One of the biggest risks to financial stability if the UK crashes out of the EU next year without a deal is what happens to trillions of dollars of derivatives contracts. The Bank of England turned up the volume on an already rowdy debate on the issue this week when it warned that £41tn of outstanding contracts — used to hedge oil prices, interest rates and other financial risks at companies across the EU27 — could be forcibly voided next March.
The BoE and the banking industry have warned before that the issue of “contract continuity” — applying to both UK-based derivatives and insurance policies that mature after the March 2019 Brexit deadline — is one of the biggest cliff-edge risks from a hard Brexit. In recent months insurers have addressed their own issue, transferring many of the affected contracts to new EU27-based subsidiaries. Some headway has been made on similar legal issues relating to European aviation.
But the challenges to derivatives are far more complex, involving vast numbers of high-value contracts. They also rely extensively on London-based investment banks as the ultimate providers of those hedges, and on London-based clearing houses, or central counterparties (CCPs) as the intermediaries. The European Central Bank estimates that EU-based groups clear 90 per cent of their interest rate swaps in the UK. It is alarming that with barely five months to go until the Brexit deadline, this issue remains unresolved.
To their credit, the BoE, and its governor Mark Carney, have long been pounding the drum. But despite the fact that ECB president Mario Draghi is co-chair, alongside Mr Carney, of a “joint technical working group on Brexit-related risks”, Mr Draghi has said little publicly on the issue.
Many of the risks that such a committee — and the broader central banking and regulatory community — must worry about are inevitably infused with political tension. Mr Carney and Mr Draghi cannot design the architecture of post-Brexit financial regulation in Europe in the absence of a political deal. But the issue of existing derivatives contracts should not be part of this game of political brinkmanship.
At risk is the stability of CCPs. These have become highly systemic institutions following post-2008 reforms that ensure that most derivatives contracts must go through the clearing house system in an effort to mitigate the possibility that a future crisis would spread unchecked from one investment bank to another. Also at risk is the stability of corporate Europe, given the extent to which London is Europe’s dominant hub for derivatives.
Even if EU leaders conclude that European companies should direct their future hedging through Paris or Frankfurt, they should at least wait until the continent has the requisite licences and clearing capacity to take the business. Currently much of that infrastructure simply does not exist. At the very least, contracts that are already in force, and extend beyond March 2019, should be exempted.
In the short term, the BoE could do more than amplify its rhetoric on risk, and step up its prudential oversight of CCPs. For too long, these companies — particularly the London-based trio of LCH, ICE Clear Europe and LME Clear — have been growing in importance without a commensurate increase in their safety buffers.
It is time, too, for Mr Draghi, as the protector of eurozone financial stability, to speak out as Mr Carney has done. If he did, the European Commission, and political leaders of France, Germany and other EU states would find it much more difficult to ignore a united plea for sanity.
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