Streetwise Professor

June 29, 2016

Will the EU Cut Off Its Nose to Spite Its Face on Clearing, Banking & Finance?

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 7:45 pm

French President Francois Hollande is demanding that clearing of Euro derivatives take place in the Eurozone. Last year the European Central Bank had attempted to require this, claiming that it could not be expected to provide liquidity to a non-Eurozone CCP like London-based LCH.

The ECB lost that case in a European court, but now sees an opportunity to prevail post-Brexit, when London will be not just non-Eurozone, but non-EU. Hollande is cheerleading that effort.

It is rather remarkable to see the ECB, which was only able to rescue European banks desperate for dollar funding during the crisis because of the provision of $300 billion in swap lines from the Fed, claiming that it can’t supply € liquidity to a non-Eurozone entity. How about swap lines with the BoE, which could then provide support to LCH if necessary. Or is the ECB all take, and no give?

Hollande (and other Europeans) are likely acting partly out of protectionist motives, to steal business for continental entities from London (and perhaps the US). But Hollande was also quite upfront about the punitive, retaliatory, and exemplary nature of this move:

“The City, which thanks to the EU, was able to handle clearing operations for the eurozone, will not be able to do them,” he said. “It can serve as an example for those who seek the end of Europe . . . It can serve as a lesson.” [Emphasis added.]

That will teach perfidious Albion for daring to leave the EU! Anyone else harboring such thoughts, take note!

The FT article does not indicate the location of M. Hollande’s nose, for he obviously just cut it off to spite his face.

In a more serious vein, this is no doubt part of the posturing that we will see ad nauseum in the next two plus years while the terms of the UK’s departure are negotiated. Stock up with supplies, because this is going to take a while, since (1) everything is negotiable, (2) almost all negotiations go to the brink of the deadline, or beyond, and (3) these negotiations will be particularly complicated because the Eurogarchs will be conducting them with an eye on how the outcome affects the calculations of other EU members contemplating following Britain out the door–and because immigration issues will loom over the negotiations.

When evaluating a negotiation, it’s best to start with the optimal, surplus maximizing “Coasean bargain” (a term which Coase actually didn’t like, but it is widely used). This, as Elon Musk would say, is a no brainer: allow € clearing in London, through LCH. That is, a maintenance of the status quo.

What are the alternatives? One would be that € clearing for those subject to EU regulation and some non-EU firms would take place in the Eurozone (say Paris or Frankfurt), some € clearing might take place in London or the US, and most dollar and other non-€ clearing would take place in London and the US.  This would require the EU to permit its banks to clear economically in the UK or US, by granting equivalence to non-EU CCPs for non-€ trades, or something similar.

There are several inefficiencies here. First, it would fragment netting sets and increase the probability that one CCP goes bust. For instance, if a bank that is a member of an EU and a non-EU CCP (as would almost certainly be the case of the large European banks that do business in all major currencies) defaulted, it is possible that it could have a loss on its € deals and a gain on its non-€ deals (or vice versa). If those were cleared in a single CCP, the gain and loss could be offset, thereby reducing the CCP’s loss, and perhaps resulting in no loss to the CCP at all: this is what happened with Lehman at the CME, where losses on some of its positions were greater than collateral, but losses on others were smaller, and the total loss was less than total collateral. However, if the business was split, one of the CCPs could suffer a loss that could potentially put it in jeopardy, or force members to stump up additional contributions to the default fund during a time when they are financially stressed.

Second, default management would be more difficult, risky and costly if split across two or more CCPs. It would be easier to put in place dirty hedges for a broader portfolio than two narrower ones, and to allocate or auction off a combined portfolio than fragmented ones. Moreover, it would be necessary to coordinate default management across CCPs in a situation where their interests are not completely aligned, and indeed, where interests may be strongly in conflict. Furthermore, there would be duplication of personnel, as CCP members would be required to dispatch people to two different CCPs to manage the default.

Third, even during “peacetime,” fragmented clearing would sacrifice collateral and capital efficiencies and increase operational costs and complexity.

