Britain's attempt to leave the EU could cause a storm in financial marketsby / September 20, 2018 / Leave a comment
Published in October 2018 issue of Prospect Magazine
In a letter to shareholders in 2002, the great money man Warren Buffett issued a warning. There was one financial asset traded on world markets that was making him worried. “Derivatives,” he wrote, “are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
When Buffett wrote those words, the total value of all derivatives in existence was $142 trillion. Things didn’t stop there: by the dawn of the crash in 2008, the figure stood at $458 trillion. Suddenly Collateralised Debt Obligations, and their close friend the Credit Default Swap, both forms of derivative, became almost everyday phrases, as they became the nitro and glycerin that helped blast the global financial system to pieces.
Ten years on from the crisis, they are more popular than ever. According to the Bank for International Settlements, the notional value of all outstanding derivatives currently stands at $542.4 trillion, higher than the pre-crisis peak. To give some sense of what that number actually means: if a million pounds is a cube of fifties about three feet high, then—from the same 3 square foot foundation—a billion pounds would make a tower of notes 3,000 feet high. A trillion, on the other hand, would reach an altitude of about 570 miles, stretching out past the orbit of the International Space Station.
There are a dizzying volume of derivatives out there—and it looks like they are about to become a problem again. The trigger last time was the stretched “sub-prime” borrowers who could no longer afford the repayments on their condominiums in Florida or the suburbs of the Midwest. This time the problem is set to be the mix of high politics and low farce that is Brexit.
In his recent testimony before a Commons committee Mark Carney, the Bank of England’s Governor, issued a warning. The UK has said that it will pass laws allowing EU firms to work on derivatives trades with our companies post-Brexit, but the EU has made no corresponding offer. If Brussels and London can’t get a deal in place, British firms would not be able to work on derivatives in the EU. Carney warned we would then see “a financial stability risk developing fairly quickly.” The value of the vulnerable contracts? “Notionally,” he said, “it is £26-27 trillion.”
The overwhelming lesson of 2008 is that financial risks, like the one Carney now sees in the derivatives market, can have consequences for us all, and not just the banks. Nicky Morgan, chair of the committee that was questioning Carney, told me that without some sort of deal to “put in place provisions to allow existing contracts to be honoured and trading to take place,” she expects “an immediate impact,” which would threaten “the way our financial institutions work and their ability to conduct business in a variety of sectors.”
After being stung in 2008, why are we so exposed to another derivatives disruption? Partly, it’s because our economy has become hooked on these complex contracts, and partly, in the words of Carney again, “I’m not sure when Article 50 was designed, it was done so with the derivatives market in mind.”
You may think of derivatives as a disturbing blend of high finance and hi-tech. But their basic principles go back into antiquity. In his Politics, Aristotle told the story of Thales of Miletus, a philosopher who’d become fed up with people calling him useless. Using his knowledge of astronomy Thales accurately predicted, when it was still winter, that a bumper crop of olives was on the way. “So,” Aristotle wrote, “he raised a small sum of money and paid round deposits for the whole of the olive presses in Miletus and Chios, which he hired at a low rent… and when the season arrived, there was a sudden demand for a number of presses at the same time, and by letting them out on what terms he liked,” Thales made it rich.
The old philosopher wasn’t so useless, after all. He’d worked out a way to take a position—to make a bet—on the future cost of processing olives. Notice that he’s not bought or sold any presses, or olives. Instead he entered into a contract that derived its value from these things. Thales may not have known it, but he’d essentially invented the derivative contract.
The modern era of the derivative also grew out of agriculture. It began in 19th-century Chicago, the railroad hub where the harvest from America’s midwestern plains was bought to be traded at the Chicago Board of Trade. But the problem with buying and selling crops is that supply goes up and down and, with it, the price—and traders in the wholesale markets don’t like sharp swings in price any more than shoppers on the high street.
To hedge against price swings, traders started protecting themselves by buying the rights to future harvests at fixed rates. Sure, they might agree to buy at 100 only for the price to drop to 90. But that extra 10 they pay over what turns out to be the market rate brings peace of mind: the security of knowing they won’t face a bill they cannot pay. This type of derivative is known as a “future;” countless variants have followed, including “options” and “swaps,” covering all sorts of contingencies going well beyond prices, including the movement of exchange and interest rates, and whether or not particular loans will be repaid. The details can be complex, but the basic idea still tends to involve taking a position based on something that might happen in the future—just like Thales.
