Trading and clearing executives have had to work closely with politicians and policymakers since the financial crisis. They have endured many hours explaining how proposed regulations would affect their complicated world of markets infrastructure.
That plumbing — which includes exchanges, clearing houses, over-the-counter markets, derivatives and fixed income trading technology — has already been heavily redesigned. Now, just as the final stages of the sweeping post-crisis reforms come into sight, the prospect of further regulatory problems has suddenly appeared thanks to the UK’s decision to leave the EU.
“The problem is that the rules were built on the assumption that London, one of the world’s biggest and most important trading hubs, would be within the single market,” says Jonathan Herbst, a partner at lawyers Norton Rose in London.
Scores of banks, exchanges and trading venues have based their operations in the UK in recent years, attracted by a mix of the favourable timezone, language, expertise and regulatory approach. Whether they stay will now depend on political decisions.
“There are nine circles in Dante’s Hell and we are just at circle one of Brexit — limbo,” says David Wright, chairman of Eurofi, a think-tank. Mr Wright is the former secretary-general of the International Organization of Securities Commissions and worked at the European Commission for 34 years.
For many the problem is simple. “No European city is ready to replace London as a centre of finance,” said Sergey Shvetsov, first deputy governor of the Bank of Russia, at an industry conference in Geneva last month. Others note that a lot of the business London conducts — including insurance, trading, risk management, tax and legal services — is on behalf of companies in the rest of the world, and not just the EU. For optimists, the divorce may be a way to unhitch the UK from incoming EU rules that, to them, make little sense.
“We’re certainly hoping that the UK will take a step back and look at Mifid II and some of the requirements that went well beyond the G20 agreements,” Scott Hill, chief finance officer at Intercontinental Exchange, said at a recent event. The US exchanges operator has invested more than $1bn in London-based market infrastructure over the past 15 years.
The experience of Switzerland — which is outside the EU — offers some clues as to what the UK can expect.
Last year SIX Group, which operates Switzerland’s domestic exchange and clearing house, needed to gain EU approval that its new laws were “equivalent” to those in the rest of Europe. “On the technical level with Esma [the European regulator] this worked perfectly well, in a very constructive and productive way,” says Urs Rüegsegger, SIX chief executive. But he adds: “The EU Commission — the final approval [stage] — was rather a slow process and it was not very transparent.”
He doubts the UK would have to make wholesale changes. “The age where each country could, at least in the financial sector, have completely independent regulations is probably over,” he says.
The regulatory uncertainty has overshadowed a series of big industry deals this year. Nasdaq bought the International Securities Exchange for $1.1bn in June, presaging the Chicago Board Options Exchange’s $3.2bn deal for Bats Global Markets last month. Dwarfing them all is the planned merger between the London Stock Exchange Group and Deutsche Börse.
The merger would create a behemoth — offering trading and clearing in equities and futures, swaps clearing, index and data analytics, and collateral management — on a scale no other exchange operator in the world can match.
Yet it also offers a test case for the post-Brexit world. The deal will reveal the UK government’s approach to regulating market infrastructure. German watchdogs will have to assess whether it matters that the holding company was due to be based outside the EU. Brussels will weigh up whether it meets European competition rules. As the deal links two of the world’s largest clearing houses, prudential regulators will gauge potential risks to the financial system.
The deal is a symptom of the vast changes in the OTC derivatives market and fixed income trading, once the preserve of big investment banks.
Amount CBOE paid for Bats Global Markets in September
The LSE and Deutsche Börse intend to link their clearing houses, offering the banks billions of dollars in savings from the requirement to post margin to support their derivatives trading portfolios.
Tougher prudential and capital rules are restricting banks’ ability to trade and to make profits from activities that were once the lifeblood of their businesses. For a market used to calling the shots, it has been a painful adjustment.
“The market structure had to be re-created — the old market structure, where banks originated all the trades, has gone away,” says Seth Merrin, chief executive of Liquidnet, which operates equity and fixed income trading venues. “Anything that had been facilitated by capital — derivatives, repos, any type of fixed income — the liquidity dried up.”
Amount of notional FX swaps cleared by LCH this year
Some banks have already withdrawn from the market. In their place came dozens of new bond trading platforms, each offering a centralised venue to entice traders. The market had little need for so many venues and there has already been a shake-out. But Mr Merrin predicts a centralised electronic marketplace will be established in their stead. “Like the way equities played out, fixed income will be the same,” he says.
Post-crisis reforms are also having a significant effect. The first rules requiring more collateral to back OTC derivatives that do not go through clearing came into effect at the start of September and the results were dramatic.
LCH’s foreign exchange swaps clearing business has this year cleared more than $1tn in notional — the broad measure of all outstanding derivative positions. Around a fifth of that was in September, as banks turned to clearing to reduce their margin financing costs. “Central clearing is one of the few available mechanisms capable of providing relief to [banks],” says James Bindler, global head of G10 FX at Citi.
Amid this regulation-driven change, parts of the industry have turned their attention to blockchain to reform antiquated post-trade settlement systems. Companies are trying to combine the peer-to-peer computing ethos of Silicon Valley with the money management of Wall Street, automating the networks of trust on which modern finance sits.
In spite of some scepticism over blockchain’s applicability, start-ups such as R3, Digital Asset Holdings, Setl, Paxos and Axoni have forged partnerships with a host of infrastructure providers. Several of these start-ups have found that regulators are willing to adapt to new business practices.
“They are learning fast,” says David Rutter, chief executive of R3. Industry executives preparing for the Brexit fallout will be hoping they will soon be saying the same thing.