Brexit: Last chance saloon

After months of wrangling, the referendum on the UK’s continued membership of the EU is finally upon us.
By and large, financial professionals remain broadly in. Some begrudgingly have acknowledged “that their heart says leave, but their brain says remain.”

The vote is too close to call, and polls spectacularly miscalculated the 2015 General Election result so there is good reason for scepticism of some of the numbers being bandied about by pollsters.

But make no mistake. The implications of exiting the EU will be adverse for the UK. Any withdrawal from the UK will take years and be mired with uncertainty. The uncertainty around an event is oftentimes more dangerous than the event itself.

The EU is intertwined in the UK financial services industry. Sterling movements have indicated there could be a short-term drop in value, followed by a possible recession. Perhaps most dishearteningly, some individuals feel that is a price worth paying for exiting. It is not.

Neither outcome of a potential Brexit are appealing. If the UK became a European Economic Area (EEA) country, it would still be bound by all of the rules propagated in Brussels. The only difference being our role in framing those rules would be much reduced if non-existent.

Regulation is rarely perfect. Look at the EU’s Alternative Investment Fund Managers Directive (AIFMD) and its evolution. Such was its hostility to alternative asset managers originally, many genuinely felt it would result in hedge funds and private equity managers re-domiciling to the US, Switzerland and elsewhere.

Tireless lobbying by the UK, its service providers and industry associations resulted in major reforms to AIFMD. Some hedge fund managers who once claimed the AIFMD would wreck their business now speak warmly of a possible brand emerging modelled on UCITS. UCITS is of course the most recognisable and popular mutual fund brand globally. Divorcing from the EU would result in less influence on matters that affect UK financial services.

If the UK were to leave the single market as looks more likely, the costs would be enormous. Huge swathes of regulation would have to be rewritten. The UK would have to attain third country equivalence on nearly every facet of law governing financial services. The only beneficiaries would be the lawyers.

The long term damage would be significant. The European Market Infrastructure Regulation (EMIR), for example, gives EU central counterparty clearing houses (CCPs) authorisation across the entire EU. UK CCPs – should Brexit materialise – would require recognition under EMIR.

If we look towards US efforts to gain equivalence under EMIR, it looks like the UK could be in for the long haul. Custodians would no longer be EC credit institutions and this could force some structural changes if they were to continue supporting their clients.

UK fund managers have reported falls in inflows amid the uncertainty. Fund managers have spent years complaining that EU regulation has hurt their businesses and distracted them from making returns. There is no doubt regulation is costly, but the commercial benefits of pan-EU distribution through UCITS and AIFMD surely outweigh the administrative pain of appointing a depositary or registering and reporting to different regulators.

Some managers point out they have no EU investors yet are hit by EU rules. It is true these firms are disproportionately hurt by EU regulations but that is not to say those managers will not solicit EU capital in the future. APAC has been volatile amid China’s market wobble; the Middle East has seen an oil price drop, which has caused many of its investors to withdraw from external funds; while the US has its own political risks. Shutting out an entire market is not helpful for investor diversification.

For those managers with EU interests, they will likely need to restructure their business out of an EU member state, probably Ireland or Luxembourg. AIFMs in the UK would lose their passporting rights until the European Securities and Markets Authority (ESMA) grants equivalence, a process that could take years. The cost of restructuring a fund would be high, at a time when margins are under enormous pressure and investor stickiness is far from assured.

The EU is currently pushing through its Capital Markets Union (CMU). CMU is ambitious and could take some time to implement, but it is a step in the right direction from regulators. CMU seeks to streamline a number of inefficiencies in EU regulation (i.e. distribution challenges faced by UCITS and AIFMs) and inject more non-bank capital into the real economy.

CMU is being shaped by a British EC Commissioner, and it is a positive piece of regulation and thinking, which could bring about major beneficial changes in EU capital markets. The UK should be a part of its creation and implementation, as it should other pieces of regulation which will impact our financial services.