Swap Trading post Brexit

Why US SEFs are the big winners so far

Curbs on swap trading between the UK and EU have already had a big impact on trading patterns and global liquidity, resulting in more expensive hedging deals and higher costs for end-users.

The absence of an equivalence deal for derivatives between the UK and EU means that US firms (who already have equivalence with the EU and since January directly with the UK) can still access global liquidity, but EU and UK firms can only trade impacted derivatives where the EU and UK both have equivalence - for example in Singapore or on a swap execution facility (SEF) in the US.

$200 billion of IR swap trading was carried out each day on UK platforms in 2020, but post Brexit much of the EU trading in Euro denominated swaps has moved from London to EU and US venues. Euro-denominated rate swaps traded on SEFs increased from 11% in December to 22% by the middle of January.

The impact of Brexit on Regulations

Before Brexit, financial firms in the UK and Europe could trade with each other under European Regulations such as EMIR, MiFID II and MiFIR. Following Brexit the UK has 'onshored' European regulations into UK law so that UK firms are following the same regulations as firms in the EU. So far the EU has only granted temporary recognition of three UK CCPs and one CSD. This causes problems for firms trading across both locations as they have to comply with two sets of (albeit currently identical) regulations.

What is Equivalence

The EU restricts market access to non-EU firms until it agrees that their rules are equivalent to its own rules. Until this happens, non-EU firms, such as investment firms and clearing houses are prevented from working directly with EU market participants from a non-EU base. Workarounds include trading through a European subsidiary, trading via an intermediary which already has market access and trading on a venue that is approved by the EU and the UK. These options are likely to add to costs - for example subsidiaries require the allocation of significant capital.

The UK granted equivalence in some areas of financial services in November 2020, which allows branches of EU banks based in London to continue trading without having to convert into subsidiaries.

However, the EU has not granted UK equivalence at this stage. The EU typically completes lengthy deliberations before granting equivalence - one US derivatives clearing rule took 4 years to be granted equivalence. In theory equivalence should be easier to grant, given that the EU and the UK have identical regulations in many areas.

The case for mutual recognition

The UK had originally asked for an agreement based on mutual recognition, where the UK and the EU would accept each other's regulations, but this was not accepted by the EU. The UK can request equivalence, which has disadvantages compared with mutual recognition. Firstly under equivalence the UK will need to mirror EU regulation without having a say on the rules, which isn't aligned with the UK's desire to stay aligned with EU regulation but have the opportunity to make changes, or for example to maintain financial stability. The second is that the EU can withdraw its equivalence determination with only 30 days' notice, creating uncertainty.

The outlook

An equivalence deal for derivatives between the EU and UK would improve access to global liquidity and reduce reliance on US SEFs. But by delaying equivalence the EU has the opportunity to build up its share of the market. In practice this may end up driving trading activity away from EU and UK venues.