Brexit and UK-Based Financial Services

Britain's financial eco-system

According to Olivier Wyman Research, it is important to recognise that the UK's financial sector and allied professional services (in law, accounting, etc.) make up an "eco-system", and that "the effects of the UK's exit from the EU could be felt more widely than simply in business transacted directly with EU clients". In its analysis conducted for TheCityUK, Wyman provides some quantitative forecasts relating to soft and hard Brexit. In the former case, in which the UK is outside the European Economic Area but still has passporting rights and equivalence providing access to the Single Market, the reduction in activity would be modest. The fall in EU-related activity would be about -£2 billion (equal to roughly 2% of total international and wholesale business). This drop in output would be accompanied by job losses of 3-4,000, and a fall in tax revenues of less than £500 million per year. At the other extreme, should the UK's relationship with the EU resort to World Trade Organisation rules, then 40-50% of EUrelated activity (£18-20 billion in earnings) would be at risk. This in turn would be accompanied by job losses in the order of 31-35,000, and falls in tax revenues of about £5 billion.

Such forecasts are of course broad figures, and surely much subject to change, depending on the dynamics of how the Brexit process unfolds. Many other factors will likely come into play. Some of these are linked to the question of Brexit itself, for example the impact which new immigration controls and the welcome (or not) given to foreign workers who are highly-skilled and still wanting to work in London. This is where the concept of Britain's financial services industries constituting an "ecosystem" is important. The issue is discussed at quite some length in the House of Lords report (see above). The interconnectedness of business activities in finance and related professional services (such as legal services, accounting, information technology, etc.) means that it is very hard to estimate what exactly the effects of losing some activities will be on the eco-system as a whole.

Competition from other European centres and the costs of "hard Brexit" to Europe

Conversely, the density of the UK-based financial services eco-system with its focus on London may make shifting business elsewhere in Europe quite difficult. To be sure, numerous European financial centres are fishing for business which may leave London. Favourite locations likely to capitalise on Brexit are Dublin (which shares English and common law with London) and Frankfurt (home to the European Central Bank, and perhaps a logical site for the European Banking Authority to relocate to when it leaves London). Paris too is in the running, with Valérie Pécresse announcing in early November 2016 that the Ile-de-France region is setting up a one-stop-shop to help companies move to France. Greater Paris also has an advantage of being Europe's only other real metropolis, and hence an unparalleled business hub within the EU.

But, a simple switching of locations in Europe may not work out so easily, precisely because no other financial centre in Europe offers anything like the concentration of skills and infrastructure found in London. It is notable, for example, that in October 2016, Jamie Dimon (the CEO of JP Morgan) opined that instead of relocating business elsewhere to Europe, where the infrastructure of financial services is limited, American banks may repatriate work to the New York. Mr Dimon also reckoned that Brexit significantly increases the risks of the Eurozone breaking up. This would obviously make other EU centres far less attractive to international financial firms.

Indeed, any dislocation to finance which Brexit could cause is likely to occur as Europe's banking sector is still struggling to emerge from the financial crisis of 2007-2008 and the European sovereign debt crisis at the start of the 2010s. Europe's oldest bank, for example, the Monte dei Paschi di Siena founded in 1472, is regularly in the news with its on-going problems. So too is Deutsche Bank, the German behemoth that has faced difficulties since its massive expansion in the early 2000s. Large French banks too face structural challenges, and are currently reliant on their investment banking activities to earn profits, as large branch networks are costly to maintain. More generally, all of Europe's major banks operate in London, and reorganising their work to take Brexit into account will entail costs, and the probable loss of profitable business.

A specific difficulty and its attendant risks concern the central counterparty clearing house (CCP) activities related to transactions in euro-denominated derivatives that are currently booked through London. The CCPs have become more important following the financial crisis, as the G20 agreed on the need for much standardized derivative trading to be transacted through such clearing houses. As a result, risks that were previously born directly by buyers and sellers in direct deals (OTC deals) are hence born by the CCPs, which stand between buyers and sellers, guaranteeing both sides of any transaction. In principle, CCPs can therefore offset risks in any one particular deal because they also clear deals carried out in opposite directions, between very many parties (for example in interest rate swaps or currency trades). The UK is by far Europe's largest base for such derivative trading, including in euro-denominated assets. This location is, however, controversial. After all, why should such euro-business take place outside the Eurozone? Indeed, in 2011, the European Central Bank said it would withdraw liquidity support for any CCP dealing above a certain level of eurodenominated transactions outside the Eurozone, thus putting pressure on such activity to migrate to the Eurozone. The UK, however, challenged this decision in the European Court of Justice, and won its case.

