As published in the Financial news on 5th April 2018.

As politicians wrangle over Brexit, there are already signs the market is expecting significant swap liquidity to shift to the continent.

Holding onto the €700bn-a-day euro-swap clearing market is one of the City’s biggest Brexit battles. But as the politicians continue to posture, there are already signs the market expects significant liquidity could shift to the continent.

Two big rivals are contending the market for “clearing”, or verifying and approving, financial derivatives contracts denominated in euros. These are LCH and Eurex, two clearing houses that stand as neutral parties between the banks that are conducting the trades, and the clients they are trading with.

In the City’s corner stands LCH, owned by the London Stock Exchange. In the EU’s corner is Eurex, together with the challenger Deutsche Börse. LCH dominates the clearing landscape at present, but since the Brexit vote, European politicians and regulators have begun to suggest euro-swaps should only be cleared inside the EU.

As negotiations grind on, for anyone clearing swaps either side of the English Channel, the only certainty is continued uncertainty right now. But there are indications as to which way the wind is blowing.

One little-noticed feature of the clearing landscape is a market that allows banks to switch books of cleared swaps from one clearing house to another. The market exists because the cost of clearing a euro-swap can be different depending on whether it is cleared at Eurex or LCH; and these differences persist through the lifetime of the swap, creating ongoing volatility for banks’ profit and loss.

It’s usually clients, not banks, who decide where their trades should be cleared, but banks often hedge these swap trades by conducting opposing trades with other parties. And it’s up to the bank where these are cleared.

Thanks to its dominance of the market, most banks will have existing relationships with LCH. But increasingly, their EU clients may look to clear with Eurex or another EU-based competitor. For the banks, this raises the prospect of mismatches between client trades cleared on Eurex and hedging trades cleared through LCH.

Fortunately for the banks, the switching market exists to address this issue. It involves brokers, such as Tradition or TP ICAP, matching up banks that have opposing positions, cleared through different clearing houses. It allows the banks to neutralize this “intra-clearing house” risk.

The idea is nothing new, but a lack of clarity about where euro-swaps will have to be cleared has thrown this market into the spotlight. Indeed, sentiment across this switching market is now a key barometer of where the market thinks euro-clearing will ultimately reside.

And during the last few months, the cost of shifting risk from Eurex to LCH has reduced from 1.9 to 1.3 basis points. This is material; it translates into €60,000 on a 10-year €100m notional swap. The chief driver of the cost of clearing any particular swap is the liquidity available at the clearing house for that instrument; in other words, how many other people are clearing similar swaps there.

So this change in the cost of transferring risk to LCH may well be linked to the market’s increasingly positive expectation of liquidity developing at Eurex as Brexit looms.

The CCP switching market is a good indicator of the market sentiment towards the outcome of euro swap relocation. If the difference between the cost of clearing between Eurex and LCH continues to narrow it would be a strong sign that the market expects significant liquidity to build at Eurex. Click To Tweet

With the euro-clearing saga set to run and run right up until March 2019, what is the most likely ending? Based on the UK government’s hard-line position on being outside the single market, significant euro-denominated trades could well move to Eurex, increasing that institution’s liquidity, and providing an increasingly meaningful choice for banks and investors on the choice of clearing house.

But banks can’t afford to wait for the outcome of the politicians’ tortuous negotiations. With shifts in liquidity already under way, analysing how to access the most cost-effective venue has to be at the heart of any banks’ clearing contingency plan right now.