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Derivatives netting could push clearing from London if euro trade exiled

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Derivatives netting could push clearing from London if euro trade exiled

Therisk of London losing euro-denominated derivative clearing after Britain's voteto leave the EU could be compounded by the departure of dollar-denominatedbusiness, pushing clearinghouses and their customers out of the U.K.altogether, a senior industry official has warned.

Thepossibility that EU authorities could insist that clearing of euro-denominatedderivatives contracts be carried out in the eurozone is one of the biggestthreats to the City from the Brexit vote, but the official warned that becauseinvestment banks need to be able to cancel out, or net, contracts that mirroreach other on two sides of the same trade, much of the remaining business couldhave to go with it. Derivatives denominated in dollars and other currencies andcleared in London at exchanges such as LCH.Clearnet Group Ltd. could no longer be nettedagainst euro contracts if they were handled by an exchange in the eurozone, theofficial said.

Separatingeuro- and non-euro netting pools would push up clearing margins by 2.5x,according to a 2009 study. Although this estimate dates from before therequirement for mandatory clearing of over-the-counter derivatives, the increasein cost would likely be of a similar magnitude today, the official said,adding: "I would insist LCH move to euroland."

LCH.Clearnet,majority-owned by London StockExchange Group Plc, handles about €78 billion of euro-denominatedderivatives daily, out of its total activity of $553 billion, more than half ofwhich is in dollars. Other U.K.-based central counterparties — CME ClearingEurope Ltd., LME Clear Ltd. and ICEClear Europe Ltd. — would also be hit if euro clearing moved.Average daily turnover of euro-denominated interest rate derivatives in Londontotaled $928 billion in April 2013, about 70% of the world total, according tothe most recent data.

Althoughclearing itself, despite its significance, is a relatively small industry,employing several hundred people in London, any migration by centralcounterparties could takeinvestment banking offices with them, according to the NationalInstitute of Economic and Social Research. At least 100,000 U.K.-based jobswould be in danger if clearing left, London Stock Exchange Group CEO XavierRolet told Bloomberg News on Sept. 23.

Clearinghouseshave become more important within global financial architecture since thefinancial crisis, with regulators now insisting that OTC derivatives contractsbe cleared in order to avoid any repeat of the aftermath of the collapse ofLehman Brothers, which left hundreds of billions of dollars of such contractsneeding to be unwound.

TheU.K. has already fought off one attempt by the ECB to force euro clearing outof London, when the European General Court ruled in 2015 that it was notallowed to discriminate against an EU member. But this defense will cease to beavailable once the U.K. leaves the trade bloc, as a result of the June 23referendum. Although the ability of London-based financial firms to do businesswithin the EU's single market using passporting rights will be determinedduring complex trade negotiations, the ECB's openly expressed concerns thateuro clearing outside the single currency area adds to systemic risk have ledmany in the financial services industry to expect it to try again to transferthis key activity to within its jurisdiction.

TheU.K. has yet to trigger the start of a two-year negotiating period on the termsof its departure from and future trading relationship with the EU, but onlydays after the referendum result, French President had already declaredthat London should lose euro clearing. The former deputy governor of the Bankof England, Charlie Bean, said earlier in September that he was certain thatthe business would leave London, and Frankfurt's finance industry marketingorganization has said the German city would be well-placed to receive anyclearing business pushed out of London.

Representativesfor the U.K. clearing houses declined to be quoted on the subject, although inprivate two of them said optimism was growing that the ECB would leave Londonclearing alone. One pointed out that restrictions on euro clearing woulddetract from the euro's status as a reserve currency, and the other noted thata revised framework for ECB oversight of the eurosystem issued in July removedits earlier call for euro clearing to be based in the single currency area.

Despitethe ECB's systemic concerns, the future of clearing could be caught up incomplex negotiations involving passporting for banks and other financial firmsand rules on equivalent standards, said Radi Khasawneh, who covers capitalmarkets at Boston Consulting Group. Even if the ECB does make agrab for clearing, it might be far from simple to keep trades out of London,given the complex structure of derivatives contracts, he observed.

"Itwouldn't actually be that difficult to set the framework, but to enforce itwould be very difficult," he said.

Butany confidence among London clearers resulting from the ECB's framework changemay be misplaced, said Michael McKee, a partner at law firm DLA Piper, addingthat it may simply be a necessary consequence of the earlier court ruling.

"Idon't think it necessarily follows that that would preclude some attempt in thefuture to shift the location of eurosystem clearing, but equally I would besurprised if the ECB or other EU bodies were to do that in the short to mediumterm," he said. "There are a lot of things on theiragenda already."

TheU.K.'s chancellor, Philip Hammond, said Sept. 9 that eurozone authorities wouldstruggle to force clearing activity to a center of their choosing, adding thatif the business were pushed out of London, it might go further away from Europeto New York. Attempts to weaken London's financial center would backfire byweakening the European economy, Hammond also said.