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EU restrictions on euro clearing could cause big disruption globally

EU plans to restrict euro clearing in the U.K. have raised concerns in London and New York about the potential "Balkanization" of the global derivatives market, according to industry observers.

London is the world's largest center for the clearing of derivatives denominated in euros, processing some 74.9% of transactions with an average daily turnover of $574 billion per day, according to data from the Bank of International Settlements.

However, euro clearing has become a point of contention in Britain's negotiations with the EU over the future of financial services following the country's vote to leave the union in June. The EU is looking to impose territorial restrictions on some forms of euro clearing even before the U.K.'s expected exit from the EU, the Financial Times reported Dec. 15.

"On a more macro level, U.S. policymakers are concerned about this move because they fear it would further Balkanize the clearing world," Sean Tuffy, senior vice president and head of regulatory intelligence at Brown Brothers Harriman, said in an interview. "It would force euros to be cleared in the EU, and [the EU] could write a rule that euros can't be cleared in New York."

While the volume of euro-denominated trades cleared in New York is relatively small, the EU would set a precedent for the further fragmentation of clearing globally by restricting euro clearing to EU countries, which, in turn, would raise concerns about the loss of economies of scale for investors in derivatives, Tuffy added.

On average, $7 billion of euro-denominated derivatives are cleared in the U.S. each day, compared with $1.24 trillion of dollar-denominated derivatives, according to data from the BIS.

Bad news

The EU's moves to impose territorial restrictions on euro clearing are at odds with the global nature of the derivatives business, according to Angus Canvin, senior adviser for regulatory affairs at The Investment Association.

"This is also bad news beyond the U.K.," he said in an interview. "London and New York are global leaders [in derivatives clearing], and with good reason. You wouldn't want to disrupt that unless you had a very good reason to do so."

Restricting euro clearing in London is likely to prompt some banks and financial services businesses to move operations to a city in the EU, such as Paris or Frankfurt, Dr. Andrea Vedolin, assistant professor at the London School of Economics, told S&P Global Market Intelligence.

"The whole derivatives brokerage and settlement business should be based in the same place where the trades are cleared," she said in an interview. "If you can't clear trades in the same place, it does not make sense to be in London."

Vedolin added that it was evident that the derivatives clearing business was being used as a bargaining chip in the Brexit negotiations and that the City of London was likely to push back "very hard" against any EU move to restrict euro clearing.

The ECB previously tried to introduce a requirement for clearing houses to base themselves in the eurozone but was defeated by Britain in a landmark legal battle in 2015. It is "unsurprising" that the EU has decided to revive the issue in the aftermath of Brexit, Tuffy said, adding that he also expected a significant pushback from the City of London.

"Derivatives clearing is a key part of what makes the City the City. It would certainly be damaging for London if euro clearing cannot take place," he said. "It would really mean that a lot activity would need to move, along with people, into the eurozone. It would be a huge effort. These ecosystems aren't that portable."