Over-the-counter (OTC) derivatives markets, in particular interest rate derivatives (IRD), have grown significantly in recent decades and now constitute a systemically important component of financial services activity. The UK plays a central role in clearing derivatives, both at a global and EU level. It is the single biggest venue for OTC derivatives activity and is even larger in terms to euro-denominated IRD contracts clearing. Yet, the fact that a large share of euros is traded, and will be traded after Brexit, in a non-euro area country raises questions about the regulation and supervision of such markets and the sustainability of liquidity provision, particularly during a time of financial turmoil. The burning question is thus whether the clearing of euro-denominated derivatives can remain in London or should be moved to the eurozone.
With the aim of shedding light on this issue, this report explores the OTC IRD market and the UK’s role in it, and examines the potential costs of a relocation policy of CCPs after Brexit. It argues that there are aspects of the Commission’s proposal that require further attention and clarification. The easiest approach might be to establish a location policy to require systemically important CCPs to be located within the eurozone, but this would be an error of judgement. The report highlights the urgent need for an impact assessment of the fragmentation, risks and costs of such a move. It concludes that the best hope of addressing the risks of clearing post-Brexit is for heightened supervision, deep cooperation and clear coordination between the EU and the UK, rather than a potentially forced relocation of services currently provided by UK firms to the EU.
Apostolos Thomadakis, PhD, is Researcher at the European Capital Markets Institute (ECMI).
Keywords: interest rate derivatives, over-the-counter, euro-denominated, central clearing, Brexit, relocation policy, fragmentation, initial margin