Out of the euro but run by the euro? The UK & ECB prepare to lock horns at the ECJ in what could be the most important case yet...

Could euro clearing be moved from the City to the eurozone?

Tomorrow will see the first hearing of the next in the line of important UK cases at the European Court of Justice (ECJ). The case in question is the UK’s challenge against the ECB’s location policy – and it could be the most important of all the cases. The case is shrouded in technical detail but, fundamentally, is whether we're moving towards a two-tier single market and an EU run by the euro for the euro.

Background
On the 5 July 2011 the ECB published its Eurosystem Oversight Policy Framework, which argued:

As a matter of principle, infrastructures that settle euro-denominated payment transactions should settle these transactions in central bank money and be legally incorporated in the euro area with full managerial and operational control and responsibility over all core functions for processing euro denominated transactions, exercised from within the euro area.

In that paper and future opinions the ECB has stressed that it will not provide central bank liquidity to clearing houses outside the eurozone but that all such institutions should have access to it.

The UK quickly challenged the policy in September 2011, calling for the ECB’s policies to be annulled, and has launched two further challenges at the ECJ, in which it updates its list of complaints, the key points of which are as follows:

• The ECB lacks powers in the specified areas, especially since it did not include the plans in a regulation to be adopted by the Council or by the ECB itself, simply decreed it in a policy paper and opinion.
• “De jure or de facto” the rules will impose a residence requirement on clearing houses which want to clear euros, meaning existing clearing houses will face a choice of moving within the eurozone or changing their business approach.
• The rules offend the principle of equality in the single market since firms incorporated in different EU member states will be viewed differently and the rules will not apply equally.
• There are less onerous methods for achieving the same goals (namely security of the financial system) cited by the ECB.

Why is this case so important?
The case manages to combine two crucially important issues:

1. The question of maintaining the EU single market and whether countries outside the eurozone will be dominated by those inside
2. How to ensure the safety, transparency and security of the modern financial system in Europe to avoid a similar crisis to one we have barely overcome

For the UK, there are additional concerns:

• Firstly, it will once again play a role in setting the boundaries of action the ECB and eurozone can take without the non-euro members. It will also create a clearer boundary on what powers the ECB has. 
• If the ruling goes against the UK, there would be a clear split in the single market and, the precedent set, will make it harder for the UK to stay in the EU
• It would raise further questions about whether the UK can trust the ECJ as a neutral arbiter.
• It would undermine the role of the City of London as a financial centre serving the eurozone (the City remains a trading hub for a single currency of which the UK cannot take part), meaning London could lose business to Paris and/or Frankfurt.

Does the ECB have a point?
From the financial stability perspective it is easy to have some sympathy with the ECB’s stance. More and more transactions are being directed on to exchanges and through central counterparties (clearing houses) therefore it makes sense for them to have access to sufficient liquidity. Then again, the LCH Clearnet clears products in 17 different currencies without the need for central banks backstops in all of them.

Given that, and the huge political stakes, one option would be to establish a permanent swap line between the ECB and the Bank of England (or all non-eurozone central banks). Such swap lines are well tested and were used extensively during the financial crisis. In exchange, the ECB would likely require some greater involvement in terms of supervision of institutions which may receive such cash. The easiest and most practical way to achieve this would be through the existing EU institutions such as the European Systemic Risk Board (ESRB) and the European Securities and Markets Authority (ESMA).

Needless to say, the UK also has a strong case since its hard to say this will not hamper the single market at the very least. In any case, whatever the outcome there will likely need to be changes made to accommodate a new structure, hence the repercussions of the ruling will be widely felt.

On what and how might the ECJ rule?
Trying to second guess the ECJ is a hazardous business. That said, this case is interesting because there are a few different elements which the ECJ could choose to rule on or not.

Whether the ECB has competence or not? The first relates to the UK’s first point of challenge regarding whether the ECB has competence in this area. While the ECB does have control of payment systems and gave an extensive legal grounding in its original policy paper its clear that this is a very political decision. Determining who has competence should be a fairly basic question which the ECJ can rule on.

