How will financial services repsond to a hard Brexit?

Fund domiciles and depositary services may transition easily in the case of a hard Brexit, but concerns over delegation, capital and the impact of de-regulation in the US will make it unclear for financial services.

It is going to be a pretty hard Brexit for UK financial services. Even in the unlikely event that a miracle middle-ground is found between the intransigence of the EU 27 and the inanity of the political headbanging wings of the UK political elite, the UK white paper makes clear that financial services are not to retain their European passports.

This serious challenge is further aggravated by the fact that the EU is taking a keen look at the scale of delegation permitted, especially in investment management, despite such structures being broadly accepted global norms. There also remains a critical question of whether UK firms, in those areas where it is permitted, will seamlessly move to operating under EU third country equivalence rules. However, the option of super equivalence whereby the status quo cannot be changed arbitrarily appears to be off the table.

There are several other background noises, perhaps spurred on by Brexit but, in reality, driven by the tide of protectionism that is swamping the globe from the US and which is secretly welcomed by “EU firsters” in several of the second line European financial centres. There is the potential for local incorporation within the EU if one is to sell some services there, especially into the retail market. And there are debates in process about the capital treatment of exposures to non- EU clearing houses when trading EU instruments.

The reality is that the bulk of asset management and post-trade activity, perhaps with the exception of clearing, can easily be moved to an EU eligible location. Funds can domicile in several locations; depositary services are freely available and relatively easy to relocate. The challenge could be less the oft-discussed issue of the substance of the entity in the EU location but more the scope of delegation permitted. There is little risk argument in favour of changing the globally acceptable standards on delegation from well-regulated financial centres. There is, however, a political desire to sponsor certain EU financial centres by toughening up such rules. A change in the delegation rules could legally not be Brexit specific but would have to be third country applicable. Thus, in such an event, the US, Far East and others would see their funds industries under attack from the EU. The response from the Trump America First lobby would be paralleled by other jurisdictions and we would see a trade war developing in fund related activities across the world. The only difference is that the major protagonist could be the EU rather than the traditional culprits.

The EU is nervous about equivalence rules and Brexit makes their potential usage even more significant. There can be no argument that on the day the UK leaves the EU, the UK regulations will mirror those of the EU, and paradoxically may well be more stringently applied. UK regulators tend to be the most forceful in control of risks, driven by necessity in view of the size of the UK financial sector and by temperament as they see one of their prime roles to be the protection of the public purse from financial impropriety or imprudence. The US easing of Dodd-Frank has led some within the EU to question if the US should be granted equivalence in its current form. To some extent, this ignores the fact that much of the relaxation in Dodd-Frank is not that systemically significant, although it could raise the number of smaller corporate failures in financial services. It also ignores a recognition by US and other financial groups that they need to be diligent in credit assessment, both in their bilateral relationships but also in their collective arrangements given the cross guarantees and cross-over risks that arise in financial centres and especially across financial infrastructures. There is also some ill-conceived concern within the EU, which may be politically rather than reality-driven, that the UK will become a buccaneering free market which, through contagion, could undermine the stability of the EU. This is nonsense given the traditional conservatism of UK regulators as I have already noted.

The idea of incorporation is driven more in response to US rule changes than anything else. There is a case that can be made for such incorporation if a branch structure cannot work. But the trouble with incorporation is that it seeks to codify and ring-fence the potential capital backing needed by an entity rather than look at ways to ensure the broader parent group can undertake this task. Local incorporation could lead both to a shortfall of capital in the event of a localised crisis and inefficient use of capital across the region. Decades ago I closed down my then firms’ trustee company by insisting clients were best protected by contracting with the better capitalised parent rather than a de minimis capitalised special purpose-limited liability company. Any agreement on branch structures will need to be accompanied by iron clad consents by the impacted company and their local regulators about the joint and several claims of any injured party, as well as the mechanism for allocation of such claims across regulatory borders.

Capital could become another weapon in the post-Brexit financial armoury. Again, this could not be Brexit-specific but would need to be third country applicable. This is a huge risk as it could lead to the fragmentation of global capital markets and a major increase in regional concentration risk. Furthermore, in the event of default, it could give rise to claims that could well exceed the logical comfort and capability zones of central banks and governments. Capital may not be the only area to suffer, especially in the clearing world, for we have seen discussions on using capital weightings as a political weapon in risk management. That only works if governments have the bail out appetite and, as I have noted, this is doubtful.

So, what is to be done? Most people have done it. Hard plans have been adopted to enable smooth financial flows including fund and depositary relocations, the creation of limited service vehicles and the relocation of activity to EU local entities where these exist. However, moves in the medium-term planning horizon for the financial sector outlook is gloomy. And we have to ask the question whether we are leaving the globalised world and not moving into a politically intense, higher risk protectionism-driven environment. It is so bizarre that the driver for this could be the EU, the standard bearer over the last decades, for the elimination of trade barriers.

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