This piece is taken from a much longer blog on the (non-)impact of Brexit on the City.

The job of stock exchanges like Euronext or the IEX, or of Interdealer Brokers (IDBs) who offer a trading venue for over the counter (OTC) products, like Tullett Prebon or BGC, is to match buyers with sellers. Their systems aim to do this instantaneously, and after the trade is done they rely on the parties to settle their bargains in good faith, on T+1 or +2 or whatever. The job of clearing houses is to facilitate this by acting as a centralised clearing party (CCP) which sits between the traders and guarantees the settlement of the trades. This allows the traders to trade without fear of being “welched on.” Their counterparty is the clearing house, not the other trader. In return, the CCP takes a small clearing fee and ask the traders to post collateral. Because many traders will be buying and selling the same securities or contracts at any point, a clearing house can “net” these flows off so they are only exposed to a small volume of completion risk at any one time. This enables them to minimise the capital demanded from traders.


LCH Clearnet in London is just such a clearing house, and one of its major activities is clearing Euro denominated Swaps. The fact that this activity may be endangered by Brexit is often alluded to (see FT Alphaville) without really explaining the source of the problem. To understand this issue we need to revisit the Swaps market, described elsewhere, and in particular understand the source of the underlying demand for Swaps. The typical user of a Swap is a deposit funded bank that writes a lot of mortgages. Such a bank will, typically, derive the vast majority of its funding from customer deposits, on which it pays a floating rate (for Eurozone banks this rate tracks euribor). If it writes its mortgages at floating rates then it doesn’t need any Swaps. However many of its customers will want to fix their borrowing costs. Moreover, if its borrowers have variable rate mortgages and floating rates rise those floating rate borrowers’ monthly payments will increase and their ability to service their debts will be impaired, potentially leading to defaults. So banks are often keen for borrowers to fix their mortgages in order to minimise credit risk. But when such banks write fixed rate mortgages which are effectively funded by floating rate deposits, they end up with an interest rate mismatch. If floating rates fall then their margins increase, but if rates rise their margins reduce and, at a certain point, go negative. This is a serious, potentially fatal risk for any bank. Such banks therefore “hedge” this interest rate risk by going into the Swaps market and swapping their borrower’s floating rate into a fixed rate at the current Swap rate – of course after slapping a mark-up onto the fixed mortgage cost they charge their customers (as Robert W. Sarnoff said, “Finance is the art of passing currency from hand to hand until it finally disappears”).


Apart from mortgage borrowers, there are all sorts of other parties who want to fix interests in one way or another, for example a company might want to fix the interest rate on one of its corporate loans.


On the other side of the trade is, as described above, an entity that wants to receive a fixed rate and pay a floating rate. This might, in theory, be another bank which has an excess of fixed rate deposits, but in practice such entities are rare as hens’ teeth. In reality, the other side of the trade is usually a financial investor who is looking to earn a premium. As the fixed rate is almost invariably above the relevant floating rate, anyone writing a Swap will collect a spread, in other words will earn a positive “carry” as long as floating rates don’t rise too much.


If you take a step back, the Swaps market is very similar to insurance. Those buying the Swap pay to “insure” themselves against rising interest rates. Those writing the Swap are being paid an annual premium to provide that insurance. If floating rates rise it reduces the Swap writers’ income and at a certain point turns it negative, meaning they have to pay out – just as your car insurance company does when you have a crash. Now if you cast your mind back to the last major financial crisis, as described in Michael Lewis’s brilliant The Big Short (2010), you will remember that one of its major contributory factors was just such financial insurance products. And that those products were also a kind of Swap. At the epicenter of the last crisis were sub-prime loans, effectively mortgage loans to borrowers who were too poor to afford the houses they lived in, and which would turn sour if property prices ever stopped going up. Naturally, there was great demand for insurance against defaults on the various classes of sub-prime debt from a number of entities: the banks writing the mortgages, financial institutions to whom those mortgages were repackaged and sold in the form of CDOs, CLOs etc. and, crucially, the heroes of The Big Short who thought the whole thing was a fraud. These entities went into the credit default Swap (“CDS”) market either to hedge their credit risk or (in the case of the heroes of the Big Short) to make money when the house of cards collapsed.


On the other side of that trade were the villains of The Big Short, insurers like AIG and Wall Street brokers like Goldman and Morgan Stanley who thought it was easy money to take juicy premiums against the risk of sub-prime default – a risk they underestimated. When property prices eventually stopped rising and mortgages on variable rates (“ARM”) with two year teaser rates re-set to higher market rates, mortgage defaults exploded and a lot of the CDS “credit insurance policies” were triggered. The problem was that the companies writing the insurance turned out not to have nearly enough capital and were therefore unable to pay out; they were caught with their trousers down. Despite being incredibly risky, the CDS market was not supported by any CCPs. The investment banks were trading directly with each other, relying solely on their counterparty’s financial strength. When that financial strength turned out to be only a fraction of what was required to pay out on the credit default insurance, there was a domino effect, as Wall Street bank A had bought insurance from Wall Street bank B, but Wall Street bank B couldn’t pay out so Wall Street bank A couldn’t make good on the insurance it had sold to Wall Street bank C, and so on. Two early casualties of this hot mess were Bear Stearns and Lehman Brothers. As Warren Buffet succinctly put it with his usual barbed wit, “when the tide goes out you discover who’s been swimming naked.” The great scandal was that these firms were allowed to make lots of money writing insurance on dodgy sub-prime loans during the boom, and were then bailed out by the Federal Reserve when they weren’t able to pay up for their stupid bets in the bust. The Fed effectively waded out into the sea and handed Wall Street a towel. It makes you weep.


