Chairman J. Christopher Giancarlo Comments on Brexit, Financial Stability Oversight Council

October 16, 2018

As regulators of United States derivatives markets, world’s largest, the CFTC carefully monitors developments in Europe, especially in London, which is a key institutional service center for cross-border derivatives transactions.  The CFTC’s analysis of the potential effect on the US economy of an unresolved and disorderly Brexit (“Hard Brexit”) is informed by data the CFTC has gathered directly and analyzed internally as well as by recent statements of the Bank of England, the IMF and other public and private organizations.

The CFTC is concerned that a Hard Brexit would likely have an immediate and significant impact on the global financial system, including the US economy.  The CFTC is concerned about the specific impact of such an event on US banks and financial institutions, which account for between 40 and 60 percent of trading activity and liquidity provision in the global derivative markets.

The CFTC sees four possible sources of significant market disruption caused by a Hard Brexit.  The first, and perhaps most imminent, is central clearinghouses (CCPs) of derivatives transactions located in London being forced to disassociate with EU 27 banks and other CCP clearing members to avoid the legal uncertainty of their CCP membership obligations.  Such disassociation would likely take place as much as 90 days before a Hard Brexit pursuant to applicable CCP rules and regulations.  The second source of potential market disruption is U.K. institutions losing authorization to service uncleared over-the-counter derivative contracts and insurance contracts with EU 27 counterparts.  The third concern is EU 27 firms losing the ability to use U.K. exchanges for hedging and risk management of a range of existing derivatives products, and needing to find alternatives that in many cases do not exist in EU 27 countries, such as derivatives on interest rates, Brent crude oil and various precious and industrial metals.  The final concern is that amendments to existing swap contracts undertaken as a result of Brexit may be considered the creation of new swaps, subject to a panoply of new swaps regulations.

The CFTC identifies a number of financial stability risks arising from these four sources.  Such an abrupt transfer of hundreds of thousands of cleared swaps positions across CCPs in a matter of weeks would be unprecedented.  It could be the source for enormous operational risk.  It could cause a fire-sale scenario, with EU 27 institutions rushing to dispose of open CCP positions to non-EU 27 financial institutions that have limited absorption capacity.  There is also potential for EU27 bank distress from tens of billions of Dollars in unanticipated costs, additional margin and the write down of cleared swaps positions.  There is also concern that the wholesale exit of EU 27 banks from London client clearing would exacerbate concentration of activity in other non-EU 27 banks.  The impact of any and all of these concerns may well reverberate globally causing increased volatility and disruption across world markets for derivatives and other traded products.