradox. The world’s financial capital is the centre of a monetary union to which it does not belong. Much of the business done in the City is in fact denominated in the currency issued by the European Central Bank (ECB). That this arrangement might be a source of political friction should be apparent to even the humblest scholar of international affairs.
Financial services account for a major part of the British economy. Many banks use their British subsidiaries as a ‘passport’ to the wholesale banking of the single market. This is a particularly attractive position for US Banks. The prospect of Brexit – however hard, soft or fluffy – has dealt this arrangement a fatal blow. The passport now has an expiration date. Banks interested in business with the EU27 will have to conform to the same ‘equivalence’ standards faced by non-EU banks. As the name implies, access is granted on conditions of equivalence between EU and non-EU banking regulations. This process is not only subject to changing regulations on both sides (which would entail reevaluation) but to the discretion of the (usually not so permissive) regulators in Brussels and Frankfurt.
The spectre of red tape and higher transaction costs has compelled prominent banks to reconsider London as their hub, setting their sights on Paris, Frankfurt and Dublin (those among them more pessimistic about the future of the Euro have even considered *gasp* Warsaw). The scramble to remain in the single market instantly led to a frantic race to the bottom, with the newly incumbent Macron most vocal. His beggar-thy-neighbour rhetoric, aimed at attracting business to La Défense, somewhat belies his grand ambitions for Eurozone solidarity and reform.
This might not, however, be the only consequential relocation in the wake of Brexit. At the heart of an ongoing legal and political tussle between the British government and the EU is the location of an obscure but essential feature of the eurozone financial infrastructure. It concerns the trillion-dollar-a-day business of clearing of euro-denominated financial instruments via so-called central counterparty clearinghouses or CCPs.
Being in the clear: what are central counterparties?
For the uninitiated, it helps to clarify a few issues. What are clearinghouses anyway? What type of oh-so-important transactions are they involved in?
CCPs are the progeny of the financial crisis and the frenzied institution building that followed it. The instability in the financial sector was in no small part due to the multi-trillion-dollar business in derivatives – financial contracts linked to the fluctuation in the price of an underlying asset. Most of these derivatives are over-the-counter. That is to say they are privately negotiated by two counterparts without an intermediary.
The sprawling market of off-balance sheet activities and the uncertain systemic risk posed by them has prompted the concern of financial regulators. The newly created CCPs interpose themselves between counterparties to a derivative contract in order to guarantee its performance, for instance by managing a margin payment on each bet (and charging a fee in the process). In doing so, CCPs have become the focal point for derivative transactions, reducing or ‘mutualizing’ the risks therein while increasing market transparency.
Clearinghouses, however, bear their own risks. With an ever higher proportion of trading being cleared across CCPs, an ever greater amount of credit, liquidity and operational risks are concentrated in clearinghouses; by implication, the more centralized they are, the greater the amount of systemic risk. Due to economies of scale and the imperative to lower transaction costs, they indeed tend to be highly centralized. CCPs in London clear approximately 90% of the euro-denominated interest rate swaps of eurozone banks, and 40% of their euro-denominated credit default swaps.
Location, location, location!
The implications for the Eurosystem’s ability to manage the risks posed by CCPs are considerable. One need only imagine the rather bizarre scenario in which the ECB would have to be the lender of last resort to troubled institutions outside of its jurisdiction. And the ECB does not currently have the ability to regulate UK clearinghouses. In 2011, the ECB had already strained the City’s existence within the single market by proposing a location requirement for eurozone financial infrastructure. The location policy, as it came to be known, proposed that all clearinghouses that handled more than 5% of euro-denominated derivatives should decamp to the eurozone. The United Kingdom promptly took the ECB to court – and won. By using the term ‘securities’ in its proposal the ECB was deemed to have overstepped its mandate. It was, in other words, a single market issue.
This setback, however, has not deterred eurozone regulators. Graham Bishop, an expert on eurozone financial infrastructure, points out that “[the ECB] are not being put off because the various global regulators talk about the national central bank, the supplier of the currency, to be in a position to know what is going on in its currency, which is perfectly reasonable.”
Last June, the European Commission published a proposal refining the supervisory requirements for CCPs. The proposal grants ESMA powers to determine whether certain CCPs should be subject to a “sliding scale of additional supervisory requirements”. In this two-tiered approach, smaller clearinghouses would remain in the City while the more systemically relevant CCPs would have to adhere to stricter standards, such as higher margin and capital requirements – requirements that might compel banks to relocate despite the absence of a clear location criterion. The ECB, meanwhile, is seeking to amend Article 22 of its Statute to extend its mandate to the issue of CCP regulation. In light of this location policy through the back door, the initial legal tussle might well amount to a Pyrrhic victory for a government whose bargaining position is already weak.
