EU wish to restrict the discounting of eurozone debt by clearing houses would present extreme risk says Barnabas Reynolds (who is a partner at Shearman & Sterling LLP) on 4th December 2021.
The European Commission is making much of a wish for “strategic autonomy” in financial services, arguing that it needs to find ways to pull financial business from the UK into the EU after Brexit.
The main reason for the EU’s strong push for business might not readily be apparent to all. It is not just a matter of jobs.
Underlying the push is a wish to be in a position to control and modify global financial regulatory standards to relieve market pressures on the highly fragile – and dangerous – euro project. However, the idea is a reckless one and the consequences of such an approach, were the EU to succeed, could be calamitous for the world economy.
The reason for this arises from the structure of the eurozone. EU law splits eurozone sovereignty between the member states, who are in charge for fiscal purposes, and the European Central Bank, which governs monetary matters. As a result, neither is sovereign.
Unlike true sovereigns, such as the UK or US, eurozone member states cannot require the ECB to print more money to repay debts. So the only monies they can count on are those arising from their tax base.
Member debt is being used to fund the eurozone. Vast amounts are held by EU and international investors. Because of the lack of a sovereign issuer, those investors run the constant risk of member state default – that is, other than for a relatively small amount of EU bonds issued for Covid funding.
The zone is funding itself on the basis of debt of sub-sovereign quality, leaving the zone highly vulnerable to market sentiment. In the meantime the EU has sought to force the market to regard the arrangements as normal, and appropriate for a currency zone.
EU law and regulation requires EU financial firms to treat the member states’ sub-sovereign paper as sovereign. Furthermore, some of the costs arising from the setup have been ignored or hidden, with the adoption of accounting treatments that allow for assets, such as non-performing loans, to be reported by financial firms as being other than they are.
Similarly, accounting treatments mean that liabilities which the markets assume are borne by wealthy members such as Germany fail to appear on the relevant balance sheet, giving a misleading picture of financial health.
The fundamental problem is that the cost of mutualising eurozone member state debts and creating a unitary state is too high, politically, and it is clear this will not occur any time soon.
Also, the cost of properly capitalising and applying international standards to the EU’s financial system, to reflect the risk arising from this setup, would be prohibitively expensive.
The evolving fictions are creating flashpoints, the most public of which is euro clearing.
This very important article ends with this warning:
The EU’s wish to restrict the discounting of eurozone debt by clearing houses would present extreme risk when the markets take a different view of the value of that debt, for instance because they regard the fiscal arrangements within the issuing member state as having worsened.
What EU control would mean is that a clearing house would run an increased risk, at the behest of EU regulators, of its collateral being insufficient to cover losses; and because the clearing house sits in the middle, between buyers and sellers, this risk would effectively be mutualised among the world’s major financial institutions who provide their clients with clearing services.
The EU often likes to refer to the US as a comparator. But there is a profound difference. The US is a single country, with central organs which the federal sovereign stands behind. That is not true of the EU.
The EU is trying to run before it can walk. The world cannot stand by and allow it to do so, discarding the risks of its half-built currency system on to everyone else.
For the full article including charts in pdf, please click here:
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