Shifting trillions of euros of derivatives positions could be hugely disruptive.

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

The growing prospect of a hard or disorderly Brexit is sending jitters through the global financial community. This week the Financial Times reported that a group of “large financial institutions with big London operations” had met with US Commerce Secretary Wilbur Ross to express their dissatisfaction with the lack of progress in Brexit negotiations.

“The fears over a potential Brexit no-deal are rising, as we move within 16 months of the UK’s exit from the EU,” said Joshua Mahony, market analyst at IG.

While New York stands to benefit from some of the disruption caused by the UK’s separation from the EU, there is rising concern that Brexit could set off global ripples. That fear was compounded on Friday after Teresa May announced plans to set the UK’s departure date and time (March 29, 2019 at GMT 23:00) from the EU in law, warning she will not “tolerate” any attempt to block Brexit.

“[The banks] are becoming nervous,” said City of London Corporation’s policy chief Catherine McGuinness after meeting representatives of US banks earlier this week. “It wasn’t just curiosity, it was concern at the lack of progress that we have been making, and nervousness that it had implications beyond Europe’s borders in terms of causing disruption to markets.”

For the City of London Corporation, the prospect of a messy Brexit is even more terrifying than it is for many of the global banks it hosts within its coveted Square Mile. The Bank of England has warned that up to 75,000 jobs could be lost in the financial sector following Britain’s departure from the European Union. But it’s not just jobs that are on the line; so, too, is the Square Mile’s role as the world’s most important financial center, not to mention the backbone of the UK economy.

In recent months the European Commission and the European Central Bank have redoubled their efforts to compel financial institutions to move at least some of their operations onto the continent. “I have a very clear message to both smaller and larger banks: the clock is ticking,” said Sabine Lautenschläger, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB. “No one knows how Brexit will play out, and that’s why all affected banks should prepare themselves with a hard Brexit in mind.”

Some banks are already taking action. Goldman has set aside the top eight floors of a 37-story block under construction in Frankfurt which is expected to be ready for occupation in the third quarter of 2019. Just a few months before that, construction work on the bank’s new £350m European headquarters in central London should be completed.

Ten days ago, Goldman Sachs CEO Lloyd Blankfein, posted a tweet of an aerial shot of the half-finished construction in London, with the words “expecting/hoping to fill it up, but so much outside our control.” As the head of an organization with alumni at the very top of both the Bank of England and the European Central Bank as well as tentacles that reach out to just about every corner of the old continent, Blankfein  is clearly selling Goldman short, if you’ll excuse the pun.

Goldman’s not the only major bank hedging its bets. On Tuesday Germany’s struggling behemoth, Deutsche Bank, announced that it had signed an agreement to occupy at least 469,000 square feet at a site under construction in the City of London. The move comes despite a warning in April that thousands of Deutsche Bank’s UK staff may have to relocate after Brexit. To that end, Deutsche has begun work on a Frankfurt booking center that would take up some of the slack if the German lender was forced to turn its London branch into a subsidiary when Britain leaves the EU.

Most banks would prefer the status quo to continue, with the lion’s share of their operations remaining in London, which already has the physical infrastructure, legal apparatus and friendly political and regulatory culture needed to support the full gamut of global financial services. But the Brexit vote has presented rival European nations and the ECB with a golden opportunity to undermine the UK’s domination of Europe’s financial industry. They won’t let it go to waste.

In Germany, the benchmark index, Deutsche Boerse, has introduced a profit-sharing scheme on interest rate swaps at its clearing business as it seeks to wrest trade from the London Stock Exchange, which it came within a whisker of acquiring just months ago. Some of Europe’s biggest trading houses in swaps, Bank of America Merrill Lynch, Citi, Commerzbank, Deutsche Bank, JP Morgan, and Morgan Stanley, have already registered an early interest in the program, Eurex said.

For the City of London, the potential loss of its dominance of Europe’s clearing business would be a hammer blow, as we warned in May. The U.K. is estimated to handle 75% of all euro-denominated derivatives transactions, equivalent to around €930 billion of trades per day. It’s also home to roughly 90% of US dollar domestic interest-rate swaps. If it were to lose much of that business, as many as 232,000 jobs could be on the line, warns London Stock Exchange Group Plc CEO (and former Goldmanite) Xavier Rolet.

However, any attempt to move euro clearing away from London to the continent is likely to take years to implement and will ramp up costs for companies across the region. In September the US Commodity Futures Trading Commission (CFTC) Chairman Christopher Giancarlo warned the European Union against making “unilateral” changes to how the bloc treats foreign clearing houses amidst fears that shifting derivatives positions totaling trillions of euros across the English Channel could be hugely disrupting.

With so much at stake, the outcome of the next year and a half’s negotiations between London, the world’s most important financial market, and the EU, the world’s largest trading bloc, is likely to have implications far beyond the EU. If a hard, messy Brexit cannot be averted, what happens next in the global financial markets will ultimately depend on whether or not the banks, regulators and central banks have taken enough provisions for an event that is both entirely unprecedented and wholly unpredictable. And that is hardly comforting. By Don Quijones.

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