Leaving the EU: Central Counterparty Clearing
(6 years, 1 month ago)
Commons ChamberRead Hansard Text Read Debate Ministerial Extracts
Mr Chris Leslie (Nottingham East) (Lab/Co-op)
The title of this debate may encourage hon. Members to flee the Chamber, but I encourage them to leave via the House of Commons Library, which can explain why central counterparty clearing services are so incredibly central to the infrastructure that underpins business, corporate finance and the nature of our economy, and why Brexit could potentially have a significant effect on such services.
To give a sense of scale, the British economy is worth about $4 trillion. LCH, one of the biggest central counterparty clearing services, is owned by the London stock exchange, and this year alone it has cleared $812 trillion-worth of derivative contracts—largely interest rate swaps. That is a mind-boggling sum of money, and I am raising this issue today because it is an internationally important liquidity pool. The UK specialises in this facility, but with the UK leaving the European Union, the jurisdiction in which these CCP operations take place could well be fragmented, which could have a destabilising effect on the operation of central counterparty clearing services.
The question is: if we crash out of the European Union, or if we do not get the right sort of regulatory framework, what will happen to those trillions of dollars’ worth of derivative contracts? This is one of the most significant cliff-edge issues in Brexit, and it has not had anywhere near enough attention or coverage.
By way of background, I will provide an example of what a CCP operation does and what it clears. Imagine a construction company that is getting a big loan from a bank to build a housing estate, or whatever. That loan is quite a big liability for the business, and often the loan will come with a variable interest rate. In order to manage the liability, the construction company might want to swap that variable interest rate for something a little more predictable, a little more stable—perhaps a fixed-rate interest arrangement. Such interest rate swaps are now a common or garden part of corporate business finance. If we are talking about stability in the economy, such products, though complicated, are often the wiring behind the scenes. They really are important to how we stabilise our economy.
In recent times, central counterparty clearing facilities have developed to make sure that companies do not necessarily have to make these arrangements bilaterally with one another, because they can clear them through a central fund that has an insurance buffer arrangement in case of default on such contracts. Companies such as LCH can go through a number of layers in order to cope with the default. We saw a recent default scenario in Norway, where an energy trader was overexposed and a CCP arrangement absorbed much of that default shock and prevented contagion that could have had wider ramifications around the world. This certainly operated in respect of Lehman Brothers and others in the financial crisis. Since then, policymakers worldwide have recognised that CCP is a really important pillar of our financial stability mechanisms. So these are important insurance policies and this is an international pool of liquidity, and London and the UK are right at the heart of those operations.
Stephen Doughty (Cardiff South and Penarth) (Lab/Co-op)
My hon. Friend is drawing attention to an important set of issues of which I was not fully aware. He would probably agree that we cannot have an “It’ll be alright on the night” approach from the Government to such complex arrangements—we need surety on them. Was he interested, as I was, to see Commissioner Barnier talking earlier about how there had been misleading press reports about a deal on financial services and about many of these matters being close to being agreed, and saying that that was not the case?
Mr Leslie
My hon. Friend rightly takes us to the more contemporary story about what is happening with these, because Brexit has put everything in limbo. Will these CCP operations be able to continue to service the vast majority of euro-denominated interest rate swaps or derivative products? The European Union had been developing new supervisory arrangements that would have included the UK. Brexit came along and of course those have all now been put into abeyance because the UK may be taken out of those jurisdictions. Time has ticked on and we are now five months, perhaps less, away from the moment of change, yet we still do not have any certainty about what will happen. However, we have heard various rumours.
Last week, the Governor of the Bank of England, Mark Carney, highlighted £41 trillion-worth of outstanding contracts that could be forcibly voided—that could fall out of legal certainty—if we do not get some sort of arrangement put in place. Earlier in the week, EU Commissioner and Vice-President Valdis Dombrovskis indicated that the EU might allow the UK CCPs after Brexit to operate on a temporary basis, with some strict conditionality. Of course we saw the report in The Times today that perhaps in the negotiations there was some sort of sense in which UK financial services companies, including these CCPs, would be able to operate on an equivalence basis, which is not as good as the arrangements we have, where we are around the table and able to make the rules on regulations. We would be a rule taker, but of course we may be allowed access to European markets—and, potentially, vice versa. The danger with that is that it is precarious and it could be switched off at a moment’s notice if policymakers fell out, for whatever reason.
