A $364 Trillion Game of Brexit Chicken Gets Ugly

Politicians in the European Union are fretting about how little time is left to strike a Brexit trade deal, with French Foreign Minister Jean-Yves Le Drian publicly bemoaning British foot-dragging this week. Now frustration has hit the once dull world of financial regulation, where the City of London and EU are locked in a staring contest over a big chunk of the $364 trillion interest-rate swap market.

One side should blink eventually, but it’s likely to get messy along the way.

Both the U.K. Financial Conduct Authority and Paris-based European Securities Markets Authority want more oversight of big derivatives contracts after the Brexit transition period ends on New Year’s Eve. That seems simple enough when counterparties are located in the same jurisdiction. When both sides are British, contracts that fall within the scope of the rules will trade on U.K. venues, or those deemed equivalent for regulatory purposes. Those involving EU counterparties will have to stick to the EU.

The problems will start when EU and U.K. counterparties want to trade with each other: In British eyes the trade needs to be on British soil, while for the Europeans it should be on the continent. The conflict was confirmed this week when ESMA said it would impose locational derivatives rules in much the same way as the FCA. This isn’t stuff that can be traded in two places at once.

Ironically, the simplest way financial entities could satisfy the conflicting demands here would be by trading derivatives on U.S. venues, viewed as equivalent for regulatory purposes by both the Brits and Europeans. The Americans aren’t stealing Europe’s lunch, they’re being served it.

The average investor will wonder how carving up liquidity between the City, the EU and Wall Street will help markets work better. It’s bad news for any hope of future regulatory harmony. That U.S. venues could become the most secure way, in terms of compliance, to meet post-Brexit rules underscores the lack of cooperation and communication on both sides, according to Allan Yip, a partner at Simmons & Simmons. The unintended consequences here are too obvious to ignore.

The hope — and indeed the likelihood — is that one side will blink before long. Lobbyists are pushing hard for a large-scale truce, but the way Brexit negotiations are hardening regulators’ mindsets makes that complicated.

The EU has options. It could grant the U.K. a temporary reprieve, which it has done in some areas like clearing, or it could tweak the rules. It could even deem the U.K. an equivalent market for regulatory purposes, the financial industry’s preferred solution. But European officials are in no mood to create temporary loopholes that could turn permanent, especially given the temptation for national member states to bend the rules to attract business. And keeping U.K. equivalence off the table until the last minute provides potent leverage in touchy trade negotiations where so much remains to be agreed.

This all puts pressure on the Brits to climb down, either by temporarily waiving the rules or biting the bullet and granting equivalence to EU venues first. It may seem odd to imagine that London, the No. 1 financial center in Europe and a magnet for derivatives, would be beggar and not chooser in this instance. But the City knows its only real competitive edge is in attracting business from abroad. This is why the FCA has granted EU exemptions in other areas like share trading. Compromising on this issue would hardly be a stretch.

Regardless of who wins short-term, Brexit looks like a lose-lose proposition for the end investor. There was never much in it for the City, whose banks and brokers have lost frictionless access to a single market they helped build. The fear in Brussels that a U.K. bent on deregulation will undermine Europe’s ambition to boost continental finance hubs has prompted regulators to keep building ever-higher barriers to trade. An unintended consequence of restrictions on stock trading, for example, is that traders based in the U.K. will have more flexibility to trade cross-border than those inside the EU, according to Ergo Consultancy’s David Berney.

Somewhere lost along the way are the principles laid down in the wake of the financial crisis, when world leaders promised to set rules for derivatives markets hand-in-hand while fighting protectionism. Today, it appears the opposite is happening: Regulation is helping the likes of Le Drian turn the screw on the City.

The hope is that despite the frosty tone, such standoffs will end the foot-dragging and clinch a Brexit trade deal acceptable to both sides. If that happens, maybe French fishing fleets will have more reason to cheer ESMA than bankers on either side of the English Channel.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Lionel Laurent is a Bloomberg Opinion columnist covering the European Union and France. He worked previously at Reuters and Forbes.

©2020 Bloomberg L.P.

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