Streetwise Professor

May 30, 2017

Clearing Fragmentation Follies: We’re From the European Commission, and We’re Here to Help You

Filed under: Clearing,Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 6:33 am

Earlier this month came news that the European Commission was preparing legislation that would require clearing of Euro derivatives to take place in the Eurozone, rather than in the UK, which presently dominates. This has been an obsession with the Euros since before Brexit: Brexit has only intensified the efforts, and provided a convenient rationalization for doing so.

The stated rationale is that the EU (and the ECB) need regulatory control over clearing of Euro-denominated derivatives because a problem at the CCP that clears them could have destabilizing effects on the Eurozone, and could necessitate the ECB providing liquidity support to the CCP in the event of trouble. If they are going to support it in extremis, they are going to need to have oversight, they claim.

Several things to note here. First, it is possible to have a regulatory line of sight without having jurisdiction. Note that the USD clearing business at LCH is substantially larger than the € clearing business there, yet the Fed, the Treasury, and Congress are fine with that, and are not insisting that all USD clearing be done stateside. They realize that there are other considerations (which I discuss more below): to simplify, they realize that London has become a dominant clearing center for good economic reasons, and that the economies of scale and scope clearing mean that concentration of clearing produces some efficiencies. Further, they realize that it is possible to have sufficient information to ensure that the foreign-domiciled CCP is acting prudently and not taking undue risks.

Canada is another example. A few years ago I wrote a white paper (under the aegis of the Canadian Market Infrastructure Committee) that argued that it would be efficient for Canada to permit clearing of C$ derivatives in London, rather than to require the establishment and use of a Canadian CCP. The Bank of Canada and the Canadian government agreed, and did not mandate the creation of a maple leaf CCP.

Second, if the Europeans think that by moving € clearing away from LCH that they will be immune from any problems there, they are sadly mistaken. The clearing firms that dominate in LCH will also be dominant in any Europe-domiciled € CCP, and a problem at LCH will be shared with the Euro CCP, either because the problem arises because of a problem at a firm that is a clearing member of both, or because an issue at LCH not originally arising from a CM problem will adversely affect all its CMs, and hence be communicated to other CCPs.  Consider, for example, the self-preserving way that LCH acted in the immediate aftermath of Brexit: this put liquidity demands on all its clearing members. With fragmented clearing, these strains would have been communicated to a Eurozone CCP.

When risks are independent, diversification and redundancy tend to reduce risk of catastrophic failure: when risks are not independent, they can either fail to reduce the risk substantially, or actually increase it. For instance, if the failure of CCP 1 likely causes the failure of CCP 2, having two CCPs actually increases the probability of a catastrophe (given a probability of CCP failure). CCP risks are not independent, but highly dependent. This means that fragmentation could well increase the problem of a clearing crisis, and is unlikely to reduce it.

This raises another issue: dealing with a crisis will be more complicated, the more fragmented is clearing. Two self-preserving CCPs have an incentive to take actions that may well hurt the other. Relatedly, managing the positions of a defaulted CM will be more complicated because this requires coordination across self-interested CCPs. Due to the breaking of netting sets, liquidity strains during a crisis are likely to be greater in a crisis with multiple CCPs (and here is where the self-preservation instincts of the two CCPs are likely to present the biggest problems).

Thus, (a) it is quite likely that fragmentation of clearing does not reduce, and may increase, the probability of a systemic shock involving CCPs, and (b) conditional on some systemic event, fragmented CCPs will respond less effectively than a single one.

The foregoing relates to how CCP fragmentation will affect markets during a systemic event. Fragmentation also affects the day-to-day economics of clearing. The breaking of netting sets resulting from the splitting off of € will increase collateral requirements. Perverse regulations, such as Basel III’s insistence on treating customer collateral as a CM asset against which capital must be held per the leverage requirement, will cause the collateral increase to increase substantially of providing clearing services.

Fragmentation will also result in costly duplication of activities, both across CCPs, and across CMs. For instance, it will entail duplicative oversight of CMs that clear both at LCH and the Eurozone CCP, and CMs that are members of both will have to staff separate interfaces with each. There will also be duplicative investments in IT (and the greater the number of IT potential points of failure, the greater the likelihood of at least one failure, which is almost certain to have deleterious consequences for CMs, and the other CCP). Fragmentation will also interfere with information flows, and make it likely that each CCP has less information than an integrated CCP would have.

This article raises another real concern: a Eurozone clearer is more likely to be subject to political pressure than the LCH. It notes that the Continentals were upset about the LCH raising haircuts on Eurozone sovereigns during the PIIGS crisis. In some future crisis (and there is likely to be one) the political pressure to avoid such moves will be intense, even in the face of a real deterioration of the creditworthiness of one or more EU states. Further upon a point made above, political pressures in the EU and the UK could exacerbate the self-preserving actions that could lead to a failure to achieve efficient cooperation in a crisis, and indeed, could lead to a catastrophic coordination failure.

In sum, it’s hard to find an upside to the forced repatriation of € clearing from LCH to some Eurozone entity. Both in wartime (i.e., a crisis) and in peacetime, there are strong economies of scale and scope in clearing. A forced breakup will sacrifice these economies. Indeed, since breaking up CCPs is unlikely to reduce the probability of a clearing-related crisis, but will make the crisis worse when it does occur, it is particularly perverse to dress this up as a way of protecting the stability of the financial system.

I also consider it sickly ironic that the Euros say, well, if we are expected to provide a liquidity backstop to a big financial entity, we need to have regulatory control. Um, just who was supplying all that dollar liquidity via swap lines to desperate European banks during the 2008-2009 crisis? Without the Fed, European banks would have failed to obtain the dollar funding they needed to survive. By the logic of the EC in demanding control of € clearing, the Fed should require that the US have regulatory authority over all banks borrowing and lending USD.

