There was no announcement but word still made its way to European bankers as summer turned to autumn: For them, Brexit day was the end of 2018, not March 29, 2019, when the U.K. splits from the European Union.
That’s because executives in London needed three months notice for derivatives deals that would be closed or moved. And there was still no plan to avoid what central bankers and regulators feared was a potential Lehman-like meltdown in financial markets if trillions of dollars of transactions were suddenly put in legal limbo with EU firms locked out of London.
As politicians in London and Europe stumble toward a Brexit agreement -- with its final passage far from assured -- the race to avoid financial catastrophe is approaching the finish line. While fine legal points remain to be hammered out – and European politicians need to fulfill their promises -- officials on both sides have expressed confidence that market chaos will be avoided even in the event of a no-deal Brexit. Europe’s markets watchdog on Friday said it’s working with U.K. clearinghouses to ensure nothing goes awry.
We feel modestly comfortable that the right steps are being taken,'' Adam Farkas, executive director of the European Banking Authority, said in an interview on Nov. 22.
While banks have prepared for the worst -- setting up operations in the EU to avoid being locked out in case there was no deal -- authorities in the bloc have said they’ll do what it takes to ensure financial business continues without a hiccup. Those vows are essential for markets that rely on complex derivatives to manage risks on everything from residential mortgages to business loans to oil prices around the world.
EU-based firms have derivative contracts with a notional value of 69 trillion pounds ($89 trillion) at U.K. clearinghouses, with about 41 trillion pounds of that maturing after the U.K.’s withdrawal, according to the Bank of England. There are another 30 trillion pounds worth outside of clearinghouses.
This story recounting how central bankers, regulators and industry officials found common ground amid the political and technical hurdles is based on interviews with 10 people involved in the process. They asked not to be named because of the sensitivity of the issues.
The market where the bulk of Europe’s derivatives business is conducted -- the London Stock Exchange Group Plc’s LCH Ltd. clearing unit -- became a political football within days of the June 23, 2016 Brexit vote. Officials across Europe laid out the red carpet to lure London’s financial industry and leading EU finance ministers said euro-denominated clearing at LCH needed to move to the bloc.
At the same time, the bloc’s regulators began assessing what would happen if the U.K. and EU couldn’t agree on a withdrawal deal. At the European Central Bank in Frankfurt, a high-level group of regulators from across the EU began meeting in a Brexit task force. The group, led by officials from the ECB and national central banks, issued a series of internal “Brexit Monitor” documents that concluded the derivatives risk in case of a cliff-edge Brexit was “Lehman-like.”
By 2017, Bank of England Governor Mark Carney, joined by Financial Conduct Authority Chief Andrew Bailey and the BOE’s Prudential Regulation Authority head Sam Woods, were losing patience as politicians dithered. They sounded the alarm in parliament, speeches to industry and media interviews.
The message was blunt: the threats were simply too big to be left to industry to solve on its own, with thousands of firms and millions of derivatives contracts and insurance policies, on the line. The U.K. was ready to step in with legislation to permit banks and insurers to do business in London in case of a hard Brexit, and so should the EU, they said.
Brussels lawmakers punted the question to the regulators, and so, in April 2018, the European Commission and U.K. Treasury charged the BOE and ECB with assessing the risks.
In the febrile political climate, the two sides couldn’t even agree on the panel’s mission. The U.K. wanted to fix problems, while the EU side saw it as a technical body to make recommendations to politicians. The EU side was irked that while the private talks were ongoing, the U.K. publicly was piling even more pressure on the EU to act.
The banks kept up the pressure, with the International Swaps and Derivatives Association, Association for Financial Markets in Europe, and FIA, the futures industry association, holding a round of meetings with officials across Europe and in Brussels. Their strategy -- with lawyers drafted in from Clifford Chance and across London’s legal world -- was to get as many people as possible to call for an EU policy to solve the problem.
At one meeting, ISDA pulled together support from Danish, Dutch, German, Irish, Italian and Swedish industry groups to argue that being cut off from London would harm financial firms based in the 27 remaining member states of the EU. Bankers began briefing journalists about the year-end deadline. The EU had to hurry to reassure markets that the bloc’s banks would continue to have access to London’s clearinghouses: LCH, the world’s biggest for interest-rate swaps; the London Metal Exchange, the world’s primary place to trade aluminum, copper and other industrial metals; and ICE Futures Europe, home to the Brent crude oil benchmark.
A spokesman for LSE, parent of the LCH clearinghouse, declined to comment for this story, pointing to August remarks from Chief Financial Officer David Warren that LCH was seeking EU recognition to continue serving EU customers from London.
At the European Securities and Markets Authority, the EU regulator that writes technical standards for markets, Chairman Steven Maijoor finally went public. In an Oct. 3 speech in Athens, Maijoor called on his fellow EU policy makers to ensure access to London clearinghouses through legislation.
Valdis Dombrovskis, the EU commissioner in charge of financial services policy, was still keeping mum on contingency plans, saying he need to wait for an update from the BOE and ECB group. The commission’s technical experts were aware of the risks but wary of stepping in front of the political talks.
Finally, on Nov. 13, the eve of the publication of the U.K.’s tentative withdrawal deal, the European Commission unveiled a plan to handle no-deal risks. The EU, which had referenced the BOE-ECB group’s analysis, pledged to allow U.K. clearinghouses and firms settling the massive market for exchange-traded funds to continue doing business with companies based in the bloc. The commission said tools can be “swiftly deployed” to solve those problems.
The industry raced out statements welcoming the preliminary divorce deal. But with U.K. Prime Minister Theresa May’s cabinet in chaos and parliamentary approval far from clear, the industry emphasized that it had to continue planning for a hard Brexit.
And for those worries to be eased, the industry -- and BOE -- wants even more clarity from Brussels.
Jon Cunliffe, BOE deputy governor, told lawmakers this week that by early to mid-December, the markets need certainty about the legislative or regulatory tools the EU will use.