As my hon. Friend has pointed out, today Commissioner Barnier poured a big old dose of cold water all over that, saying, “You should not believe everything you read in the paper.” He reiterated that it was really in the hands of the EU to decide whether equivalence continued. This would not be an ideal situation at all, and the risk is that we would need to see CCP clearing services develop rapidly in other jurisdictions in Europe. Of course the Americans will have their arrangements, but that could start to undermine the centrality of the UK. That would be a great pity, because the UK has expertise and a relatively good regulatory approach, working with our European colleagues.
So the main question I want to put to the Minister is: what is the Government’s attitude to the future, long-term, stable, permanent regulation environment? Are we going to align ourselves closely or in harmony with the EU regulatory framework for central counterparty clearing arrangements? If that is the case, it would be useful to know that that is British Government policy at this stage, because that might then enable something to be built on equivalence. We could possibly move to a position in which the UK still has a say in the regulatory arrangements.
In my view, the public should be given a chance to think again about this whole thing and, if they want, there should be a people’s vote so that the option to remain is still viable. Nothing has been decided that should prevent that from happening. If we are to leave the European Union, it would not be a good thing to do so and put all these things up in the air. We should not fragment the financial safety regulatory arrangements and potentially put businesses, jobs and livelihoods at risk.
Kerry McCarthy (Bristol East) (Lab)
I used to do this sort of thing for a living as a derivatives lawyer, although that is not something to which I own up very often these days. I was working in the City at the time of preparations for the millennium bug, and when the euro came in I was involved in cleaning up the mess after the Barings collapse. With the millennium bug in particular, people said afterwards that it was a big fuss about nothing and that it was totally alarmist and exaggerated for people to say that it was going to cause chaos. What they did not realise was how much work had to go on behind the scenes to make sure that that chaos did not happen. There is a real danger of complacency with situations like the current one, with people thinking that it will all sort itself out. Does my hon. Friend agree?
Mr Leslie
I do agree, and I do not think that the work is being done. Frankly, there should be more leadership. We are in a rudderless situation right now. We have a lot of regulators—the Bank of England, the European Securities and Markets Authority and others—but they are of course subservient to the political policy makers, and although I hope that those policy makers are apprised of these issues and know the scale, I am not that confident that they are or that it is high up their agenda. I am not sure that I have heard the Prime Minister talk about these issues, let alone the Chancellor of the Exchequer. Perhaps the Minister will be able to enlighten us on that.
I shall come to an eventual conclusion by explaining why there might be a number of problems. Firms are currently discussing a lot of contracts that are not yet cleared. If we do not have the option of central counterparty clearing—in particular from the European side in respect of whether they can access London—what stability risks will be generated in those scenarios? Will we lose liquidity? If we do, will we see costs going up for businesses? When costs go up for businesses, will they be passed on to customers? That would have a drag effect on the worldwide economy.
The issue for those contracts that are already cleared—that are already in existence—is whether they will still be extant after 29 March, because if a whole load of existing contracts are in place, whether in Europe or wherever, many will have clauses that require notice to be given if their legal validity is due to expire. It could be six months or nine months, but we are now certainly coming into the period in which the holders of those contracts will have to start to give notice and to say, “We are not certain that these existing financial contracts will be viable or in place, because of the risk of falling into legal no man’s land after 29 March.” There is a clear and present risk to the stability not just of our economy or Europe’s economy, but of the worldwide economy. Although this can seem a very dry topic, everybody should stay focused on the hundreds of trillions of pounds-worth of value that might have an effect on the wider economy.
