BrexitMay 2 2018

Rays of light in post-Brexit gloom

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Rays of light in post-Brexit gloom

UK economic growth is at a five-year low. The Office for National Statistics blamed consumers’ Brexit jitters for a stagnant first quarter, and in February, Mark Carney, governor of the Bank of England (BoE), told MPs that UK household incomes could decline by 5 per cent this year, which is below BoE pre-vote predictions.  

It might seem incongruous that shining through this gloom is increasing confidence for the City’s post-Brexit outlook.  

Commercial property prices in the City are at a post-Brexit vote high, although passenger numbers are dropping at Bank and Monument tube stations, and London City Airport, for the first time since the financial crisis.

Job losses

A Reuters survey published in March, responded to by 64 banks employing almost 364,000 people in the UK, reported expectations that 5,000 jobs would move from London to the EU by March 2019.  

That figure is half the number of losses the same survey reported six months earlier. As the bulk of the later survey took place before the transition agreement was announced, the picture could be rosier. 

The predicted departing 5,000 jobs are not clustering in a single European hub, but are forecast to fragment to five separate hubs: 2,200 jobs in Paris, 1,470 in Frankfurt, 612 in Dublin, 250 in Amsterdam, with the remainder going to unknown locations. 

Hold that thought.

According to the head of the International Monetary Fund before the referendum, Brexit would be “pretty bad, to very, very bad” . 

BoE raised the possibility of the vote triggering a technical recession. Immediately after the vote, a City UK/Oliver Wyman report estimated that a hard Brexit could cull 31,000 to 35,000 financial services jobs. 

Key Points

  • The UK is the leading global exporter of financial services
  • Fears of an exodus of jobs post-Brexit have diminished
  • The future of the City depends on the success of 'passporting' rights

The UK’s financial services sector is the leading global net exporter of financial services. UK banking sector assets are the largest in Europe. The UK is also one of the largest markets in the world for fund management. 

It is the second largest centre for hedge fund managers after New York, and the most developed private equity market outside the US. It also has a 39 per cent share of over-the-counter derivatives trading globally. Both the UK banking and insurance sectors are the fourth-largest in the world, and the largest in Europe.

That the City has so much to lose is what makes it difficult for any of the five separate and competing European hubs to take a substantial amount of its business away. Were the EU to designate a single city as a competing hub, and pour its resources and efforts into that hub, the challenge would be more formidable, but that hasn’t happened, and the lack of a single credible challenger is helping London.

Regulatory and political actions are restraining push factors from the City. March’s transition agreement was a big step forward, providing that the UK’s de facto membership of the EU now continues until the end of 2020, subject to an agreed withdrawal treaty. 

The BoE and the Financial Conduct Authority (FCA) co-ordinated statement that EU-based financial services firms may continue to use their existing passporting arrangements to access the City during the transition period, with a commitment to temporary extensions for a limited period after withdrawal, if a withdrawal agreement is not ratified, also helps. This puts the leading EU financial institutions in the same position as their US and Japanese equivalents.

While these are all steps in the right direction, whether the City retains its European crown will depend on three things: the adequacy of the withdrawal agreement; the extent to which UK-based financial firms move operations to the new hubs before the transition agreement expires; and the overall resilience of the City to Brexit through its broader global relationships and position.

Maintaining passporting rights is the best outcome, either through the UK remaining in the European Economic Area, or negotiation into the withdrawal agreement. If this happens, long-term disruption could be limited, but without passporting rights, UK firms will require burdensome state- level authorisation to perform regulated activities in EU countries.  

Passporting

Without passporting rights, the retail investment products sector in particular might undergo strain. There are roughly 35,000 financial advisers in the UK advising on retail investment products as part of the UK’s £825bn wealth management industry. If financial advisers in the UK were to lose access to European markets it would become more costly to service wealthy continental clients. 

Estimates from last year predicted that the UK wealth management industry could lose a quarter of its business through Brexit. This now seems overblown, although the existing model of creating products and services in the UK, which are marketed through relationship staff based in continental Europe, will not work without passporting rights, and either the industry or consumers, or both, would have to swallow the costs of setting up new subsidiaries.

If passporting rights are not negotiated, then UK firms might need to take advantage of third-country regime (TCR) access provisions. 

These regimes were established under EU rules covering third country established firms. Under existing EU law, TCRs provide rights of access below passporting for financial services, such as conducting certain regulated activities, providing wholesale investment or portfolio management services, or fund management services, without further authorisation requirements from an EU member-state.

The TCR solution will only work if our EU counterparts decide that corresponding parts of the UK’s regulatory and legal system are equivalent to those in the EU – a political decision.  

There are two further alternatives: establishing an EU branch or subsidiary. Branch access is not currently available in all areas of financial services, and indeed is rarely used. Depending on the number of jurisdictions where a firm does business, it could also be necessary to establish multiple branches.

If a UK firm established an EU subsidiary, it would be able to take advantage of existing EU passporting rights. This advantage would be accompanied by the disadvantage of transferring all or some of the UK business to the EU subsidiary, which would be simpler if the withdrawal agreement allowed operational functions, or a substantial part of them, to remain in the UK. Again, this would be a matter of political negotiation. 

Whichever path is chosen, certain sectors are at the greatest risk, with clearing in most peril. Relocating clearing of euro-denominated derivatives to the eurozone was in the sights of envious jurisdictions even before Brexit. 

London-based LCH clears more than 90 per cent of euro- denominated derivatives. In November 2016, the Financial Times reported on Ernst & Young research that up to 83,000 jobs could be lost in London in a seven-year period if euro-denominated clearing moved to the eurozone. This figure appears high.

In February, the new chief executive of Deutsche Börse said that he wanted Frankfurt to win a quarter of the market for euro interest rate swap clearing by 2019, calling for political support to do so. He already had this with French Finance Minister Michel Sapin saying in April last year that it would not be possible for the UK to continue euro clearing post-Brexit.

Relocation

However, some EU countries, notably Sweden, are concerned that relocation would bring high fragmentation costs with reduced market liquidity and increased margin requirements, which would be passed on to end users. Estimated costs of relocating trading have ranged from £2.3bn to £72bn over a five-year period. 

As that reality bites, the head of Autorité des marchés financiers, the French market regulator, this month recommended avoiding any abrupt relocation of euro-denominated clearing.

The City is in its best position since the Brexit vote. To retain its crown, the sector and the government must do its best to retain euro clearing, and if passporting cannot be retained, beneficial branch or subsidiary access to the EU market must be negotiated. 

The political path is uncertain, but after nearly two years since the Brexit vote, things are looking clearer, and for the City, the end of the beginning is near.

Edmund Parker is global head of derivatives and structured products for Mayer Brown