Warnings from the European Central Bank (ECB) this week that financial institutions in the City of London need to “plan for a ‘worst case’ scenario” to avoid threats to financial market stability stemming from mismanaged Brexit negotiations are in stark contrast to the almost casual public attitude of Britain’s Brexiters.
In its latest Financial Stability Review the ECB warns of “frictions” in financial markets “especially if no transitional agreement [between the UK and EU] is reached”.
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Such is the unease about the negotiation process, governments of the Group of Seven (G7) advanced economies, which includes the UK, are preparing to activate their inter-governmental loan agreements designed to avert severe turbulence in the markets financial markets a senior EU official has said. The loan agreements, called currency swaps, were vastly expanded as a result of the financial crisis a decade ago.
The international financial authorities’ particular Brexit-related headache, identified in the ECB report, is the uncertainty about the regulation of central counterparties (CCPs). These are giant financial institutions which take on, and try to minimise, hundreds of billions of pounds daily of trading risks in London’s derivatives and money markets.
At present, London based CCPs dominate the clearing of euro-denominated over-the-counter derivatives instruments and, as the ECB report also highlights, play a crucial role in the eurozone money markets, a vital source of financial sector liquidity.
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With London in effect Europe’s international financial marketplace, financial market turbulence stemming from, for example, even a temporary breakdown in the Brexit talks, could have global repercussions. This could require an official G7 response – which would, in turn, cut across Theresa May’s Brexit negotiations and economic strategy.
There is particular concern about CCPs because of the looming confrontation between the UK and the EU over the ECB’s stated policy on CCPs. The ECB has maintained that, partly for financial stability reasons, CCPs engaged in euro denominated trading should be located, for regulatory and judicial purposes, in the eurozone and the EU, not London. A formal policy statement on the issue is expected from the European Commission next month.
A report earlier this year (CCPs post Brexit) from the quasi-official, UK-based, International Regulatory Strategy Group (IRSG) raised the question of the impact of Brexit on CCPs and financial stability. The IRSG is chaired by Mark Hoban, the former Financial Secretary to the UK Treasury. The Council of the IRSG includes, as observers, representatives from, inter alia, the Foreign Office, the UK Treasury and the Bank of England.
By implication, the IRSG report warns that, without a transition agreement, markets could seize up. The report said that without a smooth Brexit transition EU27 banks could find themselves holding trading positions at UK-based CCPs “that would no longer be authorised and would suffer punitive capital increases”, a scenario the ECB report describes as a regulatory “cliff edge”.
Since it is not practical for EU27 banks to move their existing positions from UK CCPs, the IRSG report added that “(to) avoid financial instability ….it is therefore necessary to agree and put in place transitional arrangements that will enable markets to continue operating [our italics].”
The looming confrontation between the UK and EU over CCPs is just one of several signs that London is failing to grasp how serious the EU27 think Brexit’s impact on the EU and global financial markets could be.
Edited by Michael Prest
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