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.

Commission banking union plans met with scepticism

As we noted in our flash analysis yesterday, the European Commission has put forward its plans for a Single Resolution Mechanism (SRM) which would oversee the eurozone banking union, manage bank resolution and enforce the recent bank bail-in plans.

The proposal seeks to move quickly and decisively to create a strong banking union but do so within the current framework of EU treaties and domestic politics. Unfortunately, it seems to have found itself in the worst of all worlds. The mechanism is unlikely to be large enough or responsive enough in a crisis, while it will not be in place until 2015 at the earliest. Furthermore, it is based on a significant legal stretch of the EU treaties, which has already raised objections from Germany and creating concerns for non-eurozone members (due to fears that the EU's single market could be hijacked by the eurozone).

The German response was swift and hostile. At a press conference German Chancellor Angela Merkel’s spokesman Steffen Seibert argued:

“In our view the Commission proposal gives the Commission a competence which it cannot have based on the current treaties…We are of the opinion that we should do what is possible on the basis of the current treaties.”

Dr Gunther Dunkel, President of the influential VÖB (the German association of Public banks) added:

"We reject the creation of a European resolution authority for many good reasons …it is not up for discussion for us, that funds gained through the work of German banks are used to contribute to the rescue of banks in other Member States… [Furthermore] the SRM would require a change to the EU treaties to necessitate harmonised corporate, insolvency, and administrative procedural law.”

The FT cites an unnamed German official as saying:

“We would be willing to speed up the process, but then the proposal has to be realistic…The commission is behaving like a vacuum cleaner, sucking up everything into its proposal. It may be effective but it is not legally safe.”

Dutch Finance Minister Jeroen Dijsselbloem was none too keen either, suggesting (in what seems to be a veiled insult to the Commission) that the new authority had to be "decisive, effective, and impartial," adding, "It's not completely decided what that authority should look like."

All in all, a rather disappointing proposal given the numerous delays (it was due out at the start of last month) and the fact that it forms such an important pillar of banking union. The Commission’s inability to produce the full text of the proposal, making detailed analysis difficult, also provoked some understandable outrage.

There was also another interesting development on the banking front. The Commission yesterday confirmed the expected changes to bank state aid rules which will come into force at the end of this month. The rules mean that any bank receiving aid would have to present a restructuring plan in advance, likely with shareholders and junior bondholders taking losses. Any bank which accepts aid will also face strict limits on executive pay.

The move may seem innocuous but, as we have consistently pointed out, all other changes to bank regulation and supervision won’t come in for some time. This means that the new rules on state aid will de facto enforce some of these measures, in particular the move away from bailouts towards bail-ins. That at least adds some limited certainty but still leaves the banking union looking woefully incomplete.

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.

EEA plus: a model for the future of the UK in Europe?

For all the noise about Europe in the UK, British sceptics (with some exceptions) aren't necessarily great at thinking outside the box. 

We have previously looked at the existing models used by countries that have decided against/been refused EU membership (i.e. Norway's EEA membership, Switzerland's Free Trade Agreements, Turkey's customs union with the EU, or simply the WTO) and concluded that they would all have drawbacks for a country and economy as large and diverse as the UK. In particular, the Norwegian model is pretty much a non-starter.

However, there is another hypothetical model, which we will set out in a forthcoming briefing, that could be more attractive if it could be secured: let's call it 'EEA plus'.

Now, we don't necessarily advocate this particular option and this is only a blogpost, but intellectually and politically, it's far more attractive than anything we've seen so far in terms of a fundamental replacement for the current EU structure. 

Over the last decade, several figures, including Jacques Delors, former EU Commission President, and Valery Giscard d’Estaing, former French President and author of the EU Constitution, have suggested the UK be given ‘associate membership’ or ‘special status’. Neither concepts have been fully fleshed out, but Giscard d’Estaing suggested that a ‘special status’ could allow the UK to opt-out of future EU policies, which could allow it to continue to vote on policies it took part in but not on those it didn’t. Lord Owen has made a similar argument - which he will expand on in a speech today.

