Swaps traders fear further fragmentation post-Brexit

Swaps participants have urged regulators to act fast to avoid further fragmentation of trading and clearing derivatives.


Market participants are concerned the global swaps market could further fragment with the creation of a third liquidity pool in the case of a hard Brexit.

Speaking at an industry conference in London, market participants warned that fragmentation of pricing and regulatory arbitrage could arise if agreements over equivalency are not made soon.

“If there is a fragmentation with clearing that is a daunting prospect. If that clearing landscape is broken and forced to fragment across the continent, we as an institution have done years of compression and backloading so are at the better end of the situation, but looking at the increased margin and capital costs projections, those are big numbers,” said Ciaran O’Flynn, global co-head of fixed income electronic trading, Morgan Stanley.

“That is one area for derivatives where Brexit can be poisonous.”

A potential fragmentation of euro-denominated derivatives clearing could arise if the business is forced to relocate from London to either Paris or Frankfurt.

London is home to largest clearers of euro-denominated swaps including LCH, ICE Clear Europe and CME Clearing Europe, with many clearing banks established in the City.

Market participants also fear further fragmentation in the swaps market could arise from Brexit if agreements over equivalency between US, UK and European regulators are not made.

“Brexit throws up further challenges, in which we could end up with three different trading zones,” added David Coombs, global rates product manager, eCommerce, Icap.

Scott O’Malia, head of the International Swaps and Derivatives Association (ISDA), warned potential delays over cross-border equivalency of trading venues could pose damaging effects.

“Progress has been made on the CCP equivalence between the US and Europe, which is very positive but the process was hardly ideal, taking three years to reach a conclusion. A repeat of that process for trade execution would be damaging and exacerbe the fragmentation of liquidity pools,” said O’Malia.

“With just over a year until the MiFID rules come into force, the cross-border recognition [process] needs to get into gear now.”

MiFID II is set to introduce a mandatory trading obligation for derivatives, with market participants required to execute their swaps trade on a multilateral trading facility (MTF) or an organised trading facility (OTF).

Europe is expected to adopt a similar model to the swap execution facility (SEF) regime in the US, however, regulators are pressing for Europe and the US to agree on equivalency and allow cross-border trading without increasing costs.

“Our future derivatives markets are likely to be marked by deeper liquidity, greater efficiency, and a better ability to distribute risk effectively if EU firms, subject to the EU trading mandate, can trade at the same venues as US firms, subject to the US trading mandate. The prize to gain from agreeing on each other’s models is substantial,” added Edwin Schooling Latter, head of markets policy, at the UK Financial Conduct Authority (FCA).