London likely to lose all euro repo clearing business

Fear of post-Brexit curbs on clearing and netting concerns propel shift to eurozone

Twin pressures on the clearing of euro-denominated repurchase agreements in London are likely to push the business to the eurozone, and it may happen even before the UK leaves the European Union, the market’s participants predict.

They point the finger at the prospect of LCH’s London entity – which is the sole clearer of repos in the UK – being barred from clearing for EU firms after Brexit. Those fears are accelerating an existing shift in liquidity driven by a new pan-EU settlement platform, which allows trades to be netted irrespective of where in the bloc they are settled.

LCH has been clearing growing volumes of cash eurozone government bonds and related repos at its RepoClear unit in Paris since its creation in 2003. Meanwhile, activity at RepoClear in London – which comprises a wider range of bonds and repos in eurozone markets, as well as in gilts – has declined every year bar one since 2012. Within that, euro-denominated repos are seen as the biggest flight risk.

One former EU central banker recently said the repo market would move out of London completely by March 2019 – the planned date of the UK’s departure from the EU. The official was speaking at a conference held under the Chatham House Rule of anonymity.

The market is restless partly in anticipation that the European Central Bank (ECB) will use its recently proposed powers to effectively deny recognition to LCH’s UK entity, which will become a third-country central counterparty after Brexit.

In that case, “a continental division of a global bank would need to clear its repo transactions on a repo CCP that is recognised in order to obtain qualifying CCP [capital] benefits”, says Josh Galper, managing principal at capital markets consultancy Finadium.

In 2011, the ECB tried to introduce a location policy on CCPs clearing euro-denominated contracts, arguing it should have direct oversight of a clearing house that services eurozone clients if it were to provide the CCP with backstop euro liquidity or act as a lender of last resort. That policy could be revived in some form after Brexit. While its potential effect on London’s lucrative swap-clearing business has grabbed most media attention, it is the UK’s repo market that stands more directly in the line of fire.

“[Repos] stick out as a market in which central banks have a particular interest, as they conduct monetary policy in them,” one central banker tells Risk.net. “Also, they are settled on a gross basis, so they generate a higher liquidity need. Swaps are neither.”

The advent of T2S does indeed provide improved netting possibilities, and we do see a greater proportion of euro-denominated securities clearing moving to [LCH] SA, regardless of any localisation policy

Head of clearing at a large bank in London

Some bankers acknowledge the ECB has a point. “I have always had a sympathetic view of localisation of repo and [sovereign] bond clearing,” says the head of clearing at a large bank in London. “Given the bond and repo markets are so intrinsic to how governments fund themselves, there is some sense there.”

Even before Britain’s vote to leave the EU, the Target2-Securities settlement platform had boosted the appeal of clearing repos in continental Europe.

T2S connects market participants’ securities accounts, held at national central securities depositories (CSDs), and their cash accounts at central banks via a single IT system, aiming to make cross-border settlement in the EU safer, faster and cheaper.

A key benefit of T2S is clients’ ability to net their purchases and sales from across the EU, as the platform is treated as a single settlement location. Settling in the same location is one of the preconditions for netting.

Netting is important, as it reduces banks’ overall exposure, delivering capital and collateral savings. LCH’s Paris entity, LCH SA, can settle members’ trades on T2S via participating CSDs in mainland Europe, including Clearstream Banking and Euroclear France. In contrast, LCH Limited in London cannot because the relevant CSD, Euroclear UK & Ireland, has not signed up to the platform.

“If you are clearing a product in LCH SA and you have the other side in LCH Limited, you cannot net them,” says the global head of fixed income at one major bank in London. “T2S can be a pull factor in that it will allow people to net without needing to settle in the same location. You can physically settle your Bunds in Frankfurt and Italian bonds in Milan and still net them.”

If two to four banks decided to move to Paris, the others will follow the liquidity. It’s not clear when it’s going to happen, but I’m sure this is going to happen

Head of a trade association

Work on T2S began in 2006, and CSDs started linking up with the platform in 2015. However, the platform’s largest CSD by far, Clearstream, did not come on board until February this year, doubling the existing settlement volume.

“The advent of T2S does indeed provide improved netting possibilities, and we do see a greater proportion of euro-denominated securities clearing moving to [LCH] SA, regardless of any localisation policy,” says the head of clearing at the first bank.

T2S has prompted another development, which in turn is driving more traders to the platform: in March, RepoClear in Paris started clearing cash Bunds and related repos to help its members make greater use of netting. This was a significant step, as the German repo market is the second biggest in Europe, after Italy’s.

When contacted by Risk.net, LCH declined to split out Bund repo volumes from its public figures on RepoClear in London and Paris, or to provide a breakdown between all repos and cash bonds.

But there is some anecdotal evidence that a migration is afoot.

Netting benefits

The global head of fixed income says Bund liquidity is already moving to LCH in Paris as a result of netting benefits, and forecasts a bigger shift in the future: “When enough firms have… moved over for netting ability, and the liquidity at LCH SA exceeds the liquidity at LCH Limited, then it will be a very fast process, and everybody will move… I suspect it will happen.”

His former counterpart at another bank echoes those observations, adding that once one repo market relocates, all others will probably follow to make the most of netting.

Likewise, the head of a trade association says: “If two to four banks decided to move to Paris, the others will follow the liquidity. It’s not clear when it’s going to happen, but I’m sure this is going to happen.” He adds the repo market might relocate even before any action by regulators – that is, before the UK leaves the EU.

Volumes could drain away from London particularly quickly as repos are mostly short-dated, meaning counterparties wouldn’t need to wait long for existing trades in London to expire and to book new ones in Paris. Three-quarters of European repos have a maturity of three months or less, according to December 2016 data from the International Capital Market Association.

Risk.net calculations based on the latest available data, covering 2015, show RepoClear in London accounts for around 40% of the cleared European repo market. The unit cleared €79 trillion ($92.5 trillion) that year and €74 trillion in 2016.

Between January and August this year, the unit’s nominal volume stood at €58.6 trillion, only a touch above the amount cleared at its Parisian cousin. If the volumes stay this close over the remainder of 2017, it will be the first time RepoClear in Paris had cleared at least as much as RepoClear in London in a single year.

Galper at Finadium agrees euro repo clearing could relocate completely from LCH in London to LCH in Paris, but says Frankfurt-based Eurex Clearing may also enjoy an increase in volumes.

However, that is further away in the future, says a second head of fixed income at a big bank in London: “LCH Limited to LCH SA is a more immediate migration. Changing ‘pipes’ even further from LCH Limited to Eurex Clearing is not an obvious thing, and would take longer.”