Having had the luxury of being away from Europe for over a month, my thoughts returned to Brexit as I headed back to the home country. It is unclear where the UK is heading. It could accidentally fall into a hard Brexit although the odds still must favour a deal. The government could fall, although the odds are not high for such an event; however we cannot preclude a change of government and the arrival of a high personal tax, high corporate tax, penal banking tax and a unique Tobin tax alternative socialist administration.
Or the whole Brexit bubble could burst and the UK remain in Europe, although that I find hard to credit unless there is a referendum that over rides the last one; an event opposed by the current government and one where the question to be asked is difficult to gauge.
So where does this leave the UK? The only credible deal on the table at the moment is the one proposed by the EU. This respects the red lines set by the current UK government but includes the unacceptable (for Parliament) of a potential, albeit unlikely, forced stay in the EU by the UK or Northern Ireland with them being unable even to revert to a no deal/WTO tariff arrangement without the consent of their former EU partners. The EU are said to favour the UK opposition preference of “close alignment” between the UK and the EU through a permanent customs’ union and the adoption of some single market rules, but the main Labour opposition party is almost as split as the government party on this issue and some of the sub text to their proposal would be fertile ground for disagreement between the UK and the EU.
It is clear that it is in nobody’s interest to fail to come to a deal and hopefully one will be reached. The UK will suffer if no deal is reached as it will see major barriers between it and its major trading partners. Ireland will suffer although one presumes the rest of the EU will provide some help to alleviate their pain, although the hard border issue could translate from a UK/EU issue into an EU-Ireland conflict.
The EU will suffer because it will lose funding, but, more importantly, the resultant decline in trade will lead to unemployment and lower fiscal revenues at a time when the global outlook is rocky. And, most importantly, there is likely to be a cultural shift, most prominently in the UK, with antipathy towards our former EU partners translating into lower demand for their goods, services and even potentially tourism.
Funds will hardly be affected by the move as the bulk of them have already re-domiciled to Ireland or Luxembourg and, unless there is an eventual change in the rules on delegation of investment management, they will maintain the status quo.
Custodians are mostly affected by the domicile of their depository although the major custodians have sufficient reach in the EU to overcome this. However, we need to also question if rule changes could not cause problems for UK-based entities especially if the equivalence rules are not enacted quickly or if there are unintended consequences of the quite major impacts of a hard Brexit on MiFID structures, such as data collection and collation, and other regulations. In that context, the brokerage community will need to keep a close eye on rules relating to the substance of their presences behind the entities that book trades as distinct from those that make the markets.
EU banking licences, CCP status and the usage of UK law in areas of ECJ competence are all further challenges that will need to be overcome. We need to keep a close look at collateral with the exit of the UK changing eligibility rules on UK assets and bringing the likelihood that substantial potential collateral will be re-domiciled with banking activities. This could all affect availability and price at a time when increased margining is likely especially at CCPs where initial margin is now really out of kilter with the potential volatility of markets faced with major political, economic and social uncertainties.
There will be pressure also on major European custodians to relocate activities out of the UK. I suspect this will happen irrespective of the eventual Brexit genre we adopt. If we look at the mood music of much of the EU debates of recent years, there has been a desire to locate EU, and especially euro-denominated, activity within the EU. This has the makings of a potential financial trade war that would extend well beyond the Brexit debate and could mark a further step in the destruction of the global order that has allowed capital markets to flourish over the last thirty or so years.
All in all a hard Brexit is bad for the UK. It will lessen the attraction of the UK market for Europe focused activities. And the UK has been the global point of entry for the bulk of inbound activity. The negative on the UK may not become a major positive for the EU. Firms will revisit the structures they need for their global activity and one should also note that that is one of the reasons for the low level of UK based global financial entity corporate restructuring relative to earlier fears or expectations. The EU minus the UK is not an automatic centre of choice for many of the financial businesses based out of London.
Brexit has destabilised the financial community and it could have far reaching impacts beyond the location of businesses. The world financial markets are dependent on liquidity, credit worthiness, knowledge, certainty of law, credibility of regulation and many other criteria. Brexit and its likely economic, political and regulatory consequences changes these. We really have to ask if the biggest challenge will be the location of different activities, which the major firms can accommodate within their geographical business model, or the economic effects of the likely increase in the cost of capital within both the EU and the UK, which will hit investment and damage production.