ECON Study: Post-trade services and financial stability

17 July 2023

Assessing prospects for post-Brexit market infrastructure in the EU

EXECUTIVE SUMMARY
Aim
This study analyses how post-trade financial services impact on financial stability and economic growth, and the consequences of where these services are rendered. It examines:
• The role central counterparties play in financial stability and the impact of their functioning on economy;
• The pros and cons of continuing to rely on services from outside the EU;
• The potential for cliff-edge effects, added costs for EU business, and weakened capacity for CCPs after migration from London
• Evidence of recent migration of post-trade services from London to the EU and the US;
• The requirements for financial stability in the EU added by EU regulations, supervision and public backstops.
Key Findings
Post-trade financial services encompass central counterparties, central securities depositories and trade repositories. Central counterparties in particular are considered essential to financial stability since they were mandated in 2012. They ensure that payments are fulfilled by financial market participants, stepping in to pay on their behalf if necessary. Their purpose is to ensure that failure to pay does not result in a systemic financial crisis. They themselves are financial institutions, associations of banks and other financial trading companies that are subject to capital requirements, risk management procedures and even rules about resolution if they collapse.
Central counterparties for the EU were located in London before Brexit, and the member banks argued that only they had the financial resources, expertise and connections to international financial markets required to clear complex financial derivatives. Migration to the EU would be technically impossible, be hugely expensive to EU businesses, and unleash financial instability. However, business has largely fled London in the first half of 2023, showing the claims to be false. Not only has the EU benefited from initial migration, American companies cleared just over half of trading in mid-2023. This shows that the EU has work to do to reach its goals. Meanwhile, work is underway in the EU to enhance private infrastructure and public oversight. As business moves to the EU, European central counterparties will be able to serve larger volumes of transactions, and more easily serve larger institutional investors.
There is a clear distinction between companies that moved from London to the EU, and those that moved to the US. Larger institutional investors chose for the United States, with its direct access to deep pools of capital and US-dollar denominated bonds that serve as the foundation for interest rate and currency derivatives. Smaller institutional investors chose more frequently for the EU market. This suggests that future moves to calibrate clearing requirements for EU companies should look to the future relationship between EU CCP size and their ability to compete favourably with American clearing houses. Recent shifts of clearing are still new and subject to change.
There are further reasons to proceed with plans to ensure most clearing for the EU market takes place in the EU. The mechanisms by which central counterparties manage risk and are supervised make them vulnerable to political and economic risks, particularly when they are located outside the EU. Political risks are primarily related to the possibility of very different attitudes to what constitutes appropriate levels and forms of financial stability regulation. It also encompasses questions of whether and how strenuously a public authority should ‘do whatever it takes’ in a systemic crisis. Judgement calls on prudential requirements like minimum capital standards or risk assessments during a crisis are examples of such discretion that were used for banks during the COVID crisis and could be relevant for CCPs as well. Economic risks are derived from very different economic conditions in another jurisdiction, such as a sovereign debt crisis, rampant inflation, non-payment of loans and different interest rates that might lead to negative consequences for others.
Overall, cliff edge scenarios related to clearing requirements in the EU or an equivalent territory have not materialised, and markets have largely adjusted prior to the 2025 deadline. There is still significant clearing taking place in the US. The groundwork for preparing an inviting and safe environment for that clearing to take place in the EU lies in consolidating migration to date, building on the subsequent growth of EU central counterparties, and upgrading the coordination of CCP supervision in the Single Market.

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