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Brexit Derivatives Risk: Did the City Overplay Its £38 Trillion Hand?

Summary:
It’s not pretty seeing members of the financial services industry in a tizzy over the difficulties and risks of moving £38 trillion in notional amount of derivatives agreements to which EU members are a party, out of the London clearinghouse that dominates interest rate swaps, including euro-denominated ones, to someplace else. Provisions that made it seamless for EU denizens to conduct business happily in the City go poof in a crash out. As we’ll discuss in short order, this does look like it will be quite a mess, and IMHO an unnecessary mess. This process is operationally taxing and how to do it is being sorted out at the 11th hours. At a very simplified level, first, both parties to the trade will have to agree to the novation. Second, it will be impossible to assure that the

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It’s not pretty seeing members of the financial services industry in a tizzy over the difficulties and risks of moving £38 trillion in notional amount of derivatives agreements to which EU members are a party, out of the London clearinghouse that dominates interest rate swaps, including euro-denominated ones, to someplace else. Provisions that made it seamless for EU denizens to conduct business happily in the City go poof in a crash out.

As we’ll discuss in short order, this does look like it will be quite a mess, and IMHO an unnecessary mess. This process is operationally taxing and how to do it is being sorted out at the 11th hours. At a very simplified level, first, both parties to the trade will have to agree to the novation. Second, it will be impossible to assure that the termination of the first contract and the creation of the replacement contract elsewhere will be on identical terms. Prices move and there can even be small price difference between different venues at the same time. So how do you prevent one party from profiting unfairly (whether by accident or design) from this type of mismatch? A letter to the Financial Times’ editor by Scott O’Malia, Chief Executive, International Swaps and Derivatives Association, outlines the issues:

Philip Stafford, in his Tail Risk column of June 28, correctly points out that existing derivatives contracts between UK and EU entities will not instantly become void once Brexit occurs. Firms will be able to carry out contractual obligations already agreed on cross-border contracts, like payments and settlements. But many other critical actions that take place during the life of a derivatives trade will be disrupted.

These so-called lifecycle events include material amendments to contractual terms, the rolling over of trades and trade compression. These occur on a daily basis and are vital to the efficient functioning of the derivatives market. In fact, some — like trade compression — are important risk management techniques required by EU regulation.

Firms need to be authorised in the UK and EU to conduct these activities, but may no longer have the necessary permissions in the other jurisdiction after Brexit. That means a UK-domiciled firm would no longer be able to perform these lifecycle events on existing contracts with EU counterparties, and vice versa. Without action by both EU and UK legislators, the only way these legacy contracts could continue as before would be to transfer them to a locally authorised entity.

Mr Stafford references the Bank of England’s estimate that £29tn of existing cross-border contracts would be affected and points out that the actual risk exposure would be lower.

However, the problem is not the notional figure but the substantial number of contracts that would have to be transferred and the number of counterparties that would individually have to agree to the transfer in a short period of time. A transfer of this scale has never before been attempted, and is operationally unlikely without regulatory and legislative support from the EU and the UK. This support would enable the wind-down of portfolios in an orderly fashion, without compromising the interests of end users that depend on these contracts to manage important financial and commercial risks.

Hopefully readers who are up on the specialist derivatives press or follow regulatory updates can fill in more detail, but from what I have inferred from occasional stories in the Financial Times, the late action on derivatives has at least something, and perhaps a lot, to do with it having become a political football. Recall that the morning after the Brexit vote, banks started looking into, and even in some cases applying, for licenses in places like Ireland so as to be able to set up or expand operations in the EU27. And at least one Financial Times reader, in a June 2018 comment, claimed that some banks were already on top of this issue:

‘Senior EU officials have told banks, for instance, that it is their responsibility to change the terms of relevant financial contracts signed since the June 2016 Brexit referendum’. Banks should be doing this now. The 2 US GSIBs I have best knowledge of have this problem under control.

Now admittedly one Financial Times reader won’t have as much of a view of the problem as a senior ISDA official, but the flip side is the ISDA chap is a de facto lobbyist. It’s not hard to imagine why ISDA members (dealers) would want regulatory and legislative cover. It would obviously help them operationally to have Someone Official play arbiter. But with that, one images the dealers are probably also looking for legal cover, since it’s not hard to imagine end customers thinking they were screwed in how the novation was handled and having a legal case.

A weekend story by John Dizard gives a detailed and often colorful overview of the problem:

LCH UK, which operates the London-based derivatives clearing house for interest rate swaps, let its EU members know that they could be given just three months to move £38tn in notional value of swaps contracts to other venues…

This is not simply a matter of moving data files from one location to another. Each swap contract would have to be offset with matching positions, and the new clearing houses would have to ensure they have the correct margining and netting procedures for all the new business….

To their credit, the European Securities and Markets Authority, the EU regulator, and the Financial Conduct Authority, its UK counterpart, have drawn up memos of understanding that could allow for something other than a legal, logistical and market liquidity fiasco…

Those memorandums, though, will need to be approved at the political and bureaucratic version of light speed. This requires a level of sanity and lack of posturing that has not been evident so far.

