“Clearing” of financial transactions has suddenly become a political hot potato. Chancellor Hammond told the House of Lords - in his first appearance before a Parliamentary Committee – that you cannot make “clearing” go where it does not want to go. The implication was that if it left the UK, it might well not go elsewhere in the EU. In contrast, former Bank of England Deputy Governor Sir Charlie Bean told another House of Lords Committee that he had “absolutely no doubt at all” that euro-denominated clearing will be taken back into the European Union.
Drawing on his regulatory experience, he made the strong point that regulators want to know exactly what arrangements exist in the event of an institution failing. This approach can hardly be a surprise when the pursuit of `financial stability’ is still seen as the number one public good by everyone connected with the financial system. That is exactly why Prime Minister May signed up to the G20’s Communiqué from Hangzhou “We encourage members to close the gap in the implementation of the Principles for Financial Market Infrastructures (PFMI) and welcome the reports by the Committee on Payments and Market Infrastructures (CPMI), International Organization of Securities Commissions (IOSCO) and FSB on enhancing central counterparty resilience, recovery planning and resolvability.”
Such a statement may sound rather technocratic for the Heads of Government, especially when applied to the very specific example of clearing derivatives but it underlines the importance of the issue – identified so powerfully at the early G20 Summits several years ago and still unresolved. The timeline to the start of the G20 Summit probably explains why a key consultation Note was released by the FSB in the middle of the holiday season when the chances of it attracting public attention were particularly limited.
The issue of Central Counter Parties (CCPs) clearing vast volumes of derivative transactions within the EU is made particularly complex by the number of currencies involved and that the City of London – the key player – is not part of the Eurozone. In a post-Brexit world, it will not even be part of the EU. The nub of the problem flows from the FSB’s statement that “For CCPs that are systemically important in more than one jurisdiction, resolution planning and resolvability assessments should be conducted by the home resolution authority [so Bank of England for UK –based entities] and coordinated within cross-border Crisis Management Groups (CMGs) or equivalent arrangements.”
The original Principles for sorting out these problems were published in 2012. It is disturbing that, four years on, the latest discussion document simply poses 24 questions and states that the feedback will be used by the FSB to “develop proposals for more granular guidance by early 2017”. For the European Union, this surely pushes back the timetable for a CCP resolution proposal well into 2017 – perhaps amidst fraught Brexit negotiations. CCPs are often likened to nuclear power stations: wonderful if they work well, but the ultimate catastrophe if they melt down. Whatever else it does, Brexit must surely force regulators to take a firm grip on this red hot potato.
Perhaps the key lies in the Note’s chapter analysing the legal framework conditions for cross-border cooperation. It talks glibly of the resolution authority having powers over “local branches of foreign firms” and also perhaps “the capacity to use its powers… ordering a transfer of property located in its jurisdiction to a bridge institution established by the foreign home authority”. Given the scale of derivatives trading, any `transfer of property’ could be massive. If the resolution authorities are bound together by a common legal framework such as an EU Directive or Regulation, then both sides start with the presumption that in a crisis, the other side will be bound by the same EU laws so can be relied upon. In a world of Brexit, that presumption may drop away in a crisis where sums of money that are many percentage points of GDP may have to be transferred instantly in real-time settlement systems. Crucially, these sums will not necessarily be providing liquidity – as in a classic foreign exchange swap line – but will be money at real risk of credit loss.
Thinly-capitalised central banks go to huge lengths to avoid incurring such credit risk as losses have to be made good – ultimately – by taxpayers. So the problem becomes ever more acute when the losses might be payment to a foreign authority to plug a hole resulting from that authority’s failure to supervise a CCP adequately. Moreover, the ECB might feel that it would face a huge political storm if it had to ask the politicians of all Eurozone members to make good losses in the UK.
The Eurosystem describes itself as performing “oversight to ensure the smooth functioning of payment, clearing and settlement systems. It monitors their performance, assesses them against its objectives of safety and efficiency and, where necessary, induces change.” It may well have to answer the question of whether it actually has the power to induce necessary change as a crisis develops looms. After Brexit, it may be even more difficult to answer unequivocally Yes. As a former insider, Sir Charlie Bean may have understood the inexorable dynamics of clearing locations rather better than many City players.