Photographer: Peter Macdiarmid/Getty Images

This Obscure Corner of London Finance Is Suddenly a Key Battleground

Updated on
  • Clearing loss may lead to erosion of London finance: lawyer
  • ECB has already tried once to strip London of euro clearing

An obscure back-office function intended to bring more stability to trading has emerged as a pawn in the post-Brexit battle for London’s financial-services industry.

There are signs the U.K. is readying its defenses now that French and German officials have already targeted the industry. Clearing, which acts as a firewall against defaulting traders, has boomed since the 2008 financial crisis. Britain’s vote to leave the European Union could endanger the thousands of jobs at the clearinghouses and their member banks if other countries follow through on their threats to repatriate euro clearing after Brexit.

Clearing, along with bank access to the EU, are key pillars supporting the 2 million workers in the U.K.’s financial industry, says Davis Polk & Wardwell’s Michael Sholem.

“A gradual erosion over 10 to 15 years is likely if those pillars are knocked away,” said Sholem, European counsel at the law firm. “There’s a question about how much of that can be replaced by new markets.”

Banks and brokers may choose, or even be required, to move some staff and operations closer to any clearing firm that leaves the City of London, weakening the foundations of one of the U.K.’s biggest private industries and its biggest source of corporate tax. Bankers including JPMorgan Chase & Co.’s Jamie Dimon and HSBC Holdings Plc’s Stuart Gulliver have warned that Brexit may move force them to move jobs out of London.

For an explanation of how Brexit threatens London’s clearinghouses, click here.

The City’s main lobbying group published a report on Aug. 3 setting out how the financial district could protect itself after Brexit. TheCityUK said London’s clearinghouses should start handling emerging-market currencies and make more of their processes electronic. Both measures would help reinforce London’s position, the report said.

The European Central Bank tried years ago to require euro trades to be cleared in the euro area, prompting a successful legal challenge by the U.K. In the days after the referendum, France’s President Francois Hollande warned that London would not be allowed to continue clearing euro trades from outside the EU.

It’s a fat prize. London’s clearinghouses hold about $174 billion of cash and bonds as collateral against their members defaulting, compared with Frankfurt’s $62 billion and Paris’s $25 billion. About 700 people are directly employed by London’s clearinghouses.

To wrestle euro clearing from London, the remaining EU members would have to change treaties to give the ECB the necessary power, says LSE chief Xavier Rolet.

“That is not impossible, but I would say at this moment, there is no immediate threat from that standpoint,” Rolet said today on a conference call.

But if clearing does go, “there would be a knock-on effect” for moving other jobs, says Raoul Ruparel, co-director of Open Europe, an independent think tank.

After the financial crisis, the world’s largest economies mandated clearing for many derivatives contracts. London’s LCH Group, part of LSE, was already the largest clearer for interest-rate swaps; efforts to make derivatives safer have only increased its market share.

Daniel Maguire, who runs the swaps business at LCH Group, spends his day ensuring that LCH’s member banks have supplied sufficient collateral to cover the risk taken by their clients.

Maguire was there when Lehman Brothers collapsed in 2008, back when LCH was the sole clearinghouse in London. (Now there are three others -- ICE Clear Europe, LME Clear and CME Clearing Europe.) In the aftermath, his team worked 18-hour days to stop the bank’s $9 trillion of cleared interest-rate swaps, denominated in five currencies, from wreaking havoc throughout the market.

Two metro stops away from LCH, Iain Greig keeps an eye on the metals market.

One column of a giant wall-mounted computer screen changes from green to amber to red to purple, showing each member’s level of risk. In the event of a default, the office serves as the “war room” for LME Clear, the clearinghouse of the London Metal Exchange. Greig, the chief operating officer, and Chris Jones, the chief risk officer, gather their key lieutenants and start closing down the financial firm’s trades. It takes days or even weeks.

In a clearinghouse, bankers and operations teams move funds between the clearinghouse and its members and back again. Risk managers run the show, deciding on risk thresholds and monitoring members.

“It’s important to have people who have a risk mindset,” Maguire says. “The core purpose of a clearinghouse is to manage risk. Clearing requires a certain level of expertise, but certain elements can be taught.”

Algorithms perform many of the risk calculations at clearinghouses, but humans are still essential. In the war room of LME Clear, numbers turn from green to amber as the amount of risk taken by a client account climbs above half of the collateral held. The field turns red when it breaches 80 percent. At 100 percent, it turns purple. That’s when humans take over.

“If we need to make a margin call, a human does that,” says Adrian Farnham, LME Clear’s chief executive officer. “The risk team will establish whether a call needs to be made.”

The 10-strong operations team asks one of LME Clear’s 13 settlement banks for additional collateral -- known as initial margin -- which arrives at the derivatives clearinghouse within a couple of minutes or up to an hour.

The handling of a major default is the ultimate test. The price at which a trade has been executed is guaranteed, but only “as long as the clearinghouse is still there,” says Diana Chan, the CEO of equity clearinghouse EuroCCP.

Clearing’s role in preventing market contagion after Lehman, the only major default in recent decades, has helped put the industry on the map, Maguire says.

“The successful close out of the cleared swap portfolio contributed to the view that clearing could be a positive force in the market,” he said.

— With assistance by Hayley Warren, and Samuel Dodge

(Adds graphic. A previous version of this story incorrectly stated total initial margin in London clearinghouses.)
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