Which has primacy - ECB policy or EMIR? That said, the matter is complicated by the recent European Market Infrastructure Regulation (EMIR). In the preamble point 47 and 52, as article 85 in the main text, all stress that there must be no “discrimination” with regards to where currencies can be cleared and that nothing should “restrict or impede” clearing houses based in other jurisdictions from clearing foreign currencies. As such, the ECJ may have determine who has primacy in this area, as currently it isn’t clear which set of rules should be adhered to (although given that euros are still being cleared in London one might de facto think EMIR is winning). If the ECJ is swayed by the non-discrimination provisions in EMIR, the UK Treasury should be given some credit for pre-empting the ruling - which Open Europe also has recommended.

Does the ECJ actually have anything to rule on? As with the Financial Transaction Tax decision, the ECJ has shown itself reluctant to rule on issues it sees as hypothetical. Given that the rules that the UK are challenging are actually not in place, the ECJ may rule that the challenge is somewhat premature. Obviously, the risk here is that this would be self-fulfilling and act as a catalyst for changes to happen. It would also leave many questions (not least those above) unanswered.

What happens next?
The oral hearing will take place tomorrow. After that the Advocate General will produce an opinion and a ruling will follow, both most likely in a few months’ time.

It’s possible the ECJ could rule on only part of the UK’s claims or support some and dismiss others. It will also be important to see what happens with regards to the primacy of a regulation over the ECB in this particular area which could itself be an important legal precedent (not least because the ECB is becoming increasingly powerful).

It's also still possible that this will be 'settled out of court', given the stakes involved and the risks of unintended consequences.

We'll watch this one closely.

Another UK win on single market safeguards in financial services?

An interesting report popped up on Reuters this afternoon. According to internal documents seen by the news agency, the UK has secured another important safeguard on financial services.

Specifically, during last week’s negotiations over the controversial revision of the Markets in Financial Instruments Directive (MiFID), an agreement was reached which saw the insertion of the following clause:

“No action taken by any regulator or the European Securities and Markets Authority (ESMA) should discriminate against any member state as a venue for the provision of investment services and activities in any currency.”

This is important given the on-going dispute between the UK and the eurozone concerning the location of institutions engaging in the clearing of euro-denominated financial transactions outside of the single currency bloc.

Quick recap: the UK has launched a case against the eurozone and the ECB at the European Court of Justice after an ECB legal opinion suggested that all transactions in euros should be cleared within the eurozone. This raises questions over the City of London’s position as the financial centre of Europe, and could force trillions of euros worth of financial transactions away from the city.

Although this is a very technical issue it could be a very important one in terms of the debate about the UK’s position in Europe.

That said, we’re hesitant over getting too excited for a couple of reasons:

• Firstly, this is just a preliminary agreement between officials. The final text still needs approval from the European Parliament and EU political leaders, meaning it could well be subject to substantial revision.
• Secondly, even if it is kept in, it’s not clear whether it will be legally binding, particularly when it comes to the ECB. Since the ECB is independent and currency issues usually fall under its purview, it may retain jurisdiction and authority over this decision.

Some important caveats then, but there is no doubt this is a positive step and highlights that progress can be made if the UK explores all of its political and legal options to boost its position. The government must continue to do so.

"If you had kept quiet, you would have remained a philosopher" - The Commission utterly fails to address flaws in the financial transaction tax

There's an old Latin saying, "If you had kept quiet, you would have remained a philosopher." Reading the Commission's defence of its proposed EU financial transaction tax (FTT), that phrase immediately sprung to mind. It's not the strongest piece, to say the least.

In our continuing quest for transparency, we have published the Commission’s direct response to the concerns raised by the 11 participating FTT member states (docs which we exclusively published last month).

The Commission's response ranges from weak to capricious to outright ridiculous. For example, when it says that "we're not aware of any credit crunch" in Europe. Right...

