The UK Can Leave Europe but Not EU Regulations

By Antonia Colibasanu

One of the major concerns following Brexit was that Britain’s departure from the European Union would be detrimental for the financial sector in the U.K. 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 fails to recognize that both the U.K. and the EU will be able to adjust to the new circumstances and do not want to see a massive shake-up in the sector.

The proposed plan would allow the EU to regulate clearinghouses that settle certain types of euro-denominated contracts and which are 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 U.K. 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 U.K. 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 U.K. could refuse to accept the regulations. But that would be a politically motivated move by the U.K. 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 determine whether it will comply with the regulations, and it has no incentive not to.

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 U.S. has for the dollar-denominated clearinghouse business in London. Once the U.K. 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.

The commission’s proposal still has to be approved by the EU member states. Once that’s done, the U.K. 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 U.K. are dependent on the euro clearing business, and the government wouldn’t want to jeopardize these 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 U.K., but it’s unlikely that the U.K. 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 U.K.’s financial sector. It is merely proof that Brussels and London are adapting to the new post-Brexit reality.