Andrew Bailey, governor of the Bank of England, has warned policymakers against taking steps that would lead to increasing fragmentation in the financial system.
In a speech given in Ireland, Bailey recognised the argument that the global financial system is overly dependent on London’s financial infrastructure.
However, he said that this argument leads “wrongly, in my view, to a belief that the dependency needs to be reduced”.
Bailey said given the impact of fragmentation on financial stability, there was “an overwhelming case for rejecting the false allure of fragmentation.”
He noted the prominence of London in the clearing market, a crucial part of financial plumbing that helps firms manage the risks that might arise if one counterparty defaults on a deal.
“Fragmenting this type of market infrastructure creates rather than reduces risks in markets,” Bailey said. “It also increases the cost of market functioning.”
The comments come as the EU continues with plans to develop its own clearing business, with financial services commissioner Mairead McGuinness recently saying the plans were vital to the EU’s “financial resilience“.
Through a combination of coercion and encouragement, the EU is hoping to build a larger domestic clearing market in the bloc, arguing it is essential to the bloc’s financial stability.
The issue has become one of the most prominent sources of tension between the UK and EU because the vast majority of euro-denominated swaps take place in London. Even after Brexit, around 94 per cent of Euro denominated swaps take place at London Clearing House (LCH), according to figures from Clarus.
Initially, the EU said it would grant equivalence status to London-based clearing houses until June 2022, meaning they could continue to operate in the bloc exactly as they could pre-Brexit.
This deadline was then pushed back to June 2025. Firms warn that if the EU does not extend its deadline, there could be a “cliff edge”.
“Inevitably, with such financial infrastructures, they have to be located in a single place, and become the responsibility of that place in terms of their safety, soundness and stability,” Bailey said.
“Strong co-operation and co-ordination is a much better approach than fragmentation,” he continued.
A UK Finance spokesperson said they agreed with Bailey’s concerns around risks that fragmentation could bring.
“Any forced relocation of clearing services from one market to another may fragment the liquidity available, so any developments in this space should focus on ensuring the best outcome for clients and upholding market integrity,” they said.
The Governor’s comments come as the Bank confirmed that central clearing houses had passed the latest round of stress tests.
“The results confirm the continued resilience of UK CCPs to market stress scenarios that are of equal and greater severity than the worst-ever historical market stresses,” said Sarah Breeden, Deputy Governor for Financial Stability at the Bank of England.