Is London’s position as Europe’s clearing house under threat?

Investment contributor Thomas Huckle wonders if London's star role as Europe's derivatives clearing house is in decline

Photo: Lauris Rozentals

by Thomas Huckle
on 21 January 2021

in Issue 1758

I am too embarrassed to ask... what are derivatives?

A derivative is a contract between at least two parties, with value based upon the value of an underlying, an agreed-upon financial asset, such as stocks like Apple or Amazon, or maybe a commodity like gold. Derivatives come in two flavours, lock and options products. A lock product must be exercised at a specified time, known as expiry. Examples of lock products are futures, forwards, and swaps. An option contract gives the buyer the right but not the obligation to exercise the contract. What does that all really mean? Let us say we think apple stock is undervalued at $120, so we buy a “call” option contract from a bank for $1, with a strike price of $130 for the underlying (Apple stock). If Apple rises to $135 at expiry, my derivative contract is worth $5, and I make $4. While if Apple stock is worth $125, I will not exercise my contract and I lose the $1 I paid for the contract. Had that contract been a future (lock) I would be forced to exercise it and pay the agreed $130 for the Apple stock.

The global derivatives market is estimated to be worth over a staggering quadrillion dollars; considering world GDP is around 90 billion dollars, that is a pretty big number. When two sides enter a derivatives contract, there is a risk of one side defaulting and being unable to fulfil their obligations. To mitigate this risk, most contracts are cleared through a central counterparty (known as a CCP). CCPs collect leverage from both sides of a contract and, in the event one side defaults, they step in to honour the contract. If the contract is fulfilled, the CCP takes a fee and both parties get their leverage back. This is incredibly important for the global financial system and can prevent a domino effect, where one firm’s financial troubles become a crisis for many.

London completely dominates the lucrative market for clearing Euro-denominated derivatives, clearing around €540 trillion worth of contracts in 2019. The London Clearing House (LCH), the world biggest CCP, alone controls over 90% of Euro-denominated interest rate swap contracts. The industry is estimated to add over 80,000 jobs directly to the UK economy, according to EY, and has become a major part of EU-UK trade talks.

The EU is looking to move the clearing of Euro-denominated contracts back inside the single market post-Brexit, threatening London’s position as Europe’s and the world’s centre for clearing. The reasons are twofold, firstly the EU would not want such an important part of its financial system to be regulated by a country independent of the EU, like the UK. Secondly, and probably more importantly, the move could be a huge boon economically for many of the continent’s financial hubs. Frankfurt and Paris have long been envious of London’s dominant position in the markets, and could potentially see many highly-skilled, well-paid jobs transferring from the city if the EU gets its way.

The industry adds over 80,000 jobs directly to the UK economy

Fortunately for the City and UK government, it is not quite as easy as flicking a switch and seeing the market flood back to the European Union. London has built up its position as the centre of global derivatives clearing through over a century of work, building up attractive legal frameworks, large capital reserves and world-beating expertise in managing counterparty risk. This has allowed CCP’s, such as LCH, to clear more contracts and for smaller fees than could be done elsewhere. Therefore, if the EU were to act too fast to close London off, they would see the cost to clear derivatives contracts rise substantially and hurt their own financial institutions as a result. Such a move has been estimated to come at a cost of nearly €100 billion and the EU has recently been forced to grant access to the City’s financial markets for an extra 18 months in the event of a no-deal Brexit.

An additional 18 months is unlikely to be enough time to wrestle the industry over to the EU, but it is slowly moving in that direction. LCH has already moved substantial operations to Paris and plans to move more to the continent in near future. In the event of a no-deal Brexit, this process is only going to be accelerated and London could slowly see itself lose a very lucrative industry to the continent.

From the Investment Editor - Geoff Sang: get in touch with us for an interview or to write via the Investment Column email address,

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