The nirvana style relationship sought by the UK government is, simply speaking, freedom of trade and services without freedom of movement of people, payment of EU dues or the primacy of EU law. That extreme option, effectively a single market without constraints, is not going to happen. BREXIT, for the remaining members of the EU, if only for political reasons, needs to be less attractive than membership of the EU club. And financial services, the UK’s gold standard industry, will be at the fore of that vision. On the other hand, as long as politics is not allowed to prevail over economic common sense, a transitional arrangement and a soft landing across the financial sector should be viewed as being to the benefit of all. And that remains the more likely, if still uncertain, option.
At a corporate level, most of the major financial institutions have adequate footholds within the EU to be able to migrate impacted services to a new location. Policy decisions on such migrations will be initiated fairly promptly, although the end to end process will take time. Elsewhere, migration of functions to the EU is likely to be more gradual and challenging, including a need for potential corporate restructuring and reassessment of firms’ business models and objectives. Perversely we may see meaningful repatriation of business to the US if there is more than expected EU intransigence around the openness of their future business model, thereby making London based regional entities less attractive to operate.
Take the most politically charged area of all, namely clearing. If the EU wishes to place politics as supreme and over rule economic common sense, then all EU institutions will be mandated to only clear EU instruments through EU based and regulated entities. If the liquidity of markets is taken into account, ESMA or EBA may well decide to levy a cost in terms of capital, for EU institutions, were they to use non EU clearing houses, to reflect the absence of direct control over such entities. However, equivalence could possibly come to play in such cases. Each party to a transaction, be they EU or non EU based, will make their choice of preferred clearer. A major driver will be their CCP membership profile and their net collateral position and business structure. And there will be a further impact if their clearing house of choice has a link into an appropriate EU based clearer. There is no binary solution. The outcome will be dependent on cost, efficiency and control and that will also dictate the impact on market liquidity.
I cannot see the EU promoting an environment which effectively culls the sources of liquidity to its financial institutions, many of whom are fragile. The UK is likely to continue to adopt Basle guidelines in the fullest manner, for that has always been Bank of England policy, and that should allay any regulatory fears that UK based banks could prove unreliable sources of liquidity. I do not see a huge amount of retail lending out of remote entities across the EU. As in insurance, most non EU headquartered retail distributors have opted to create retail entities in their countries of operation or in a continental hub, although many will need to look to establish EU holding companies where hitherto they have had branches. The question is how many will stay and how many, in such an environment, will decide the business case, with the added costs of incorporation, does not work.
On the funds’ side, there would be an issue if distribution were driven by the domicile of the manager rather than the fund but that appears unlikely at the moment. The major custodians have fund administrators in the EU and, although some may have to scale up their presences, most have critical mass. Funds that are based out of the UK and distribute into Europe under the UCIT or AIFM label will need to consider relocation, although recent studies show that the hidden cost of distribution into each county of the EU has been a very high barrier to entry for even passport eligible firms unless they have genuine scale and sizeable local market potential. There will thus again most likely be a withdrawal by some funds. Key may well be less the distribution across the EU but the value of the UCIT and AIFM brands across the world. It will be interesting to establish if funds will relocate such global funds, if that is necessary, or whether an equivalent UK comparable brand will emerge.
Foreign banks who use the UK as a gateway will be torn several ways. The UK still has critical mass and could, in extremis, be more flexible than the EU in its capital demands on UK based subsidiaries of countries with equivalence to UK capital rules. The EU, without the UK may adopt more rigorous and intrusive rules. And given the openness of the UK domestic market as well as the powerful and global origination function based in London, those banks will have to balance the potential need for a continued UK presence on a stand-alone basis against a dual presence with all its associated added costs and risks. Labour laws will come in play as will the availability of legal and other professional expertise. A key issue will relate to capital market funding sources, for these are likely to come under relentless pressure, with many EU entities being forced to cut back their lines to counterparties in the face of adverse performance and increased capital requirements. UK based banks will also suffer as they will have no source of contingency funding in the Euro through the ECB, except through locally incorporated EU entities. The Bank of England is unlikely, based on past experience, to offer an alternative source of Euro liquidity and the maintenance of special lines between the EU and UK central banks is highly unlikely post BREXIT.
Overall, I sense three potential waves. Those for whom migration is simple will act soonest in areas where they feel an imperative. Clearing is likely to be one such area. Those who will need to add material cost, perhaps through incorporation, will only move if they feel a major adverse effect on their business model. And most, by number if not volume, will treat the EU as any other foreign market. The more complex it is to operate there, the less attractive it will appear. And one must never forget that the UK, with its large financial services wallet, will become a foreign market to EU institutions and BREXIT impacts them as well.
But, we cannot rule out an Armageddon option. The US is becoming much more protectionist. Its focus is on physical trade rather than financial services. But it is also preaching deregulation although the likelihood, as some at the extreme are saying, for the abandonment of Dodd Frank or even the entire Volcker rule appears low. The EU is prone to protectionism but also to detailed regulation. It could produce both; indeed the move to financial sector holding companies was inspired as a reaction to US regulatory change rather than local logic. The UK is unlikely to ease the regulatory burden currently in place as politically and economically it cannot risk a repeat, or even a reduced impact repeat, of the 2008 crisis. But it may adopt a “Singapore” option should it fail to gain a “fair” agreement, for which the bar may be lower than many currently believe. Such an option would allow offshore branches to operate out of the UK more freely as long as their parent was located in a well-managed jurisdiction. It could provide tax concessions. It could even be the home of a valuable offshore market if, for example, a Tobin tax were to be introduced across the EU.
The future is uncertain. But it always is. BREXIT cannot be avoided. But, hopefully, it will be managed in such a way as to avoid undermining EU financial institutions, ensuring that the UK remains a full member of the regional diaspora, if not the EU, and looking to find a solution that ensures the region does not become a myopic and inward looking quasi nation state in a world where cross border activity and globalisation risks becoming an anathema.