But it could be worse! Maybe the Europeans will cut off their noses and ears (and maybe some other parts lower down), and deny a UK CCP equivalence for any transaction undertaken by an EU bank. The outcome would be EU banks clearing in Europe, and most everybody else clearing outside of Europe. This would result in multiple inefficiently small CCPs clearing in all currencies that would exacerbate all of the negative consequences just outlined: netting set inefficiencies would be even worse, default risk management even more difficult, and peacetime collateral, capital, and operational efficiencies would be even worse.

Oh, and this alternative would require the ECB to obtain dollar and sterling (and other currency) liquidity lines to allow it to provide non-€ liquidity to its precious little CCP. How hypocritical is that? (Not that hypocrisy would cost Hollande et al any sleep. It hasn’t yet.)

The fact is that CCPs exhibit strong economies of scale and scope, and although mega-CCPs concentrate risk, fragmentation creates its own special problems.

So the wealth-maximizing outcome would be for the EU to come to an accommodation on central clearing that would effectively perpetuate the pre-Brexit status quo. Wealth maximization exercises a strong pull, meaning that this is the most likely outcome, although there will likely be a lot of posturing, bluffing, threatening, etc., before this outcome is achieved (and at the last minute).

I would expect that EU banks would support the Coasean bargain, further increasing its political viability. Yes, Deutsche Borse would be pushing for a EU-centric outcome, and some Europols would take pride at having their own (sub-scale and/or sub-scope) CCP, but the greater cost and risk imposed on banks would almost certainly induce them to put heavy pressure behind a status quo-preserving deal.

This raises the issue of negotiation of banking and capital market issues more generally. There has been a lot of attention paid to the fact that British banks would probably lose passporting rights into the EU post-exit, and this would be costly for them. But European banks actually rely even more on passporting to get access to London. Since London is still almost certain to remain the dominant financial center (especially since the UK government will have a tremendous incentive to facilitate that), European banks would suffer as much or more than UK ones if the passporting system was eliminated (and a close substitute was not created).

Thus, if the negotiations were only about clearing, banking, and capital markets, mutual self-interest (and political economy, given the huge influence of the finance sector on policymakers) would strongly favor a deal that would largely maintain the status quo. But of course the negotiations are not about these issues alone. As I’ve already noted, the EU may try to punish the British even if it also takes a hit because of the effect this might have on the calculations of others who might bolt from the Union.

Furthermore, the most contentious issue–immigration–is very much in play. Merkel, Hollande, and others have said that to obtain a Norway-style relationship with the EU, the UK would have to agree to unlimited movement of people. But that issue is the one that drove the Leave vote, and agreeing to this would be viewed as a gutting of the referendum, and a betrayal. It will be hard for the UK to agree to that.

Perhaps even this could be finessed if the EU secured its borders, but Merkel’s insanity on this issue (and the insanity of other Eurogarchs) makes this unlikely, short of a populist political explosion within the EU. But if that happens, negotiations between the EU and the UK will likely be moot, because there won’t be much of the EU left to negotiate with, or worth negotiating with.

In sum, if it were only about banking and clearing, economic self-interest would lead all parties to avoid mutually destructive protectionism in these areas. But highly emotional issues, political power, and personal pride are also present, and in spades. Thus, I am reluctant to bet much on the consummation of the economically efficient deal on financial issues. The financial sector is just one bargaining chip in a very big game.


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  1. This is going to get very interesting. The French have never made a secret of their desire to have more clearing happening in Paris. This has been ongoing for 15+ years and the ECB Euro support policy was just the latest attempt to achieve their goal. I’ve never quite seen why they are so keen. It doesn’t mean that trading activity and revenues / taxes follow. From a practical point of view how can they force 2 non-EU entities to clear a Euro denominated swap in the Eurozone?

    It must surely be impossible to fairly price the LSEG DB merger in this environment? Does the deal get put on hold until Brexit is clearer?

    As you state, the lack of competitiveness of both Paris and Frankfurt are the reason that they are not global financial centres. Their labor laws are incredible when viewed from a US or UK standpoint.

    I am certain the French and Germans will wilfully damage their own industries to punish the UK for wanting to leave the EU – the EU project is just too important. Like a concentration camp, they will punish escapees to keep the others under control. Maybe they will squeeze too hard and cause internal strife with those industries that like to export to the UK like the Frech wine industry or the German car industry.