Turning back to the Euro interest rates Swap market, if we were ever to have a rise in interest rates, the European mortgage bank which used to sleep soundly at night in the knowledge that it had swapped (or insured) its interest rate risk doesn’t want to wake up in a cold sweat because the other side of the trade, who wrote the Swap, isn’t going to pay out – just as the Wall Street banks and AIG couldn’t pay out on their credit default Swaps during the sub-prime fiasco. As I explained above, as interest rates rise, LCH Clearnet will be demanding more and more capital from the investor who wrote the Swap. If that investor can’t post the collateral then LCH will close the position at a loss for the investor. All its collateral will be used to make good on the “insurance policy” it wrote. But if interest rates rise any further that capital will already be eaten up, and it is then LCH Clearnet’s capital which is guaranteeing the Swap.


This is where the ECB starts to get worried that we get a repeat of a scam like the one perpetrated in the sub-prime bubble. It may fear that City investment banks and others will make a lot of money in London writing Swaps in the good times, but not hold enough capital to make good on the insurance they promised if interest rates ever rise. It may also fear that LCH has been too generous in the amount of capital it forced them to post, in order to encourage them to trade (just as spread betting companies will try to entice customers by offering to let them trade with small margin deposits, much to the horror of regulators). The ECB should be able to take some comfort from the fact that the bank’s counterparty in these swaps is LCH as CCP, not each other. But for this to be any comfort, LCH Clearnet has to hold enough capital to honor the Swaps which its customers aren’t able to pay out on. If LCH doesn’t hold enough capital, this would represent a very serious risk for the ECB. If the interest rate insurance purchased by European banks doesn’t pay out, and LCH can’t stand in to make up the shortfall, the ECB will be left holding the baby. The banks with fixed rate mortgages and whose Swap counterparties have defaulted will be hit by rising interest rates and/or increased defaults. This could rapidly make those banks insolvent. Any other bank with exposure to such banks will be at risk and seek to withdraw its deposits. But, just like last time, no one will really know who is at risk, everyone will deny everything, the rumor mill will go into overdrive and confidence will evaporate. You could easily have a domino effect similar to the one which brought the financial system down in 2008, leading to another run on the banks. The ECB might end up in the ignominious position of having to bail LCH out to stop the European banking system from collapsing. Like Wall Street in 2008, the London banks would have made money in the boom and been bailed out (by the ECB) in the bust.


This is far from being a theoretical risk. The parallels between the current interest rate situation and the housing boom that preceded the 2008 crash are frankly spooky. Central bank interest rates and government bond yields have been steadily declining since the 2008 crash to the point of being negative in real terms in many countries; such low rates have no historical precedent. Financial leverage in the housing market and house price (un)affordability reached similarly unprecedented levels before the last crash. The one way direction in which interest rates have moved has left large parts of the financial industry totally unprepared for and vulnerable to a rise in interest rates, just as the one way rise in property prices did in the 2008 crash. Although rising interest rates generally help banks make money, especially on their deposit margin, they could simultaneously torpedo the value of the bonds and other financial assets held on their balance sheets and with it their solvency. So you can understand why the ECB might be worried.


Because of these risks, European banks may be reluctant to trust a Swaps clearing house that is not backed by the ECB. So, for LCH Clearnet to continue to clear Swaps post Brexit, it may need to operate with the ECB’s agreement to be lender of last resort in some form or other to the customers whose Euro denominated products it guarantees. For the ECB to agree to this, LCH may have to be regulated by the ECB and in particular require leverage ratios from its clients and implement collateral policies which reassure the ECB that the investment banks playing in the Swaps market are not taking the piss in the way Wall Street did during the sub-prime debacle. In fact, LCH is already regulated by numerous European regulators, including France’s Autorité de Contrôle Prudentiel . LCH could, of course, open an office in Frankfurt in which all its regulatory, client approval, risk assessment and collateral management functions were performed. This would allow the IT and sales functions to stay in London. But the ECB may insist that everything moves out of London. It’s a hard one to call.
All that said, this is a relatively small part of the wealth generated by the City and the impact would not be significant. The important point is that there is no read across from Swaps clearing to the rest of the City’s activities. The robustness of Euro denominated Swaps clearing is important for the solvency of the European banking system. ECB support is therefore likely to be demanded by the Swaps customers. None of this applies to the City’s other activities.