Tags: EU | Regulate | London | Financial | Sector

EU's Recent Plans to Regulate London's Financial Sector Are Overblown

Image: EU's Recent Plans to Regulate London's Financial Sector Are Overblown

Skyline of Londons financial district with Canary Wharf and Citigroup (John Braid | Dreamstime.com)

By    |   Tuesday, 20 Jun 2017 09:47 AM

A major concern after Brexit was that it will destroy the financial sector in the UK and and the EU since London is a financial hub.

Those who hold this view would see the European Commission’s new plans announced on June 13 to regulate a very lucrative industry in London’s financial sector as a case in point.

But this view fails to recognize that both the UK and the EU do not want to see a massive shake-up in the sector.

What’s the Exact Proposal?

The proposed plan would allow the EU to regulate clearing houses that settle certain types of euro-denominated contracts located outside the EU.

Clearinghouses act as a middleman between buyers and sellers of derivatives. They ensure that transactions are completed smoothly and bear the cost if one of the parties doesn’t hold up its end of the deal.

They, therefore, help ensure that the effects of a default don’t spread to the rest of the financial system.

The London Clearing House, which is partly owned by the London Stock Exchange, is the global leader for the euro clearing business. It clears roughly three-quarters of all euro-denominated interest rate derivatives transactions.

Since this is a substantial portion of the global business, what happens in London could have a significant impact on the stability of the eurozone, even though the UK doesn’t use the single currency.

For this reason, the European Central Bank insisted in 2011 that euro-denominated derivatives trading should take place only in the eurozone. Eurozone countries had argued that the LCH made the debt crisis even worse by raising its margin requirements (the amount that buyers and sellers are required to hold in an account as collateral against derivative contracts) on debt for Spain and Ireland. The UK challenged the ECB in court and won.

The European Commission’s proposed measure is a way to ensure that, once Britain leaves the union, the EU will have some control over euro-denominated clearinghouses. Some have speculated that London may lose this lucrative business because the UK could refuse to accept the regulations.

But that would be a politically motivated move by the UK government, and since it would go against the country’s own interests considering the value of this business to the British economy, it is unlikely to happen. The London Stock Exchange will decide whether it will comply with the regulations, and it has no incentive not to.

Clearing House Relocation Isn’t Required

Ultimately, this move will not force clearinghouses to relocate to EU member states. The commission’s proposal says that when handling transactions denominated in currencies used in EU states, clearinghouses in non-EU states will need to respect requirements outlined by the central banks that issue those currencies.

These requirements can relate to liquidity, payment or debt settlement arrangements, or collateral margin requirements. The proposal does not, however, require that clearinghouses be located in the EU.

The EU has no financial incentive to force all euro-denominated trading out of London. London is where most currency derivatives are traded—larger clearinghouses can afford to offer better rates to their customers because of economies of scale, which explains why the LCH is more attractive for traders.

Having clearinghouses move to continental Europe would create a fragmented market, which would lead to higher costs for customers and less trading in euro derivatives—bad news for the EU.

The proposed policy also mirrors the arrangement the US has for the dollar-denominated clearinghouse business in London. Once the UK is no longer an EU member, the ECB can demand more oversight over the way London handles euro-denominated trade, as the United States does.

This Doesn’t Change a Lot in the End

The commission’s proposal still has to be approved by the EU member states. Once that’s done, the UK will need to decide whether the proposed regulations are in its interest.

The government doesn’t want to be seen as giving in to the EU, especially while negotiations over its withdrawal from the union are still taking place. But 83,000 jobs in the UK are dependent on the euro clearing business, and the government wouldn’t want to lose those jobs.

More important, the LCH already said last week that it is willing to accept more oversight from Brussels.

The EU may be using this proposal as a bargaining chip in its Brexit negotiations with the UK, but it’s unlikely that the UK will reject the regulations. It doesn’t want to lose such a valuable business.

Therefore, this move should not be interpreted as a sign that Brexit will have drastic consequences for the UK’s financial sector. It is merely proof that Brussels and London are adapting to the new post-Brexit reality.

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