Battle for the City of London Tips in Favor of the Queen; Poland to the Rescue

A short time ago, the financial relevance of the UK seemed in jeopardy, but two events announced only yesterday suggest the Square Mile will remain a major player in international trading, at least for the time being. First, the board of LCH.Clearnet, the country's largest counterparty clearinghouse, announced it had approved a buyout offer from the London Stock Exchange, edging out a materially lower offer from Markit, with a shareholder vote to determine the final outcome. Jeremy Grant explained a salient point earlier in the month in the Financial Times (emphasis ours):

But what about SwapClear, the over-the-counter (OTC) interest rate swaps clearing service under LCH.Clearnet?

While LCH.Clearnet books OTC derivatives revenues on its accounts from the SwapClear service, this does not tell the full story on where SwapClear profits go. Some [profits] go to the OTC derivatives dealer-banks that form a curious governance mechanism for SwapClear, known as OTCDerivNet. The amount of profit that goes to these banks is dictated by a sliding scale of thresholds set out in an arrangement between LCH.Clearnet and the banks, revised last year.

It is a glass bead game that few even in the industry understand, but the bottom line is that any LSE deal with LCH.Clearnet would probably have to allow SwapClear to be ring-fenced somehow to allow the banks to carry on. I can’t see the SwapClear banks represented on the LCH.Clearnet board being enthusiastic, either, about exchange control of LCH.Clearnet (which is what you’d get if the LSE wants 51 per cent).

This is one hurdle that Markit, the LSE’s rival bidder, does not face. Perhaps that is why the LSE has offered a knock-out €21 a share price for LCH.Clearnet, above Markit’s €15 offered for 100 per cent of LCH.Clearnet.

So, the big London banks on the LCH board capitulated. But why? Perhaps they read the proverbial handwriting on the wall, as power centers on the Continent were jostling for a carrot-and-stick-induced LCH crossing of the channel. If London were to lose LCH, the Deutsche Borse/NYSE Euronext faction might shift the occidental financial axis firmly along a New York/Frankfurt line.

The carrot was that the EU is currently considering giving clearing houses access to central bank liquidity in a crisis (i.e., ECB bailout funds), similar to the arrangement between the Federal Reserve and the DTCC and CLS Bank. The stick was that the ECB would require clearing activities to be conducted within the EU (sic Germany) as a precondition to access, which would require a re-domicile of LCH on the Continent. On September 15, the UK threatened to sue the ECB over the issue, but only yesterday, the tide turned, as Poland intervened (emphasis ours):

Derivatives clearinghouses such as LCH.Clearnet Group Ltd. may face less pressure to move parts of their business from the U.K. to the euro area as European Union negotiators seek to resolve a clash between Britain and the European Central Bank.

Poland, which holds the EU’s rotating presidency, proposed changing a draft law on over-the-counter derivatives so that “no member state or a group of member states should be discriminated, directly or indirectly, as a venue for clearing services,” according to the document posted on an EU website. The U.K. said “there are a number of issues” requiring discussion before Britain can sign off on the law.

The new wording was added to negotiating texts after the U.K. said on Sept. 15 that it would sue the ECB over its plans to prevent some euro-denominated securities from being cleared outside the 17 countries that share the currency. The text was added to ease U.K concerns that the ECB may push for clearinghouses to relocate, according to an EU official familiar with the talks who couldn’t be identified because negotiations on the measures are private.

Bloomberg continues:

‘Highly Unclear’

“It is highly unclear whether the ECB has the power to make policy like it did in the July paper,” Damian Carolan, a lawyer at Allen & Overy LLP, said in a phone interview from London. “People were quite surprised how far it felt its jurisdiction to extend.”

The Polish proposal would put the U.K. “in a far stronger position in saying that the ECB has gone outside its remit,” Carolan said. “I don’t think it brings you legal certainty but it brings this policy decision clearly into the legal framework.”

The U.K. lawsuit hasn’t been officially registered with the EU Court of Justice in Luxembourg.

Clearinghouses such as LCH.Clearnet and Deutsche Boerse AG’s Eurex Clearing operate as central counterparties for every buy and sell order executed by their members, who post collateral, reducing the threat from a trader’s default.

The derivatives rules are scheduled to be discussed at a meeting of EU diplomats on Sept. 29, according to the EU official. Draft EU laws need approval from the European Parliament and national governments before they can take effect.

The seemingly unlikely bridge between the UK and Poland is made by Poland's finance minister, Jacek Rostowski, a "British-born economist and academic...[who]...will now chair meetings of EU finance ministers and hopes to take part in critical talks among euro-zone finance ministers." A hardliner for EU solidarity (though Poland has itself yet to join the euro), he has pushed strongly for the Greecian bailout and an IMF-style approach that, at least initially, favors growth over austerity. What concessions or favors he might have wrung from the UK are unknown, but we would not be surprised to see a British role in the EFSF cum pan-European bond, once the twin Hungarian calls for a crisis come to fruition.

Regardless, the LSE's vert just improved by a few inches. Not enough for a slam dunk, but enough to maneuver in the paint.