13 February 2017

Financial Times: UK must wake up to risks of LSE/Deutsche Börse exchange deal

[...] Conceived at a time before the Brexit vote when the UK was still expected to stay safely tucked inside the single market, the deal was supposed to take advantage of a converging EU rule book by roping together Europe’s two most vibrant securities markets and the financial plumbing that serviced them — their clearing activities.

The pay off was to come partly from conventional cost savings, valued by the pair at some €450m annually. But there was also what one might call a regulatory “synergy” that would benefit their customers. That came from the creation of a so-called “bridge” linking the clearing operations that would permit users to net off derivatives positions between them, and thus reduce the cost of collateral they had to post to back trades.

The aim was to synthesise a single giant “pool of liquidity” of the sort enjoyed by the large US and Asian clearing houses. Capture sufficient scale economies, went the argument, and you might even be able to compete on even footing with the very biggest of them all, Chicago’s CME.

That, at least, has been the dream of Carsten Kengeter, the DB boss who would lead the combined exchanges. But events since the deal’s announcement have contrived to alter the jurisdictional tavern signs in a distinctly van Winklesque manner. Britain is now destined to leave the EU, and there is no certainty about further convergence in the financial rule book. Indeed, depending on the outcome of Britain’s exit negotiations, national laws and regulation could even diverge.[...]

To make their own common pool a reality, DB and LSE would have to do something much more ambitious. How feasible that might be is far from certain. Not only is there the question of Brexit-related regulatory uncertainties, the exchanges might also bump up against legal obstacles, such as clashing national bankruptcy frameworks. If one of them experienced a big insolvency, would the members of the other consent to let their collateral be shunted across the bridge to meet the claim?

Normally one would not worry about such issues. The exchanges’ shareholders have voted in favour of the combination. And if the EU competition authorities also approve when they reach their decision shortly, then what is the hitch?

The answer is that clearing operations have a wider impact on the functioning of capital markets; not just the management of systemic risk but on the very competitiveness of financial centres. Look at the private report LSE’s boss Xavier Rolet commissioned last year to divine the implications of a post-Brexit City losing its trade in clearing euro-denominated securities. Some 83,000 financial jobs were deemed to be at risk.

Now consider how DB and LSE might achieve the customer synergies were the regulatory bridge to prove a non-starter. One option might be to move some or all of the UK exchange’s euro-denominated clearing to Frankfurt, thus turning a virtual liquidity pool into a real one. That would not only achieve their strategic and financial objectives; it would also please the eurozone authorities. Since well before Brexit, the ECB has been agitating for just such a shift.

Given the importance of finance to the post-Brexit economy, UK politicians have a strong interest in the deal not damaging London as a financial centre. Fortunately, they and the regulatory authorities also have an entrée. The Bank of England and the Financial Conduct Authority hold vetoes, and, additionally the government has the authority to determine the outcome in the wider public interest.

Ministers need to think hard whether these are powers they should be using. Given the uncertainties it might be wiser to intervene and prevent the risk of a future loss of business — even if only to pause things until Britain’s future relationship with Europe is clearer. Better certainly than to do nothing and — like van Winkle — wake up too late.

Full article on Financial Times (subscription required)

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