From where we sit, there is one absolutely vital element that has to be added if this is going to work for the UK: voting rights. The great weakness of the EEA model at the moment is that a country like Norway, as we have noted repeatedly, is out of the EU but run by the EU. It just wouldn't work for the UK (which is home to 36% of the EU's wholesale finance market, for example).

So what 'EEA plus' would involve is single market access but with votes on all laws which are EEA relevant. For EU geeks, it would be a bit like EEA-EU co-decision over single market laws. There are several ways in which this could work. For example, an "EEA council" already exists with members from both the EU and EEA states. This could be expanded to be the effective decision-making body for the EU as a whole in the fields that apply to both constituencies. Alternatively, a majority could be needed in both the EU Council of Ministers and a comparable EEA body for it to become law in both. A range of other issues, such as an arbitrage mechanism and ECJ jurisdiction, would have to be thought through. Also, it would have to be designed so that only genuine single market measures made it into the agreement - not the add-ons such as employment laws (which Norway has to accept) - whilst the UK may wish to stay inside the EU customs union (which Norway and Switzerland are not part of). The UK may also want to be part of other areas, such as crime and police cooperation (perhaps on a bilateral opt-in basis) and there would also need to be consideration about the merits of retaining its veto over EU foreign policy for example.

But, crucially, such an arrangement would get around the massive drawbacks inherent in the Norwegian model. Another great advantage of this model is that it could provide an institutional wrapping for all those countries that for one reason or another cannot be full EU members, and certainly not eurozone members: the UK, Norway, Switzerland and maybe even Turkey. It would be a new mode of European membership - and, if the UK can get its act together, very much the "economic growth" tier.

If you think this is far-fetched, you might be right, but it's actually not a new idea. In 1989, ahead of the negotiations that would establish the EEA agreement, Delors mooted a “more structured partnership with common decision-making and administrative institutions”, which would have potentially given those countries market access and decision making powers, rather than the limited right of refusal that EEA countries currently have.

In a speech in 1989, discussing the potential approach to those countries who had remained in the European Free Trade Association (EFTA), Delors said:

“There are two options:

(i) we can stick to our present relations, essentially bilateral, with the ultimate aim of creating a free trade area encompassing the Community and EFTA;

(ii) or, alternatively, we can look for a new, more structured partnership with common decision-making and administrative institutions to make our activities more effective and to highlight the political dimension of our cooperation in the economic, social, financial and cultural spheres.

It would be premature to go into the details of this institutional framework. I have my own ideas, but they need to be discussed by the new Commission and then informally, without obligation, with the countries concerned. It should be noted however that the options would change if EFTA were to strengthen its own structures. In that case the framework for cooperation would rest on the two pillars of our organizations. If it did not, we would simply have a system based on Community rules, which could be extended — in specific areas — to interested EFTA countries and then perhaps, at some date in the future, to other European nations.

But if we leave the institutional aspect of such a venture aside for a moment and focus on the substance of this broader-based cooperation, several delicate questions arise. It becomes clear in fact that our EFTA friends are basically attracted, in varying degrees, by the prospect of enjoying the benefits of a frontier-free market. But we all know that the single market forms a whole with its advantages and disadvantages, its possibilities and limitations. Can our EFTA friends be allowed to pick and choose? I have some misgivings here.”

This option could probably qualify as both "in" and "out". For one, it would be very similar to the Single Market plus deal that Boris Johnson has argued for in the past and, could be defined as staying in the EU, although on a radically different basis.

A final sobering thought: the final result of the EEA talks only granted EEA states ‘decision-shaping’ powers through representation on non-legislative committees and consultation with the EU Commission and a right of refusal that is relatively weak becuase it can result in loss of market access – giving an indication that this will be a challenge to achieve.

You know it's bad when even a former EU commissioner calls for a eurozone break-up

Former Dutch Internal Market Commissioner Frits Bolkesten is best known for having authored the liberalising EU Services Directive (in its original form before some member states and the EP watered it down significantly) but from today he has another claim to fame - becoming the first former European Commissioner to publicly back a breakup of the euro. Here is what he said to Dutch paper Algemeen Dagblad:

"The Netherlands has to exit the euro as quickly as possible... The monetary union has totally failed. The euro turned out to be a sleeping pill which made Europe doze off instead of thinking about our competitiveness... Let’s stop with the euro and instead strengthen the Single Market... We don't need the euro for that."