Will the Minister say what we are going to do to come to a swift conclusion—certainly within the next few weeks—on this issue? I know that the UK has made an offer to the EU to allow temporary access to UK firms. The question is obviously whether that is going to be reciprocal, but if we are to offer that, are we going to legislate for it and put that guarantee into law? That could be done right now. I really want to find out the Treasury’s plan. Do we know that the Government care and are taking an interest in the stability of the UK and EU economies, and in businesses, jobs and the livelihoods of all our constituents, who will undoubtedly be affected by this issue?
The Economic Secretary to the Treasury (John Glen)
I congratulate the hon. Member for Nottingham East (Mr Leslie) on securing this debate and thank him for what he said. He set out very clearly the risks and the need for clarification. I am very happy to give him the answers to the questions that he has posed in his thoughtful and helpful speech.
I, first, wish to acknowledge the issue of no deal and to clarify from the outset that the Government firmly believe that it is in the interests of the EU and the UK to strike a deal. That remains the clear goal on both sides and we are confident that that will be achieved. I reassure the hon. Gentleman and the whole House that an enormous amount of work and dialogue is going on at all levels in order to understand the issues that exist on both sides.
Our proposal for the future UK-EU relationship in financial services seeks to be both negotiable and ambitious. It is founded on preserving the economic benefits of the most important financial services traded between us and on ensuring stable institutional processes for governing the relationship into the future. That is the best way to protect financial stability and open markets, and it is in the interests of businesses and consumers on both sides. Just for clarification, under our plan, we would build on the EU’s existing equivalence regimes but expand their scope to recognise business activities that are in the interests of both the EU and the UK but not covered by the existing regime.
Mr Leslie
Just stepping back from the specifics, on the policy stance of the UK Government, are we intending to remain in lock-step with our European neighbours in terms of the regulatory approach that we take—as a matter of philosophy? The Americans would perhaps like us to depart from that, but it feels to me important, for our existing market access, that a commitment is given to preserve some of the harmonies that we already have.
John Glen
I am very happy to respond to that point. We are seeking to recognise that we start from a common starting point. What we acknowledged in the White Paper in July is that there is an appetite on both sides—on the part of the UK and the EU—to retain the autonomy around their supervisory bodies. But we need to develop a strong bilateral relationship in the future should either side wish to innovate and deviate from the existing alignment, so that we can then have a strong bilateral dialogue on how to resolve any disputed areas.
However, I reassure the hon. Gentleman that we are not seeking to differentiate ourselves and to become a bargain-basement regulatory environment. We secure such significant investment in the City of London because of the world-class nature of our regulatory environment. In fact, we have led the way in many of the dialogues over the years within the EU. So our aspiration is an ambitious one and it is based on a strong trading dynamic with the EU into the future.
I want to move into the specifics, because the hon. Gentleman has raised some significant and sensible points. We are prepared for all outcomes, including for no deal. The Government recognise that, in the event of a no deal, this is a critical issue. We are not complacent and he has set out the stakes clearly, which are so high for jobs and livelihoods up and down this country.
As the Financial Policy Committee has said, £69 trillion- worth of centrally cleared derivative contracts could be affected. Central counterparties, as the hon. Gentleman set out, are financial institutions that firms use to reduce counterparty risk. CCPs do that by standing between the parties of a trade, becoming the buyer to every seller and the seller to every buyer. That guarantees that transactions will be honoured if the other party defaults.
CCPs are central to the UK and global financial system. They reduce risk and ultimately improve the efficiency and resilience of the system as a whole. Any disruption to this system would affect large banks and institutional investors, which use these clearing services when hedging their risks.
There are key issues for CCPs and their members. First, when the UK leaves the European Union, EU CCPs will not be recognised to provide their clearing services to UK firms, and vice versa. Secondly, there is legal uncertainty about whether EU clearing members can continue to meet their contractual obligations to UK CCPs. This disruption is particularly acute for EU firms using UK CCPs. The European Central Bank estimates that UK CCPs clear approximately 90% of euro-denominated interest rate swaps used by euro area banks. The only industry mitigant available would be to close out or transfer the contracts that EU clearing members have with UK CCPs before March 2019. But as the FPC has said, the movement of such a large volume of contracts in a short timeframe would be costly and would strain capacity in the derivatives market.
