Hard Brexit is a systemic risk to U.S. banks

WASHINGTON — The lower house of British Parliament on Tuesday resoundingly defeated Prime Minister Theresa May’s agreement with the European Union for an orderly exit from the economic bloc, but what comes next could be disastrous for U.S. banks and the financial system.

American bankers may have received the news of May’s historic defeat with the kind of bemused inattention that so often characterizes the way Britons regard our own political foibles. If Britain and the EU have a rocky breakup, many believe it's ultimately their own business.

But international commerce — and particularly the international swaps market — is profoundly interconnected, and a no-deal or “hard” Brexit could throw that market into disarray in a way that could be difficult to predict, and could have dire consequences for U.S. banks and the world economy.

One of the less appreciated innovations to arise out of the financial crisis was a fairly comprehensive shift toward clearing over-the-counter derivatives, known as swaps. Swaps are essentially a contract stipulating that a buyer can exchange — or “swap” — a fluctuating price for a fixed one.

After the crisis, regulators decided to mandate “clearing” of swaps in central clearing counterparties, or CCPs. Clearing requires each side of a swap trade to effectively pay a fee to the counterparty, so that in the event that one counterparty defaults, the swap will remain valid and operational for the other counterparty. The idea is that CCPs can act as a firewall for swaps in the event of an unexpected default. As of 2017, roughly 88% of all interest rate swaps — the biggest segment of the swaps market — were centrally cleared.

CCPs pose their own challenges, however, namely that they themselves effectively become the repositories of all of the risk that would otherwise be dispersed throughout the economy. U.S. regulators have recognized that risk, and have designated CCPs among the eight so-called systemically important financial market utilities in order to ensure they are adequately capitalized and supervised.

But the debate about how safe a CCP has to be in order to be really safe is one that U.S. and EU regulators had for nearly a decade before reaching a comparability agreement in 2017. Brexit could potentially upend that understanding, and in so doing throw the nearly $600 trillion international swaps market into turmoil.

Christopher Giancarlo, chairman of the Commodity Futures Trading Commission, alluded to precisely this kind of calamity during an October meeting of the Financial Stability Oversight Council.

In his remarks, Giancarlo said that swaps currently in effect that had been executed in London were entered into under the assumption that they were compatible with EU, and by extension, U.S. rules. A hard Brexit could mean that U.K. banks would no longer be able to service those swaps. It could mean that EU firms might not be able to use U.K. exchanges to meet their needs and may not be able to find equivalents on the continent. Amendments to existing swaps could be considered new swaps themselves, subject to new swap rules. And the “unprecedented” transfer of hundreds of thousands of swap positions could lead to market disruption of epic proportions, Giancarlo said.

“It could be the source for enormous operational risk,” Giancarlo said. “It could cause a fire-sale scenario, with EU institutions rushing to dispose of open CCP positions to [foreign] financial institutions that have limited absorption capacity. There is also potential for [European] bank distress from tens of billions of dollars in unanticipated costs, additional margin and the write down of cleared swaps positions.”

The risk of a no-deal Brexit is great enough that it was included among the FSOC’s top sources of systemic risk in its annual report to Congress, saying it could have “immediate and significant spillover effects into the United States.”

There are some mitigating factors at play, however. The European Securities and Markets Authority in November issued a statement saying that in the event of a hard Brexit, the agency would continue to recognize U.K.-based CCPs as equivalent on a temporary basis. That helps stave off the most immediate impacts, but a temporary agreement could ultimately just delay the inevitable havoc of a messy breakup.

And, of course, a hard Brexit may not happen. Another deal between the U.K. and EU could emerge, though that possibility is looking increasingly remote. The U.K. could hold new elections or potentially hold a second referendum on whether to leave the EU or remain in the bloc — an idea that has gained traction in recent weeks as the failure of May’s exit treaty became increasingly apparent.

Trade negotiations can be worked out, new deals can emerge and new leadership may take an alternative approach. But those outcomes require, at some point, an affirmative adoption of a structured policy. A no-deal Brexit is what happens if no one can garner majority support for an alternative — and that should have American bankers’ undivided attention.

Bankshot is American Banker's column for real-time analysis.