As an alternative, Bolkestein - who, it should be said, has long been critical of the current direction of the EU - proposed a currency union formed of economically strong countries, a so-called "Triple A euro". Bolkestein also had some tough words for the European Parliament, arguing that:

"It is not representative anymore for Dutch and European citizens. It lives out a federal fantasy which is no longer sustainable."

Who are the best Europeans around?

There has been a lot of Romania-bashing going on lately - from immigration to horsemeat. But in Europe there's always more to a story than meets the eye. Looking at the latest Internal Market Scoreboard, released by the European Commission today, it turns out that Romania - along with some of the other new EU member states - are actually the best Europeans around. At least by this measure.

It reveals that,

When all enforcement indicators are taken into account...Romania, Estonia, Cyprus, the Czech Republic and Lithuania are the best overall performers.

By the same measure, countries that tend to call for more EU integration and more EU laws, are actually the worst at implementing them. Belgium, Spain and Italy are consistently bad at abiding by their commitments. The UK tends to float around the average, but this time it is slightly worse on three of the indicators.

Below is the "Internal Market Enforcement Table" (click to enlarge), which includes the "enforcement indicators" that the Commission takes into account in its assessment (red = bad, yellow = average and green = good):

In 2012, we looked at who had been the "naughtiest Europeans", using the number of ECJ judgments as a measure, in which Romania also did well. However, this might also have had something to do with the fact that, along with Bulgaria, it is a relative latecomer and cases tend to take a while to get to the ECJ. And, of course, complying with EU laws in the eyes of the Commission is not necessarily the same experience that individuals and businesses enjoy in practice. Nevertheless, today's Scoreboard might challenge some stereotypes.

Is Germany curbing the flow of capital across its borders?

Although it might seem rather dry, the news that the European Commission and the European Banking Authority "are concerned" that Germany's financial regulator, BaFin, could be restricting the free flow of capital to lenders abroad is potentially significant.

According to AFP, via Handelsblatt, the Commission and the EBA are looking into whether Germany's BaFin banking regulator is curbing the amount of money that can be transferred from bank subsidiaries in Germany to their foreign-based parent bank. Bafin reportedly wants to avoid a bank which falls under its oversight in Germany running into problems due to concerns about its parent company elsewhere.

Apparently it seems to be the Banca d'Italia that raised the issue within the EBA.

While this is all unverified as yet and the details are unclear, it would be a big deal if Germany was found to be placing restrictions on the movement of capital across the Single Market and to elsewhere in the eurozone. It also shows, yet again, how much resistance there will to a "full" EU Banking Union, in which one financial system underwrites another.

Support for a Single Market+ deal grows: Boris calls for renegotiation of UK's EU membership terms

The Mayor of London, Boris Johnson, in a speech earlier for Thomson Reuters called for the UK to renegotiate its EU membership terms in order to, as he put it, "maximise the benefits of EU membership and the single market without being kicked out". He argued that "The choice is staying in on our terms or getting out" but that "A pared down relationship [with the EU] is essential and deliverable". He went on to say that after a renegotiation, (to remove areas not related to the single market such as social policy and fishing) the package should be put to a referendum with the question being "Do you want to stay in the EU single market as renegotiated? Yes or No?".

This is very close to what we have argued for and what our Chairman Lord Leach set out in a Times article yesterday. 

In questions afterwards, Johnson was asked about UK Government policy towards the eurocrisis, to which he said, "I do not understand why we urge countries to go forward with fiscal union" - setting himself apart from David Cameron and George Osborne who actively call for the eurozone to press ahead with more integration. He also said that the euro would limp on as the "Germans are trying to bubblegum the thing together" and backed Open Europe's suggestion of a  "double majority" voting safeguard in the European Banking Authority to counter eurozone caucusing.