With the UK now set to leave the EU, and escape from ECJ rulings, the issue of repatriating the trading of euro-denominated derivations is likely to be reopened and François Hollande has already specifically referred to this. Over time too, the logic of maintaining such trading in a financial centre outside the EU, and hence outside EU law and outside the jurisdiction of the ECB is surely likely to lead to change. But moving from the present situation to setting up similar clearing house capacity elsewhere is potentially fraught with difficult technical and legal problems, and it could destabilise markets. There are also very likely to be considerable costs related to relocating clearing house activities, while economies of scale available to firms and their clients will likely fall as business is moved out of the massive London markets.

Transitional arrangements to avoid the "cliff-edge"

Given the complexity of the eco-system, the intricacies of many aspects of international markets, and the ongoing fragility of parts of Europe's banking system and concerns for the global finance system as a whole, there is a good case to be made that Brexit should not prevent continued strong links between the UK and its former EU partners. So there are good arguments for some sort of transitional deal before a final trade and economic agreement is reached between the UK and the EU. The Government's White Paper makes much of the importance the UK to Europe's finance sector and business as a whole: "[o]ver 75 per cent of the EU27's capital market business is conducted through the UK. The UK industry manages £1.2 trillion of pension and other assets on behalf of European clients. The UK is also responsible for 37 per cent of all European Initial Public Offerings, while the UK receives more than one-third of all venture capital invested in the EU. EU27 firms also have an interest in continuing to serve UK customers".

On the EU side, there have been leaks relating to the awareness of how important Britain's financial services as a whole are to Europe and the Union. In January 2017, it was reported for example that Michel Barnier, the European Commission's Chief Negotiator for Brexit, had told MEPs in a private meeting that "[t]here will be a special/ specific relationship. There will need to be work outside of the negotiation box… in order to avoid instability". Mr Barnier also restated the EU position that there could be no cherry-picking by Britain of parts of the EU it likes, and he did subsequently clarify his comments via Twitter, by referring to "special vigilance" needed concerning finance. Nevertheless, the leak was a clear indication of concerns in Brussels and the EU of Britain dropping out of the Single Market. (It should be recalled that Michel Barnier was the EU Commissioner responsible for financial market and banking re-regulation in the early 2010s. He should therefore be exceedingly well-briefed on finance.) In a similar vein, in early February 2017, The Guardian published extracts of a leaked report by the European Parliament's economic and monetary affairs committee, pointing out that UK-based banks lend more than £1.1 trillion to other EU member states, and that "[a] badly designed final deal would damage both the UK and the other 27 EU member states" in terms of jobs and growth.

Outsiders too have on the whole backed the importance of moving forward carefully, and avoiding what has been called "train-crash Brexit": i.e. if the UK and the EU fail to reach an agreement between Article 50 notification and the otherwise-automatic exit of the UK from the EU treaties in spring 2019. This scenario would involve existing business relations falling of the "cliff edge", into some sort of legal emptiness, as even establishing a relationship based on the WTO regime requires new legal ratification. During her visit to sound out US banks in New York in September 2016, Wall Street as a whole warned Theresa May that it needs a "long runway" to prepare for Brexit. Now that the Government has stated very clearly that it is prioritizing control over immigration and ending ECJ jurisprudence over British law, establishing a long runaway will need strong political will and agreement between all parties

In principle, it is in everyone's interest – Britain's, the EU and even the global financial community as a whole – to manage an ordered transition from the status quo to some sort of post-Brexit arrangement. Yet, events in 2016 have clearly shown up how unpredictable the political evolution of even historically-anchored representative democracies can be. The British Government's current position is paradoxical, to say the least, in wanting to open up the UK economy to even more global trade, and to have a strong European Union as a future partner. But such contradictions pale into insignificance when compared to the tectonic changes that are occurring in the foreign economic relations of the United States since Donald Trump was inaugurated as President on 20 January 2017. Since World War II, the USA has been the main actor and guarantor of the international economy – more or less – based on the rule of law and trade liberalization. Early executive actions by Donald Trump indicate quite clearly that this has now changed: the United States is moving towards a more protectionist and confrontational stance with respect to its historical and new trading partners, as well as with respect to the international institutions and laws that have been built up since 1945. This does not bode well of the degree of international cooperation which emerged after the 2007-2008 financial crisis, in terms of re-regulating finance. In fact, the new Trump administration has already declared that it is seeking to repeal significant aspects of the 2010 Dodd-Frank Act, which applied numerous international guidelines for financial re-regulation to US law. More worrying still, is the way the new US administration has shown itself to be hostile to the European Union. This could well make negotiations between the UK and the EU over Brexit and financial Brexit even more difficult, with potential highly destabilising consequences.