The EU beckons for the City of London

Brexit spells bad news for the City of London, but how far-reaching will the impacts be on its position in global financial markets?

March is expected to be a decisive month in the next stages of Brexit negotiations. At the moment, shadow boxing is the rule of the game as commentators pore over linguistic ambiguity in texts and speeches to gauge what could happen. 

One suspects that the key focus of negotiators will be on the trading, insurance and asset management rules, but also data albeit that is not a unique financial services issue. These are areas where there is the most value in compromise on both sides. Securities services and infrastructure are only critical if they impact these and, in reality, the focus is correctly on clearing in this area for this reason.

The likelihood is that the EU will require separately capitalised EU based entities for much banking activity within their borders. The UK is likely to be more open than this. Mutual regulatory recognition, regulatory alignment and the treatment of claims against banks should drive this debate but it is likely that politics will be the dominant force. The UK is likely to liberalise branch capital rules as well as areas such as the capital treatment of lower risk trading positions if, as seems likely, the EU play hard ball.

In asset management, the options are said often to be convergence or mutual recognition. In reality there is a third option, namely convergence with a bilateral oversight framework to avoid cliff edge changes in the rules in the future. UK-based UCITS could be rebranded for non-EU markets and the UK regulatory clout should be sufficient to avoid foreign divestment from those countries, although, without a special arrangement, UK UCITS are likely to become AIFMs for EU investors post Brexit and this would lead to changes in their appeal within the EU.

If the EU further limits delegation to include asset management, then Luxembourg and Dublin will have serious issues as indeed will many EU banks with global asset management presences. The reality, though, in insurance and asset management is that the corporate structure exists for most major firms to relocate activities in many cases; the largest barriers currently to freedom of movement of such capital remain the overt barriers such as individual country fiscal law, regulatory reporting and client communication which makes distribution of all but the largest funds a costly exercise. An EU redefinition of delegation would, for the asset management sector, have as far reaching consequences as President Trump’s steel tariffs. In other words, it could become another component in a trade war. The likelihood is that we will see convergence plus for funds and little change in delegation rules.

Infrastructure is an important area for consideration as location of an entity can affect flows. However, Euroclear and Clearstream are based in Brussels and Luxembourg, and have hardly caused a major influx of international business to those centres. The critical issue will be clearing and the oversight allowed to the EU for systemically important non-EU based euro-clearers. At one level the entities will be relaxed to have EU oversight; they already have that for other jurisdictions. At another regulatory convergence could be an issue especially given the trend for the EU National central banks to want to be able to direct collateral policy at CCPs in the interest of the “public good” rather than solely for the protection of the clearer against risk as well as their increasingly interventionist strategy for great swathes of the wider financial sector’s footprint.

So, in conclusion how will the UK financial market’s relationship with the EU change?  I expect the sector to adopt a minimalist approach to re-domiciliation.

A UK-branded UCIT and AIF will emerge and be accepted as equal to, or even superior to, the EU brandings. Nevertheless, depositary activity will migrate to Luxembourg and Dublin for sales into the EU as much for marketing reasons as political or economic. However, the EU appears unlikely to impose in the medium-term any fundamental change in delegation authorities and the equivalence, which the US in its basic form has coexisted with for many years, will be adopted for the UK with a likelihood of certain added protections.

Settlement and trading infrastructure will not change beyond the peripheral needs of the Irish market. However, on the trading side, politics could make ongoing regulatory convergence a challenge, especially if the EU up the ante on issues such as black pools, securities lending, disclosure and salaries even further than they have currently. On the clearing side, the UK as a dominant player, is always on the defensive but EU regulation and oversight should be possible to arrange and concern about the adverse effect on liquidity of any sudden break will temper demands in this area.

But the critical issues could be outside the financial sector. The cataclysm would arise if the UK failed to agree overall terms with the EU, either at government level or in a confidence motion in Parliament. That is a possibility which I would put at around 30%. But if that happens and a split Conservative party had to face an election, the most likely result would be a victory for the Labour party. Brexit is unlikely to be avoided in that case but a Customs Union could be formed, albeit , according to the red lines identified by the Labour party, only if the EU waive state aid rules, change the terms of involvement of third countries in such a Union and allow some tepid controls over freedom of movement. But, if the Labour manifesto is to reflect also that of the last election and subsequent declarations, the UK would unilaterally adopt higher bank levies, a Robin Hood tax on financial transactions, directed lending by banks and higher personal and corporate taxes. Such a scenario would lead to the faster exit of a meaningful portion of the UK’s global financial markets franchise than anything that Brexit would cause!

Whatever way one looks at it, for the City of London Brexit is bad news. The real question is whether it will be the nemesis for the start of the demise of London as a major world financial market.