Opinions may differ on whether Brexit has had a positive or negative impact on either of the parties involved. However, it could be argued that an idiosyncratic event such as the liquidity crisis that took place in the United Kingdom at the end of September could have been averted, had the country been part of the bloc. Investors lost confidence in the UK government, now more isolated than before Brexit, and its ability to maintain its fiscal balance, after the announcement of a massive fiscal spending plan at the end of September. That sent yields on UK Gilts soaring and led to a spiralling lack of liquidity, as pension funds rushed to post collateral on their interest-rate derivative positions.
Ironically, the planned review of the European Market Infrastructure Regulation (EMIR), announced by the European Commission in mid-December, exposes the enduring connection between London and the Continent. The EC proposes to make clearing of derivatives in the EU more attractive, by facilitating the launch of new products by the European central clearing counterparty (CCP), Eurex, and forcing market participants to maintain ‘active accounts’ with Eurex. At the same time, the review suggests that the equivalence between the UK CCP, the London Clearing House (LCH), and Eurex, will be extended indefinitely. In a sense, the announcement appears to be a way for the EC to settle what had become a political issue.
Market participants agree that the review is a positive sign that the EC recognises the need for unrestricted access to LCH. That is where the most liquidity for swap trading, and therefore the best pricing, is generally available. The dominant position of LCH had been threatened by Brexit, with some entities even ceasing to do business with the UK CCP, but now the issue is more or less settled. It seems unlikely, at the same time, that the EC’s plan will achieve its aim of creating a level playing field between the two CCPs.
The EC announcement came at a relevant time for pension funds. From the summer of 2023, they will no longer be exempt from the central clearing of derivatives. EMIR, in its future form, will determine their behaviour when it comes to derivatives, particularly interest-rate swaps. This means they will have a choice whether to access the London derivatives market or stay closer to home in Frankfurt.
But the more relevant question is whether the regulation and market infrastructure are up to scratch. The liquidity crisis in the UK prompted widespread calls for regulators to ensure a similar crisis can be avoided in Europe. European pension funds holding derivatives may be unlikely to suffer from a similar fate to their UK peers, because the chances of EU rates rising to the same extent as UK rates did in September are lower. However, it is by no means an impossible scenario. That is why PensionsEurope and others have called for the European Central Bank to position itself as a backstop in the event that liquidity dries up due to stress in the repo market, for example.
Such calls should not be ignored. European pension funds may be more resilient than their UK peers, but they are not immune to systemic risk. Regulators should focus less on settling political disputes around Brexit and on ensuring the stability of the financial system.
Carlo Svaluto Moreolo, Deputy Editor
carlo.svaluto@ipe.com
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