LONDON (Reuters Breakingviews) - A cross-Channel tug-of-war over derivatives regulation demonstrates the limits of Brexit. The European Commission has backed away from forcing trading in euro derivatives to leave London. But its alternative solution will require UK-based clearing houses to follow EU rules – or lose out.
European regulators have long eyed London’s grip on derivatives trading. Of the $762 billion of euro-denominated derivatives traded every day, three-quarters pass through the British capital. Clearing houses like the London Stock Exchange’s LCH.Clearnet underpin this activity by guaranteeing counterparties and managing collateral. Previously attempts by EU regulators to exert greater influence over the clearing business were blocked by the European Court of Justice. Britain’s decision to leave the bloc has given them a new incentive to act.
The Commission had toyed with the idea of forcing European banks to clear euro exposures above a certain threshold with an EU-based institution. Its latest proposal is less draconian. The European Securities and Markets Authority will have oversight of clearing houses and the power to decide that a non-EU institution poses a systemic risk. In that case, European officials would have to monitor the clearing house, which would have to abide by the same rules as entities on the Continent. If it failed to comply, European banks would be forced to hold more capital against their exposures with the counterparty.
Europe already has a similar arrangement with the United States. But the UK’s dominance of euro-denominated derivatives could prompt Brussels to hold London-based clearing houses to a higher standard. For example, EU regulators might insist on the right to control margin requirements for sovereign exposures. LCH.Clearnet’s decision to raise margins during the euro zone crisis in 2011 angered European authorities. The Bank of England would find it hard to hand so much control of risk management to the EU.
If banks move derivatives trading out of London, that will limit their ability to offset different exposures in one place, which would push up margin requirements and trading costs. But even if banks want to stay put, they can do so only if Britain agrees to play by European rules it is no longer able to influence. For Brexit advocates who believe leaving the EU means taking back control, that would be an overdue lesson.