Cleverly, he ended his speech by asking the audience of journalists, commentators and finance professionals, whether they would back more EU powers, withdrawal or renegotiation. Nearly the entire audience backed renegotiation.

The UK and banking union: could the Coalition go for a 'single market lock'?

We also have an op-ed in today's Times, in which we look at forthcoming proposals for a 'banking union' in the eurozone. We urge the UK government to explore creative solutions, including what we call a 'single market lock':

In the desperate search for the euro’s saviour, all eyes have turned to the concept of a “banking union”. Regardless of whether it is a good idea or a bad idea, banking union will undoubtedly cut not only to the heart of a key UK industry — financial services — but also the wider issue of Britain’s future in the EU in the face of further eurozone integration.

However, the typical response of City people, or those in Whitehall for that matter, is confused. On the one hand they love the idea, seeing it as a backstop for shaky eurozone banks that threaten City firms and the British economy alike. On the other, they fear it on the basis that the UK could be left without “a seat at the table” in Europe, meaning that the City would be forced to accept rules written for and by the eurozone. This hardly makes for consistent policy.

A banking union effectively involves three steps: a single rulebook, a single supervisor and a joint backstop (including a deposit guarantee scheme and resolution scheme with a wind-down mechanism). Given the Continent’s vastly differing banking systems and interests, achieving these three steps will be hugely challenging — and probably take years.

Still, the European Commission will kick-start the process this autumn by tabling a proposal to make the ECB the single financial supervisor for eurozone banks, for which there is broad support. While David Cameron has ruled out the UK taking part, with zero chance of it being accepted domestically, he has actively encouraged the creation of a banking union on the condition that “British interests are secured and the single market is protected”. The problem for the UK is that a banking union, if developed to its logical end point, will almost certainly cut across the single market in financial services.

For Britain and the City there are two main risks, the extent of which are unknown at present. First, companies doing business in the euro area could be required to be supervised by eurozone authorities. The ECB has already demanded that City-based clearing houses establish themselves inside the eurozone to be allowed to clear transactions in euros, something the UK has challenged at the European Court of Justice. If such practices become part of a banking union, the City would face a series of hurdles to doing business in the eurozone. The second risk is that the eurozone 17 start to write banking and financial rules for all 27 EU states, using their in-built majority in the Union’s voting system to implement them via the EU institutions.

Here, it is vital to understand the political incentives created by a banking union. To avoid banks free-riding on German taxpayers, Angela Merkel, the Chancellor, is likely to insist on any financial backstop being backed by perfectly harmonised regulations — for example, on capital requirements or bonuses — with little or no national discretion. This could well spill over to Britain, as the eurozone is unlikely to accept an uneven playing field within EU financial services, with the UK having few ways of blocking eurozone-tailored regulation being applied to the single market, even if detrimental or discriminatory.

So what should be done? First, Britain needs a consistent diplomatic position: it cannot both actively call for a banking union and implicitly threaten to veto it, as is the case at present. Second, to avoid the new structure — including the ECB — stepping into single-market territory, the UK needs to work with EU allies to make sure that it is fully accountable. The division of labour between the ECB and the London-based European Banking Authority needs to be made perfectly clear, for example.

However, given the stakes, Britain also needs to think creatively about new institutional arrangements with Europe, not only to guarantee the City’s position as a global entry point to the single market — offered by continuing EU membership — but also to create a space in Europe for those countries not intent on joining the single currency, and also for those that may choose to leave. There are several potential solutions. For example, non-euro members could be given the right to appeal against any proposal at the European Council, where all countries have a veto, if it is deemed to undercut the single market or be discriminatory — a “single-market lock”, if you will.

Such a move may require treaty change, but so will the steps towards banking union beyond the single eurozone regulator. Furthermore, if pitched right, such proposals could draw support from countries on both sides of the eurozone divide, including Sweden, Germany and Poland, given that the motivation would be to protect the single market.

A eurozone banking union is still shrouded in unknowns. But the City, even if it wants things to stay the same, may have to accept that things will have to change.