Arguably the most worrying part of this response is the tone. The Commission is essentially saying ‘we know better’ than financial markets. For example, in dealing with concerns over the impact of the FTT on short term trading, it suggests much short term trading is often “myopic” and that asset managers which trade predominantly in the short term should be subject to less investor demand in transparent markets, despite the success of money market funds and their importance for liquidity.

Now, 'financial markets' are diverse, far from perfect and certainly not always right. However, the Commission would be remiss to just dismiss concerns raised by governments inside and outside the FTT zone - but also actors from across the business and manufacturing community (in addition to virtually every bank in Europe).

We have long suggested that there are three key areas of concern which will have to be addressed before the FTT can even hope of being implemented without huge market distortions – the extraterritoriality, the impact on repo markets and the impact on government (and corporate) bond markets.

Many of the concerns raised by the 11 FTT states - and the Commission's response - related to these issues. Sorry in advance for the length of this post but here are the key points:

Extraterritoriality

As reported this morning, the Commission argues that a “business case” can be created for enforcing the FTT outside the FTT zone. Essentially, exchanges and clearing houses will be responsible for collecting the tax and if they don’t,  the firms in the FTT zone will not want to trade with them.

This is concerning development for a number of reasons:

• First, it will increase tensions and splits within the single market. Financial firms are unlikely to just roll over and accept this. In fact, given the size of the market outside the FTT zone, they could validly refuse to trade with those inside the FTT zone. In any case, the prospects of a scenario similar to that of escalating protectionism in trade dispute cannot be ruled out.
• It also seems very punitive, using alterations in the legislation (the joint and several liability) to enforce it in areas where the tax has already been rejected.
• This also assumes firms do not move out of the FTT zone to escape the tax. This seems unlikely in the first instance, while not being able to trade with those outside the FTT zone if they do not pay the tax (or having to pay their share yourself) seems to make staying inside even less appealing.

The Commission also accepts that double taxation is a concern. However, the proposed solution of setting up agreements on where the tax will fall, seems unlikely especially in the UK’s case since it has launched a legal challenge against the tax.

Impact on government and corporate debt

The Commission also fails to provide much comfort on the impact of the FTT on national debt and borrowing costs. It admits it has been unable to estimate the impact due to lack of info, but further accepts that “Member States might be better placed to have access to such information.”

This raises two questions:

• First, surely legislating on such a sensitive issue without fully knowing the costs on a key area, with many of countries involved in the midst of an economic crisis, is nothing short of negligent.
• Second, if member states are better placed to judge these issues, why does the Commission and the EU need to take the lead and push such a tax in the first place?

Furthermore, we doubt the concerns over ‘redistribution’ will have been assuaged as the Commission accepts that some money from the trading of government bonds will not go to the country that issued them.

This could be of concern for countries such as Spain, Italy or even France which have huge debt markets but whose debt is widely traded around the world and the EU but international firms. It also seems to punish small countries with less developed financial sectors, since the tax will be paid where the bond is traded firstly with the residence principle only kicking in afterwards.

Possibly more worrying is the response to concerns over the corporate debt market. The Commission seems to brush this off, adding that it is “not aware of any credit crunch” with regards to borrowing for businesses. This is despite the clear survey results showing businesses struggle to access credit in many European countries and the many, many press stories on the issue. It surely cannot argue that given the state of the economy, now is the best time to implement the tax.

Repo markets

As we have highlighted this is an area of serious concern. Unfortunately, the Commission continues to persist with a weak counter-argument insisting that repo markets can be easily replaced by secured loans or lending by central banks (while accepting the short term repo market will be all but destroyed by the tax).

This argument is flawed for numerous reasons:

• The market has access to these other instruments but see repo as preferable, the Commission still insists, however, that it knows better.
• Moving more lending to central banks is not desirable! European policy makers are working hard to restore usual financial markets and move lending off central bank balance sheets.
• Without normal functioning markets, monetary policy cannot have an effective impact, while in the eurozone money will not flow cross border and imbalances will continue to build up (any hope of an integrated banking union would be dead).
• Furthermore, all the risks will be taken onto the central banks’ taxpayer-backed balance sheet – surely this is a terrible form of risk being socialised but profit privatised.
• Secured loans do not provide the same level of legal protection as repos. Since collateral is purchased under a repo, if there is a default the collateral has already changed hands. However, under secured loans the claim would go back into normal (lengthy and costly) insolvency proceedings.