Dizard then went on to discuss how derivatives clearinghouses hadn’t necessarily solved the problem they were supposed to, that of ending too big to fail risk, and instead shifted it to clearinghouses, which could be politically more tetchy to bail out. While it is unquestionably true that clearinghouses are themselves potential or actual TBTFs, it is also true that having central counterparties does at least somewhat reduce risk by standardizing contracts and reducing the complexity of exposures. He then proceeds to discussing the issues that arise if a central clearing house blows through its customer margin, its reserves, and its equity. Dizard depicted the alternatives as having customers who had profits in their accounts pay off losers, or a capital call to members, or a rescue.

A problem with his otherwise informative piece is that by putting these topics together, Dizard gives the impression that the Great Swaps Transfer, if it takes place, could bankrupt a clearinghouse. Yet he doesn’t give any reason to believe that, not even a dire quote from an expert. Normally I take Dizard at face value, but some mavens popped up in comments to take issue with his article. For instance:

HartleyHare
There are lots of learned papers published by Risk Magazine on CCP recovery and resolution that the author has failed to read. In extremis, at the end of the default waterfall, a CCP can tear up derivatives contracts so that they cease to exist and share this burden amongst all participants. It is not at all like a single RBS running out of liquidity and being bailed out by the state as the author purports.

Nevertheless, you could expect large, even wild, currency and interest rate movements if a crash out starts to look inevitable, and that in turn could produce losses as contracts were novated. But those would be losses to the counterparties and not the exchange unless there was a customer default.

To put it more simply, this derivatives event would be a nasty and unnecessary addition to the disruption of a crashout.

As indicated earlier, this issue became politicized, with Bank of England governor Mark Carney complaining about the EU’s failure take hard/crash out Brexit risk seriously enough as far as financial services industry risks were concerned. The wee problem is that while Carney was raising a legitimate issue, his solution was to pump for UK firms to be able to continue to provide services on the Continent, which is inconsistent with Brexit and could be managed only in the context of a EU/UK services agreement. Derivatives were the scariest part of this problem due to the large notional amounts. From the Financial Times in June:

Having put in place a scheme to allow European financial services companies to continue to serve UK clients after a hard Brexit, Mr Carney said the UK now had a “rock solid solution” to potential disruption to derivative and insurance contracts, but said he was still waiting to see similar solutions on the EU27 side…

The central bank’s one domestic concern about the financial stability consequences of a hard Brexit was the lack of continuity of derivative contracts, which it said needed action by governments on both sides of the English Channel. Only then would £29tn of derivatives, such as interest rate swaps, be guaranteed not to be disrupted after a hard Brexit.

It has since become clear that these contracts are overwhelmingly with the London clearinghouse LCH. So the bigger risk was UK financial services companies not being able to serve EU clients after a Brexit, and a remedy for that problem would have the convenient side effect of keeping business in the City. I find it hard to believe that Carney’s proposal wasn’t symmetrical, that the provisions he put forward for EU financial services firms to operate in the UK would apply to UK financial firms with EU clients.

And this sort of disingenuousness would sit particularly poorly with EU financial regulators, since the ECB, along with France, had tried to require that Euro derivatives clearing take place on the Continent, only to lose the case in an ECJ ruling, because the EU is not allowed to discriminate among members in the manner the ECB was pushing.

So with that history, Carney’s proposal probably came off as yet more UK special pleading to hang on to Euro and other derivatives clearing.

So it should come as no surprise that that the EU was of the view that this matter didn’t require official intervention. From the Financial Times in July:

The European Commission has downplayed warnings from the Bank of England that the validity of vast numbers of financial services contracts could be put at risk if regulators do not put special measures in place before Brexit, saying the market should be able to deal with most of the problems itself….

He said that Brussels had studied the potential impact on both insurance and derivatives contracts, and that “current analysis . . . suggests that preparedness by market participants can go a long way to mitigate the impact of Brexit”.

The assurances run directly counter to fears expressed by the BoE that the validity of some £29tn of derivatives, such as interest rate swaps, could be called into question after a hard Brexit unless EU and UK authorities act to legally ensure their continuity….

The BoE’s governor, Mark Carney, complained….“This cannot be solved by the private sector,…It will not be possible, ahead of March 2019, for private financial institutions on their own to mitigate fully the risks of disruption to financial services.”

So as I read this, Carney tried muscling the EU on behalf of the City and both side have sat pat until events have forced action…perhaps too late to avoid a mess. But the one bit of solace is that despite the scary big notional value, the economic value of plain vanilla instruments like interest rate swaps is vastly lower. The fact that the ISDA official thought that the sheer volume of trades is a bigger problem than their magnitude is also somewhat reassuring.

In other words, the UK side has incentives to make this derivatives problem sound like a potential comet about to wipe out the dinosaurs, since the City comes out the loser. And it will be a massive challenge to get this sorted out and have the markets not suffer a loss of liquidity. But since this issue is now belatedly being addressed, we should have a better idea in the coming weeks just how bad this could wind up being.

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