This development prompts considerations of a more political nature: has the arcane and technical issue of third-party clearing – though not directly linked to the negotiations – become a bargaining chip in the standoff between Brussels and London? Is it a political gambit aimed at securing business for continental financial centres? Or is it genuine concern over financial stability in the eurozone?
What if the cow dies?
As the location policy before it, the recent proposal was greeted with an outcry from the City. George Osborne had decried the “utterly discriminatory policy” and applauded the court ruling as a “major win for Britain and a major win for all those who want to see a European economy that is both open and successful”, while financial lobby groups have been up in arms over “this kind of currency nationalism which is likely to lead to less competition, higher costs and market fragmentation.”
There is a whiff of hypocrisy in all of this. The Bank of England itself forces every bank to act as subsidiary so as to ensure full prudential control. It is not likely to tolerate excessive pound clearing outside of the UK. Similarly, the ECB is not acting out of excessive caution. The risks associated with highly centralized CCPs are real and cause for acute concern. The liabilities – $1 billion of outstanding positions every night – are implicitly backed by the UK taxpayer and the possibility of these clearinghouses going belly up would seriously undermine the fiscal position of the sovereign, which in turn endangers the solvency of banks holding British bonds.
“What happens if they go bust?” Paul Tucker, deputy governor of the Bank of England, asked in October. “I can tell you the simple answer: mayhem. As bad as, conceivably worse than, the failure of large and complex banks.” The centralization of CCPs and risk associated with their default, then, makes the case to relocate them in a number of cities that fall under the more strictly regulated jurisdiction of the ECB. This move would also relieve the UK economy of a significant amount of risk. Waltraud Schelkle, an economist at the LSE, has pointed out that part of the motivation behind David Cameron’s demand for “flexibility” was not intended as securing protection from the City but “protection of the taxpayers from the City”.
“There is an argument that the UK has far too many central clearing parties as it is, given the systemic risk if one of these guys were to go bankrupt.” One observer in the City pointed out. “The tax authorities love the clearing houses because they are a cash cow. What if the cow dies, though? Will the taxpayers pay to bury it?”
The higher transaction costs that result from moving systemically important CCPs into the eurozone are dwarfed by the liabilities that exist in the current arrangement. Rather than a cynical beggar-thy-neighbour stratagem, then, pooling financial risk with the promise of stricter regulatory oversight strikes me as an appropriate response to the tail-risk of central clearing. As the Commission’s vice president for financial services Vladislav Dombrowski stated: “The purpose of our legislative proposal is to ensure financial stability and not moving business for the sake of moving business.”
If relocating clearinghouses provides an opportunity for risk-diversification in the eurozone, it also carries with it the prospect of a more diversified British economy. In the larger scheme of things, the shrinkage of the financial services industry as a result of Brexit might prove a blessing in disguise. This might come as a surprise after the incessant, dire warnings that preceded the referendum. Indeed, the relocation of euro-clearing alone might cost banks an estimated £63 billion while depriving London of 83,000 jobs. The slimming down of the City, as its denizens never tire of telling us, will also cut into the £71 billion it generates annually in taxes.
The argument that this tax revenue somehow justifies the City’s special status within the UK economy, however, doesn’t survive even a cursory examination. The size of tax revenue has no exculpatory value because of the contingent liabilities inherent in it. One need only consider the prohibitive cost of bailing out the biggest culprits after the financial crisis. Rescuing the Royal Bank of Scotland alone cost UK taxpayers more than half of what the sector generates in tax revenue in a year. And given the deadly embrace of sovereigns and banks, the bigger the banking system, the bigger the fiscal exposure in times of crisis.
Moreover, it is not entirely clear how the financial industry benefits the UK economy beyond taxes. Traditionally, UK banks have focused on their profitable wholesale business rather than financing the real economy (mortgage lending being the only exception in what Lord Turner has described as a ‘socially useless’ industry). Yet that is what any healthy financial system should do: channel savings into productive investments in the real economy while providing insurance and consumption smoothing. Rather than being a risk-generating entity, autonomous to the rest of society, finance should be something of a boring utility. While its departure will certainly put a dent in the budget, there might be some considerable upsides. For one, many gifted graduates of the LSE would be less enticed by the prospects of an extravagantly remunerated (and aggressively dull) career in finance. What they might instead do is use their talents to actually produce something of value – not unlike their continental cousins. One of the great ironies of Brexit, then, is that the British economy might have to become more European.