    Comment by Greenwichmeantiger — June 30, 2016 @ 6:39 am

  2. I reckon the banks at least will mostly stay in London.

    Britain has contract law. Almost everywhere in Europe has some mishmash of French or other national law. Those that do not are bad places to locate a bank in, because they can’t afford to bail out their banks if they go bust. Britain can and has done.

    Comment by Green As Grass — June 30, 2016 @ 11:58 am

  3. The tenets of the BIS Principles for Financial Market Infrastructure, which are legally binding in most financially sophisticated jurisdictions, require a CCP to have liquid assets sufficient to meet the default of the largest counterparty in extreme but plausible circumstances. The relevant principle actually prefers liquidity to be sourced from other than central banks.

    According to LCH.Clearnet disclosure under the Principles it does not have access to any central bank liquidity. Nor is LCH.Clearnet settling in central bank money.

    Politically the EU can make a lot of noise, but I don’t see what it can do without annoying European banks for the reasons set out by the Professor and Green as Grass plus essentially repudiating the Principles which will cause a messy set of cross border problems – particularly with the US.

    But you can’t put a price on bloody mindedness.

    Comment by noir — June 30, 2016 @ 5:24 pm

  4. @Greenwichmeantiger – xeno euro market? :) I believe then actually can (stop them) though, as eurodollar market always relied on the benevolence of Fed & related banking regulators. For example, EU could put an “unlawfully” EUR clearing bank on a sanctions list, prohibiting anyone to provide them with EUR nostro, and prohibition from using the payments system.

    @Green as Grass – there’s no reason why you can’t contract under English law while not being on London. In fact, it happens all the time. Party in Japan and party in Australia can happily execute under English law, w/o ever setting a foot in the UK. Moot point.

    Comment by vlade — July 5, 2016 @ 1:24 am

  5. The immigration issue is absolutely central.
    What hasn’t been commented on but seems to me critical is that most of the EU are exporting young, energetic and enterprising labor to the U.K. while the sunny periphery has been importing mostly retirees (with a sprinkling of the criminal classes).

    The size of the population flows is secondary to the makeup. Talk to any French or Italian young adult and you will quickly understand that they prefer the U.K. as the location to advance their careers not because of the climate but because of two factors:

    1. There are jobs; and
    2. In the U.K. it doesn’t matter so much who you know or who your mum or dad is – quite unlike the situation back home.

    “Free movement” of course has been dreadful for the lower classes of the U.K. It was bad enough competing with home-grown smart enterprising kids before the influx of striving foreigners, the Poles etc. Now the competition for decent jobs has become ever keener. The vote for Brexit is hardly surprising even if the motives were not exactly the kind one might want to publicise. But, tell me, if you were a lazy, unenterprising,dull kind of person, wouldn’t you vote for a cushy job with decent pay where you didn’t have to strain yourself competing with some pushy foreigner? As Keynes (might have) remarked, there is more to life than eight hours down’t pit.

    Comment by Simple Simon — July 5, 2016 @ 8:44 am

  6. @Simon-Reading your comment sparked a thought. Maybe one reason that the French in particular, but continentals in general, are so freaked about Brexit is that it threatens to deprive them of an employment safety valve. They already have big underemployment problems, including for well-educated young adults. Some of those go to the UK. If that is closed to them, or even just more highly restricted, they will add to the discontent with the Europols. Yeah, now the hostility is directed at the Brits, but eventually it will be directed at the EU for failing to create decent job opportunities.

    The ProfessorComment by The Professor — July 6, 2016 @ 10:39 am

  7. Prof:

    Have you read Diego Gambetta on Italian academia – a prototypical kakistocracy? Read it and weep. How demoralizing it must be. No wonder Prof Gambetta hopped off to Nuffield College :)

    Comment by Simple Simon — July 7, 2016 @ 7:00 am

  8. @Simon-Yes. US academia isn’t quite so bad, but you do see a similar phenomenon. I always attributed it to opportunity cost. Those with poor research or consulting prospects allocated their time towards administration because the opportunity cost of doing so was low. The need to keep deans off their backs impels even the lazy ones to do that, but some actually seem to like it. Those are the dangerous ones. My motto: those who most want to administrate are the ones you least want administrating.

    I’ll have to think whether there are ways to distinguish Gambetta’s trust hypothesis from the opportunity cost hypothesis.

    The ProfessorComment by The Professor — July 7, 2016 @ 6:21 pm

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