Can you imagine the squealing in Brussels and every European capital in response to any such demand?

Speaking of European capitals, there is another irony. One thing that may derail the EC’s clearing grab is a disagreement over who should have primary regulatory responsibility over a Eurozone CCP. The ECB and ESMA think the job should be theirs: Germany, France, and Italy say nope, this should be the job of national central banks  (e.g., the Bundesbank) or national financial regulators (e.g., Bafin).

So, hilariously, what may prevent (or at least delay) the fragmentation of clearing is a lack of political unity in the EU.  This is as good an illustration as any of the fundamental tensions within the EU. Everybody wants a superstate. As long as they are in control.

Ronald Reagan famously said that the nine scariest words in the English language are: “I’m from the government and I’m here to help.” I can top that: “I’m from the EC, and I’m here to help.” When it comes to demanding control of clearing, the EC’s “help” will be about as welcome as a hole in the head.


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  1. The French have been trying for years to get more clearing in Paris. I don’t get why. Does clearing mean, trading and traders and therefore tax revenues? It doesn’t. What is does mean is everything you mentioned above plus some other issues. How does this sit with their desire for a financial transaction tax? What about the risk of developing an offshore vs offshore clearing service. How will they force a EUR trade between JP Morgan and Goldman Sachs traded out the US? They can’t just pick up all the existing EUR trades and drop them into the a Eurozone CCP. This is getting alot or airtime ‘cos it’s one of the easiest things to point to as a consequence of Brexit. Just like with the Brexit trade deal discussions, I suspect the Eurocrats will stubbornly refuse to change their point of view to their own economic detriment. Supposed political harmony trumps economics. Utterly crazy.

    Comment by Greenwichmeantiger — May 30, 2017 @ 8:11 am

  2. There seems to be tension (perhaps i’m not thinking about it clearly) between (1) the view that there is increased systemic risk in the concentration of risk in CCPs caused by mandatory clearing, as well as increased risk in a smaller # of clearing members and (2) the view that fragmentation of CCPs increases systemic risk. iow – which is it – do you want concentrated risk or dispersed risk?

    I suppose that in both cases, there is the issue that the same 5-10 clearing members are responsible for a high % of the positions. however, i am having trouble reconciling the above points…

    Comment by GDG — May 31, 2017 @ 9:32 am

  3. Something tells me that the EU is heading for a USSR like collapse, the UK- it’s Lithuania- has been the first stepping stone.

    Comment by James — May 31, 2017 @ 2:12 pm

  4. There has been a lot of hot air about this. My initial take is that it is an attempt to “punish” the UK for the temerity of (a) not joining the EMU and, now (b) leaving the EU. They see it as a way of weakening London’s grip on euro financial markets. It is also a desire by bureaucrats to extend their franchise.

    But on another note, I wonder where this stricture would leave the EU’s other ambition to see the euro become a dominant global currency? I am not sure, but I think it is the case, that euro derivatives are traded in Asia. Presumably, if they can get the legal basis to repatriate UK clearing, this would automatically apply to any other clearing (you can see where this is going — a measure targeted at the UK only would end up in the mother of all international law suits (WTO?, etc.)) and if it applied to say, Singapore’s big derivatives business, would lead to a reduction in the attractiveness of such contracts in that time zone.

    Another issue is the difference between clearing and actual cash settlement. One reason the USA is very relaxed about who clears where is that ultimately all dollar transactions go through the fed wire. A similar thing happens with the euro — TARGET is the settlement system and while the actual clearing processing is in the UK, the cash movement occurs through TARGET. So is it a confusion by the authorities as to the role of clearing versus settlement?

    My last point is, what competitive advantage does having the clearing physically proximate to trading deliver? I suspect very little. Equally, how value-added is it? I know it is a quasi-natural monopoly and gains from size and spread for all the reasons given in the post but, equally, it is a utility and if it is earning significant rents users will have strong incentives to set up rivals.

    So all-in-all, somewhat perplexed by the fixation on getting their hands on clearing except for the reasons stated: the ability to “force” the CCP to moderate any margin increases based on a political take at any moment. That is sure to encourage self-interested users to reconsider its merits.

    Just my 1/2p’s worth


    Comment by Peter in Edinburgh — June 1, 2017 @ 2:13 am

  5. […] London’s Brexit Apocalypse Is Nowhere in Sight and The great London property squeeze and Chart of the Week: Brexit and The City and Clearing Fragmentation Follies: We’re From the European Commission, and We’re Here to Help You […]

    Pingback by Links, 1 June 2017 | illiquid ideas — June 1, 2017 @ 1:27 pm

  6. No desire to travel to Europe anymore.

    Comment by Tom Hend — June 1, 2017 @ 5:36 pm

  7. Hip Hip Hooray for EU members Germany, Italy, and France for categorically rejecting renegotiation of the Paris climate accords. Best outcome possible to deny further damage to the US by the Progressive high priests of fake science. Unfortunately the mass media will be awash in worthless reports of islands sinking and polar bears dying and hurricanes roaring and children starving that are at odds with reality.

    Comment by pahoben — June 2, 2017 @ 4:04 am

  8. For those that know their Reagan and Friedman quotes, the headline is all you need to read. Even with Brexit, London will continue to flourish and dominate as a financial centre. It has too much history, infrastructure, network effects and human capital. If you grow up in Europe and you want to be a big time banker do you head to London or Brussels? Answer that and you will know why this sentiment has nothing to do with risk and is a land grab for business and power.

    Comment by Jeffrey — June 2, 2017 @ 4:38 am

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