The Commission does raise the point that Repos can hurt financial stability, but surely this is more a case for effective supervision and regulation than taxing the market out of existence.

With widespread talk of the FTT being shelved for at least another year, perhaps it's time for the Commission to just admit defeat?

The triple challenge behind EU move to cap banker bonuses

In a comment piece in yesterday's Sunday Telegraph - trailing today's meeting of EU finance ministers that can seal the deal on capping banker bonuses - Mats Persson looks at the three challenges that form the backdrop of this discussion: 

• The mis-match between the relative importance of financial services to the UK and its limited voting weight in the EU's decision-making machine
• The tendency of EU politicians to engage in displacement activities and avoid tackling the root causes of the banking (and eurozone) crisis
• The "out of the euro but run by the euro" risk created by the creation of an EU banking union

Here's the article:

With this week’s well-publicised European Union move to cap bank bonuses, the UK now faces the prospect of being outvoted on a major piece of EU financial law for the first time. This may only be the beginning.

Fundamentally, the EU’s voting system – where almost all financial laws are decided by majority voting – leaves the UK vulnerable. While the UK accounts for 36pc of the EU’s financial wholesale market and 61pc of the EU’s net exports in financial services, it has only 73 out of 754 seats in the European Parliament and 8.3pc of votes in the Council of finance ministers. That trade-off is acceptable as long as the UK wields significant influence over EU rules – with the City serving as a global entry point to the single market, which is still does. In the 1990s and 2000s, this model served the UK well, with most EU laws aimed at facilitating trade.

Unsurprisingly, the focus of EU regulation started to change in 2008 with the financial crash. Of the 50 or so EU financial measures currently floating around, only a handful are aimed at boosting trade, most are about limiting or controlling financial activity in different ways – some of them fully justified. For many EU politicians and governments it is convenient to see the financial crash – and by extension “Anglo-Saxon capitalism” – as the fundamental cause of the eurozone crisis. Bank bonuses and the financial transaction tax, they say, help tackle excessive risk-taking and, therefore, the eurozone crisis.

This is ironic, since the same governments have simultaneously resisted many measures that would address systemic threats – such as sufficiently robust capital requirements and liquidity rules and enforcing losses on creditors. The EU has supported and approved €4.6 trillion (£4 trillion) in taxpayer-backed aid to banks over the course of the financial crisis. To think that capping bonuses will address moral hazard against trillions of state aid, borders on the bizarre.

What lies behind this self-delusion? A deliberate attempt to kill the City and drive business to Frankfurt and Paris? To some extent, but much of the motivation is, in fact, displacement activity. The tough sweeping reforms really needed to stabilise Europe’s financial sector – such as recapitalising or restructuring regional banks – often clash with regional or local politics or economics. But as politicians cannot be seen to do nothing, they take the easy route: we may not be able to create a mechanism to wind down banks but we can tell voters that we have limited the bonuses of greedy bankers. This invariably puts the City in the firing line, as that is where most of the bankers are.

This is exacerbated by a third problem – the City is a trading hub for a single currency of which the UK is not a member. The emerging union of EU banking, designed to align a supra-national currency with an interconnected banking system, creates incentives for euro states to collude in writing common financial rules that risk the City gradually being pushed “offshore”. The European Central Bank has already demanded that transactions cleared in euros move to the eurozone, which the UK has challenged in court. If we lose, it would lead to a two-tier single market, with a protectionist eurozone bloc – and trillions of euros worth of transactions could leave London.

The UK Government has taken steps to ensure a competitive financial services sector against the backdrop of an EU banking union. But the City and the finance sector are on the front line of the EU debate. If this hub of economic activity becomes a casualty, how could a UK government still defend EU membership? 

The FT today needs two separate comment pieces (behind pay wall) to make the same points - but worth a read nonetheless.