Time’s Running Out: Disorderly Brexit Would Trigger Mayhem in Derivatives Market and Insurance Industry

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March 29 is the deadline. Urgent action is needed. But it’s not happening.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

With less than six-and-a-half months to go before the UK’s deadline to leave the EU expires, progress is still lacking in the Brexit negotiations, in particular on crunch issues such as the Irish border and the equivalency of financial services. As the doomsday clock ticks down,  jitters are rising on both sides of the English Channel, particularly the English-speaking one.

On Monday, Moody’s said the probability of a no-deal Brexit has “risen materially,” and “would be negative for an array of issuers.” Such an outcome could bring with it a host of ugly consequences for the UK economy, ranging from a further weakening pound to higher inflation and sliding real wages, as well as undesirable knock-on effects for EU economies.

The longer the uncertainty drags on, the more likely it is that companies and banks will activate plan-B contingency plans, which in many cases involve moving a large chunk of their UK-based operations across the Channel. Once those plans are activated, stalling or reversing them will not be easy.

Deutsche Bank is mulling transferring up to three-quarters of the capital it has invested in the City — estimated to be worth around €600 billion — to its Frankfurt headquarters, the Financial Times reported on Sunday, citing sources close to the bank’s senior management. Tellingly, Deutsche Bank hasn’t made the move yet, since it knows that relocating key operations and staff across the channel is a costly, complex undertaking. It would much prefer to play a waiting game in the hope that the need for such drastic measures can be averted.

Most of the corporate moves that have taken place so far have involved small parts of firms’ operations, with few jobs lost in the City. But that dynamic appears to be changing as the Brexit deadline approaches. According toRisk.net, UK-based brokers and traders have already started activating contingency plans for a no-deal Brexit. Not even a last-minute agreement between UK and EU politicians will be enough to reverse those plans, they claim.

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For the City of London, arguably its biggest fear is losing its hold over the global clearings business, which it has dominated for decades. Clearing is where a company acts as a middleman between financial trades, collecting collateral and standing between derivatives and swaps traders to prevent a default from spiraling out of control. London is home to the world’s largest clearing-house, LCH, which clears almost €1 trillion in euro-denominated derivatives a day, representing around three-quarters of the global market.

For City-based firms, the clearing business provides hundreds of thousands of jobs and billions of pounds in annual profits. But those are now on the line. Euro-denominated contracts make up roughly a quarter of LCH’s daily volumes and with Brexit fast approaching, the ECB and certain European governments, with France leading the way, want a sizeable piece of that action, for largely justifiable reasons.

They’ll probably get it, said UBS analysts in a note last week. The analysts expect LCH to suffer a “25% loss of market share of the euro-denominated clearing market.” The authors also warn the clearing house will lose sales volumes “no matter the outcome” of Brexit, as “regulators like the European Banking Authority are encouraging institutions to prepare for a worst-case outcome to mitigate Brexit-related market disruptions.

This is spurring financial institutions to increase their business with Eurex, Germany’s largest clearing house, in a bid to reduce their Brexit exposure. The more customers Eurex attracts, the more competitive it becomes. Deutsche Bank shifted around half of its euro clearing volumes from LCH to Eurex in July. HSBC and Barclays also transferred volumes to Eurex earlier in the year, according to the FT.

In the UBS analysts’ best-case scenario, in which the UK and EU sign a provisional exit agreement by the March 29 deadline, LCH’s owner, the London Stock Exchange, will lose around 2-3% of its earnings per share.

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In their worst-case scenario — a hard or no-deal Brexit — the resulting economic carnage could be huge. If the UK crashes out of the EU without any deal on future trading arrangements, it “would prohibit the clearing at LCH of ANY derivative contracts (not just euro-denominated contracts) by EU-domiciled entities,” the UBS analysts warn.

This doom-laden prognosis chimes with recent warnings by the Bank of England and the UK’s Financial Conduct Authority that derivatives contracts, valued in the tens of trillions of pounds, could be thrown into confusion by a disorderly Brexit. The London Metal Exchange (LME), the world’s largest market in options and futures contracts on base and other metals, has also chipped in, warning that its clearing house could struggle to provide services to European Economic Area (EEA) countries after Britain leaves the European Union.

Of course, these dire predictions could be construed as good old-fashioned Brexit fearmongering, which is in endless supply these days. But it’s no longer just the Brits who are peddling this narrative. So, too, is the German financial regulatory authority, BaFin, which recently exhorted EU officials to take urgent action to prevent mayhem in the derivatives market and insurance industry after Brexit.

“It is almost impossible to fix that problem exclusively just by one side of the stakeholders involved, let it be the industry itself or individual supervisors,” BaFin’s president, Felix Hufeld said at a forum in Frankfurt at the end of August. There has to be “a solution on a political level” aimed at building a legislative or regulatory structure to prevent disruption, Hufeld said.

Time is running out. Until now, the European Commission and ECB have shown scant willingness to accept any form of equivalency between British and EU financial services. And without that, there is a genuine risk that a disorderly Brexit on March 29 could set in motion an unraveling of an already hugely volatile, highly interconnected derivatives industry. By Don Quijones.


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