Vast Euro-Derivatives Market, Centered in London, Is Set to Fragment as End of Brexit Transition & Uncertainties Loom

It shouldn’t “create risks to the stability of the financial system,” which is soothing to know.

About 43% of the $9.4 trillion in daily global derivatives trades tracked by the Bank for International Settlements are executed in the U.K. A large chunk of them are euro-denominated, but some of those trades will soon have to be executed elsewhere, according to the Paris-based European Securities and Markets Authority (ESMA), which announced on Wednesday that once the Brexit transition period expires, on Dec. 31, trading in euro-denominated derivatives must remain within the EU’s jurisdiction or in a country with “equivalent” standards to the bloc.

From that day, EU investors will have to use a swaps platform inside the bloc, or based in a non-EU country that — unlike the UK — has been granted “equivalence,” such as the US. As a result, branches of EU banks in London will have to grapple with conflicting EU and British trading obligations. British counterparties will have to use a UK authorized platform, while EU counterparties will have to use an EU authorized platform, making a trade between the two sides impossible.

“The decision is a starting gun for a fight between the UK and the EU for the location of international derivatives trading in Europe,” said Michael McKee, a financial services lawyer at DLA Piper law firm.

Toward a Fragmented Market

The result will be a much more fragmented European derivatives market. That is likely to be bad news for the UK’s all-important financial services industry, which accounts for more than one-tenth of the UK’s tax revenues and one-fifth of its service exports. It may also impact investors and companies, whose financing costs may rise as a result.

ESMA acknowledged that the situation “creates challenges for some EU counterparties, particularly UK branches of EU investment firms.” On the bright side, it shouldn’t “create risks to the stability of the financial system,” which is a relief.

At this late stage in negotiations, the only way this rupture of Europe’s derivatives markets can be halted is through a last-minute deal that grants so-called “regulatory equivalence” to the UK’s financial services industry. Or failing that, a last-minute extension to the transition phase.

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