A difficult break-up: Brexit 100 days on

The political war of words around Brexit, just one hundred days after the UK rejected ongoing EU membership, is gaining momentum. Proponents of a soft Brexit are considering options such as ring-fencing geographies or industry sectors. Meanwhile, the unreconstructed Brexiteers are militating for a hard Brexit including exit from both the Single Market and the Customs Union.

Although it is difficult to predict exactly what will happen when eventually the UK exercises Article 50 early in 2017, some things appear probable. In a prioritisation of UK demands, key will be border control, support for manufacturing and then, the City of London. From an EU perspective, the four freedoms are paramount as long as, during 2017, Martine Le Pen, Geert Wilders and Frauke Petry do not do too well in the French, Dutch and German elections. Furthermore, current EU majority preference is to ring-fence single market benefits to show there is clear blue water between membership and partnership with the EU.

This implies several things from a planning perspective. First, Brexit negotiations are likely to be distinct from negotiations around trade. Second, there is likely to be a hiatus between Brexit and any all-embracing new UK/EU trade pact. Third, transition concessions are likely to be more focused on physical trade, where the EU has flow advantage rather than the service industries where the flow is in the UK’s favour. This is not going to be a zero sum gain for anyone, and, given the decision making structures of the EU and the red lines of the different remaining EU members, a solution will not come quickly and will be complex. But services are likely to be the most disadvantaged and will also suffer for being the most complex and thus, in all likelihood, late in the delivery cycle.

The EU has, though, to contend with one wild card in the financial services sector. It regards Europe as the boundary whilst financial services are actually global. Thus any denial of access to the UK, which is a global as well as a European centre, could have three potential consequences. Operations currently in the UK, both front and back office, could migrate to the EU, with back office support likely to move to cost effective servicing centres in countries such as Poland; this is the preferred and most discussed post Brexit option. Alternatively firms could restructure their business to retain global functions in London or migrate them to New York or an Asian capital rather than the EU, if they decide that they do not want to create EU only enterprises alongside their remaining and much larger global business lines. Or there could, in the face of extra cost, be a downsizing of Euro activity in London by many current players for economic reasons; thus they could avoid some of the new barriers. Both of the alternatives risk reducing liquidity in the Euro financial markets and thus increasing the cost of finance for Europe.

It has been unclear how the UK would adapt to the regulatory and legal change from a Brexit. I found the initial debate on EU law and regulation bizarre and the recently suggested UK government solution to the question of EU laws and regulation is totally logical. The UK will find an instrument that adopts them in their totality as UK law post Brexit with the option of amending these in the normal way after the event. The UK needs to maintain EU equivalence across a wide range of structures for they constitute best practice and would be needed if there are to be longer term interactions with the EU. After all, as elsewhere, we could have an EU compatible segment of the UK market and an unfettered one if sectors so wish and feel it economically viable. However, the likelihood is that the EU without UK influence will become more protectionist and interventionist and that augurs badly longer term for initiatives such as the Capital Markets Union and the long term value of equivalence.

Looking at the financial sector, the UK is unlikely to change depositor protection, capital adequacy rules, the EMIR, CSDR or MAR rules covering transparency, market discipline or increased use of trading venues and central clearings. AIFMD could be met through an equivalence ruling, but that implies that UK based UCITS would be retitled as alternatives, which would be both detrimental to their global brand appeal and potentially reduce their eligibility for certain investor types. Unless it is clear early on that equivalence will be obtained, we can expect substantial fund re-domiciles ahead of Brexit. In addition, in a less globally minded EU, the rules on management could come up for further scrutiny, given UK dominance in the fund management sector. It is possible in a future EU structure that the mind of management from an investment selection perspective will have to be onshore in the EU for a fund to be allowed the full benefits of their brands. Given that the UK accounts for 40% of EU assets under management, although a large part is purely domestic, this is significant.The hard earned concessions in respect of-non-discrimination between participating and non-participating states in the Banking Union is also likely to be changed. It is unclear what freedoms would be excluded as the EU needs to be wary of moving the goalposts too quickly and causing a funding famine. After all, UK based banks are making £1.1 trillion of loans to EU borrowers and account for 60% of all capital market flows and the bulk of derivative clearings in the EU.

There has been some discussion about a potential UK adherence to the Banking Union even in Brexit, but that has major ramifications for other jurisdictions, especially the Swiss, and is an unlikely concession without full adoption of the four freedoms and a contribution to the EU budget. In reality passporting has been a fait accompli of the post Euro age and its loss for UK based banks would remove several rights. Solutions to this have been mooted to include UK based branches being regulated jointly or solely by an EU Central Bank, with Ireland, given the close affinity of the two legal systems, being an ideal candidate. However, it is unclear how such solutions would stand up to scrutiny in the EU Commission given it contravenes the concept of a branch needing local substance in the state of their sponsoring government.

Insurance companies will be hard hit by Brexit, especially as there is unlikely to be an easing of Solvency 2. Many UK life insurers already have subsidiaries in many EU countries for regulatory and operational reasons and will, therefore, be less effected. The non- life sector makes more use of the passport out of the UK. Both types of entity are also an important subset of the 8,000 EU legal entities selling services into the UK. Once again though, including businesses such as Lloyds of London, the balance of flows is on the UK side and this, assuming suppliers remain in the market, becomes a concession to be requested or a business to be migrated to the EU rather than a card to play.

Indeed that is the main issue for the City of London. Its past success in intermediating flows into Europe and selling its passport enriched product across the Globe highlights its problem. Its wishes and needs are not at the head of the queue in the BREXIT corridors of power. Paradoxically it is the needs of the proud Brexiteers in Sunderland, Port Talbot, the Midlands and the North who will have priority and the major share of mind of government.

There has been an estimate that 5,500 legal entities and a few hundred firms in the City will be affected by Brexit. The best estimate is for a loss of £ 9 billion of annual revenues as a result of hard Brexit, or 20% of the total. The impact on firms will be less as they can relocate flows but London’s loss, in terms of impact, is likely to be respectively a gain for New York, certain EU capitals and a tightening of the supply side for the EU as some firms exit much of the single market as it becomes cost ineffective for them to sell there.

These are challenging and dangerous times. In the UK, we have a loss of footprint at a time of capital challenges for regional financial firms as well as a likely deterioration in the UK balance of trade and budget and thus a need for increased deficit funding. In the EU, we see an increased threat of bank insolvency, no end to the uncertainty around the Euro and social tensions resulting from migration. The global situation is overcast with China’s deficit funding and tensions in the South China Sea, a race to the bottom in terms of protectionism and world trade in the US elections and unrest over large swathes of the Middle East.

Hopefully a logical Brexit, soft enough and with a sensible transition trajectory can be found. Definitely, from the perspective of the City of London and the financial sector as a whole, the UK vote to exit Europe was not in its interests. And Government will inevitably see reduced revenues from the financial sector in the next decade, for alternative sources of income are not going to be generated easily, or, as fast as those streams that are lost or abandoned.