Streetwise Professor

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.