Time dependency gives derivative contracts a life span and here’s where the Brexit threat comes in. Say you are a bank based in Canary Wharf and you enter into a derivative contract with an EU bank. The law is currently pretty clear on what your obligations are. But if Brexit happens during the life span of a derivative contract, its legal framework vanishes and, without some new arrangement, the British bank would be barred from working on its own derivatives contracts in the EU. That sounds like a recipe for a very sudden, very nasty shock, which, with Brexit day due in March, could arrive very soon.
Many derivatives have what are called life-cycle events, moments when the small print can be amended, or one side of the trade can sell it on. Current rules allow British banks to conduct life cycle events across the EU. Should those rules fall away, the same banks would need permission from every country where they operate if they are to do this work. With bespoke authorisation required in every other EU member state, Bank Deputy Governor Sam Woods warns, their servicing would potentially become “illegal.”
Others are more sanguine, suggesting that the European Court of Human Rights in Strasbourg, which is separate from the EU, can ultimately be relied on to ensure that freedom to enter contracts, and property rights over derivatives, will be maintained. Perhaps. But at best, this is an argument that would have to be tested in litigation. And amid the maelstrom of a cliff-edge Brexit, the banks wouldn’t want lengthy legal arguments about the status of trillions of pounds-worth of their assets. They would want immediate clarity.
There’s a secondary layer of complication, one that worries experts more than legal limbo. After 2008, regulators started pushing more derivatives into “clearing houses.” These sit between the parties of the contract and guarantee both sides of the trade. Business processed in this way is visible to regulators, increasing the chance they can spot trouble before it hits. And the parties on either side have to put up cash which is held by the clearing house in case something goes wrong. This reduces the possibility of trouble: if one side of the derivative trade goes bust, then the other still gets paid. By chance, the largest derivatives clearing house in the world is LCH—formerly “the London Clearing House”—just next to Aldgate tube station. “We regularly clear in excess of $1 trillion notional per day,” its website says. Billions of pounds-worth of those daily trades are for EU firms. But when Brexit hits, from the EU’s perspective, LCH will turn into a “third country entity,” and lose its right to do this work.
Some of Europe’s biggest banks would need to move their business into a clearing house recognised by Brussels. But this is more complicated than it sounds. A clearing house is always in balance—every derivative trade has a “buy” on one side and a “sell” on the other. If you need to get out of the UK, you have to trade your way out of London before you can move to a continental clearing house, which means you need to find someone who wants to adopt all of the trades you need to get out of. This could spark a stampede to sell assets built up over many years: the Bank of England estimates that £33 trillion-worth of derivative positions across Britain’s clearing houses would have to be exited. That volume of trades is unprecedented. It could cause derivatives markets to seize up altogether. The Bank of England and the European Central Bank have been working to get a technical fix in place.
For many non-bankers, the misery of the money men would be the least of their worries—they may even regard it as reason to cheer. Who cares if companies have to go on without derivatives which have, after all, proved so dangerous?
The economic argument in favour of derivatives is that they help to manage risk: they allow companies and people exposed to risk to offload it, passing it on to individuals and firms better placed to shoulder it, a reallocation which should in theory make the whole economy run more smoothly. Companies should find it easier, for instance, to raise money for worthwhile projects, if investors know they are protected against a price rise here, or an exchange-rate swing there. Since the crash, however, the view on derivatives has turned more sceptical: they’re used not so much to allocate risk as to conceal it.
And no doubt there is some of that going on. But at least some derivatives are doing that original -insurance job, and all sorts of companies—and their workers—could pay a price if that mechanism suddenly vanished. It’s not just financial giants either. Many firms in the real economy use derivatives: holiday operators who want to hedge exchange rate risks; modestly-sized manufacturers ensuring that the cost of raw materials don’t get out of hand. Besides, whatever the merits of derivatives, a system that has come to rely on them would suffer an almighty jolt if they were suddenly withdrawn.
One long-time city hand suggested it felt like the Y2K bug all over again—a fuss about nothing. Surely something would be worked out. But time is ticking down fast, and—as another close observer of the situation told me—the “EU is playing its cards close to its chest.” The Department for Exiting the EU has also been looking at the derivatives question, but without success; it obviously has many problems on its hands. And this summer, Andrea Enria, who chairs the European Banking Authority, said in a statement: “firms cannot take for granted that they continue to operate as at present nor can they rely on as yet unrealised political agreements.”
The potential economic damage goes far beyond the square mile. It goes so far in fact, that US regulators are getting worried about the effect on American firms.
Nobody wants Buffett to be right about derivatives a second time. And he might not be. It could be that London and Brussels will agree a Brexit plan that covers all of the issues that are raised here. But as things stand, that’s one seriously risky bet.
A longer version of this piece can be read here.