In Derivatives Trading, London is King

Date: 29-07-2016
Source: The Wall Street Journal

The city’s dominant position in derivatives may be difficult to undo in the event of Brexit

Of the $9.4 trillion in daily global derivatives trades tracked by the Bank for International Settlements, 43% take place in the U.K.

London is a player in the markets for gold, oil and bonds. But in derivatives, it is king, and that is what Brexit will put to the test.

Of the $9.4 trillion in daily global derivatives trades tracked by the Bank for International Settlements, 43% take place in the U.K. That isn’t because they are denominated in pounds—the U.K. handles four times as much trading in euro-denominated derivatives as France and Germany combined.

Britain’s vote to leave the European Union threatens to challenge a position built up over 50 years, in which the U.K. convinced the world to trade and settle its financial transactions in London, no matter the currency.

Whether it does depends in part on political negotiations between the U.K. and the EU. But it also depends on whether the rest of Europe can—and would even want to—uproot the business.

“We’ve never had to test it, because London has been the natural focal point for the financial-services industry in Europe,” said Nathaniel Lalone, partner at law firm Katten Muchin Rosenman, specializing in financial markets.

A close look at the $553 trillion universe of over-the-counter derivatives business makes plain how difficult a move away from London would be. Derivatives are financial products that get their value from something else—like options to sell a stock or bond, or more exotic contracts that pay out according to changes in the weather.

One party may agree to pay the other if, say, interest rates change. Some derivatives have standard features and are traded on exchanges, like stocks. But the bulk aren’t—they are just contracts between parties. Many derivatives are cleared through a clearinghouse, which acts as an intermediary and is on the hook if either side fails to hold up its end of the contract.

London has the biggest derivatives clearinghouse. LCH, owned by the London Stock Exchange and based in London, clears €390 billion ($431 billion) in euro-denominated interest-rate swaps a day.

Continental Europe has for years been frustrated that London dominates financial services in euros, even though the U.K. isn’t part of the common currency. The European Central Bank has tried to require that clearinghouses for euro-denominated trades be in the eurozone; last year, the British government won a legal case to block the ECB from doing it.

As what remained of sterling’s role as the global currency evaporated after World War II, London’s financial center declined with it. But in the late 1950s, the city took advantage of the new global currency, the U.S. dollar. It did this by becoming the destination for eurodollar business, where other countries stashed their dollar-denominated earnings, often to escape U.S. oversight.

In the 1990s, it established a beachhead in the booming derivatives business. The advent of the euro, which replaced scattered national currencies, brought on helpful consolidation, with London as the center. London’s share of the total interest-rate derivatives market was roughly 50% in 2013, according to the BIS.

The other large derivatives market is denominated in dollars, and winning that from New York would be difficult, according to Chris Martin, professor of economics at the University of Bath.

Because the U.K. is an EU member, banks based in Britain can operate across the 31 countries of the EU and the European Economic Area without subjecting themselves to local regulation in every place they sell securities. This so-called passport means a U.S. bank’s London subsidiary can sell interest-rate swaps across Europe without having to squeeze through the regulatory hoops and licensing requirements of each different legal regime.

The U.K. has 2,079 investment firms that use such passports, compared with 703 companies in the other 27 EU member states combined, according to the European Banking Authority.

The passport long has been a vital buffer. In 1990, Deutsche Terminbörse, now part of Deutsche Börse AG, used a lower-cost electronic platform to wrest the trading of futures in German government bonds, or bunds, back to Frankfurt from London’s trading pits.

The number of bund futures contracts traded in London fell from 45 million contracts in 1997 to zero by 1999, according to Marc Levinson, an economist who has written books on markets.

But even as the trades flowed over a Frankfurt-based exchange, the traders executing them remained in London thanks to the passport.