The importance of the financial services sector to the UK and the EU has already been noted in this debate, and it is critical that we acknowledge that and respond to these challenges wholeheartedly. I spend my time as a Minister promoting, preserving and standing up for the benefits of the sector for the whole United Kingdom—not just the City of London, but areas such as Bristol, Nottingham and Edinburgh. The sector is a British asset as much as a European one. This Government remain committed to agreeing a close future relationship on financial services with the EU that preserves the mutual benefits of our uniquely integrated markets while protecting financial stability, consumers, businesses and taxpayers across the UK and the EU, and this relationship must take into account that the UK is a global hub for these clearing services.
As I said, it remains unlikely that the UK will leave the EU without an agreement, but we are prepared for all outcomes, so I will now go into some detail on the no-deal situation. As the hon. Gentleman mentioned, we have committed to unilateral action to resolve the risk of disruption as far as possible on the UK side. Colleagues will be aware that the Government have already laid draft secondary legislation that will establish a temporary recognition regime for CCPs. That regime will allow non-UK CCPs to continue to provide clearing services to UK firms for up to three years while those CCPs apply for recognition in the UK.
My noble Friend Lord Bates debated the statutory instrument through the Lords on Tuesday, and a debate is arranged for a Delegated Legislation Committee in the Commons next Monday—the pack is ready for me to go home to Salisbury with so I can prepare—and, as has been highlighted, any successful mitigant to the clearing services problem requires action by both UK and EU authorities.
I welcome the announcement by European Commission Vice-President Valdis Dombrovskis, I think, on Tuesday this week, that the EU will, if necessary to address the financial stability risks arising from the UK leaving the EU, act to ensure continued access to UK CCPs on a temporary basis. It is right that EU authorities will have to set out further details on their plans, and we would welcome that, but this announcement is a positive step in ensuring the stability of the financial system for the UK and the EU.
The Government are committed to working with our EU partners to identify and address risks relating to the UK’s exit from the EU. We are supportive of continued engagement and co-operation between our regulators. This is continuing, including through the technical working group convened by the ECB since April with the Bank of England, and is evidence of our shared interests in these issues. I acknowledge what the hon. Gentleman has said about the lack of detail coming out. I think that is a condition of the Commission’s negotiating stance. We respect that, but will continue to engage and to observe what is going on.
There are suggestions from some in the EU that UK CCPs pose a risk to the EU’s financial stability. That is the impetus behind the proposal to revise the framework for supervising third-country CCPs, including the so-called location policy. UK CCPs are truly global institutions, and we recognise that there are legitimate questions about the future supervision of UK CCPs with EU members once we leave the EU. We should take a stable and co-operative approach to the supervision and regulation of globally active firms. This should include the ability for regulators in different jurisdictions to defer to each other based on comparable rules—a principle that the EU and the UK have committed to at the international level. Some of the measures currently under consideration by the EU undermine this principle and cannot be seen as an enhancement of the existing equivalence process. In particular, a location policy would be a poor solution that would unnecessarily harm investment in Europe, increase costs for European firms and ultimately undermine financial stability. We are making that case, and I am sure that those who use CCPs will be making the same case.
I thank the hon. Member for Nottingham East for raising, in a very thorough way, some very legitimate issues at the core of these negotiations. I want to reassure him, and the hon. Member for Bristol East (Kerry McCarthy), who contributed to the debate, that the Government are not complacent on these matters. I am acutely conscious of the large number of statutory instruments that I will be taking through over the coming weeks. Dialogue is continuing at all levels as we seek to reassure the City of London, and the financial services industry across the United Kingdom, that the Government are prepared for all outcomes, though working determinedly and passionately for the best outcome and a good deal that recognises the centrality of financial services to the UK economy.
Question put and agreed to.