No plain sailing: Brexit, banks and clearing derivatives
Author: Mark Profeti, Principal Consultant Date: 4th July 2018
As we sail the uncertain seas of Brexit, one thing is crystal clear: the increasing complexities of negotiations with the EU will result in less time to negotiate many specific details of the Brexit deal. The fate of clearing is one specific area which is likely to suffer as a result, particularly when we consider that the City of London handles a big chunk of the market, including 39 percent of the market in interest-rate derivatives alone, where global daily turnover averages $3 trillion1. As the sand continues to trickle through the hourglass, firms must take the wheel to steer preparations for how a hard or soft Brexit will impact such areas of their business.
In addition to uncertainty around passporting rights, various initiatives threaten current clearing models. One proposition from the ECB is to force all Euro-denominated clearing flows into EU-based CCPs. Specific legislation such as this must be considered alongside the broader impact of Brexit on clearing practices of banks. As with almost all Brexit solutions, there is rarely a one-size-fits-all approach. The effect of severed ties with the EU on clearing will greatly depend on the kind of clearing that a bank does, and which products and for whom, in what markets.
Here are some key considerations that your organisation needs to address by March 2019:
- Clearly map out your present environment: The very nature of clearing is complex. Banks may rely on multiple 3rd party relationships, operate different clearing entities, with multiple memberships of various CCPs. They must ensure they have a clear picture of how this is all knitted together for the services they offer, and how Brexit will affect their clearing solutions.
- Understand your geographical footprint: Is the bank offering clearing services in the UK only, in the EU only, or both? Although earlier this year the UK government committed to letting UK banks continue using EU-based counterparties for clearing services, the EU has made no such reciprocal agreement for EU-based firms. How will this affect your business and what alternative approaches are you seeking?
- Analyse your current service offering: Particularly relevant for banks who clear for in-house and 3rd party clients. Such institutions must understand what their service costs and revenues are, and whether these are sustainable. They may wish to reduce the service coverage across products and markets focusing on markets where they have critical mass or are commercially profitable.
- Review your derivative contracts and risk exposure: Mark Carney, Governor of the Bank of England raised concern towards the end of last year that the ‘legal validity’ of pre-existing derivative contracts might be questioned if they extend beyond the Brexit deadline. EU companies have signed £26 trillion of derivatives contracts which are due to mature after Brexit. Banks must aware of how Brexit will impact current contracts and understand the implications.
The approach taken by banks will be largely driven by the answers to these questions and how they deal with the challenges ahead. These include segregating collateral pools and clearing activities, counterparty risk profile changes, re-papering and re-aligning clients, and transfer of business to third-party clearers where necessary. Ultimately, all these requirements come with major potential cost and client service implications.
Approaching Brexit assuming little or no change to clearing models is risky. Essentially, the effort to achieve readiness and ensure business is not adversely affected is dependent on the clearing footprint of each organisation. Single product, single market clearers operating in a single location have fewer considerations compared to multi-asset class, multi-market clearers operating across UK and EU jurisdictions.
For more information about how we can help UK and EU-based clearing businesses in the run up to Brexit, please get in touch:
STEVEN HARGREAVESPartner (London)