(Bloomberg) -- London’s emergence three decades ago as Europe’s undisputed financial capital was sudden and transformational. There are fears that the U.K.’s pending divorce from the European Union, Brexit, will cause a precipitous decline. The City of London financial district handles trillions of dollars, euros and pounds worth of currency and derivatives trading each day, and the U.K.’s financial-services industry accounted for 11% of all taxes paid in 2018. By one estimate, U.K. firms derive one-quarter of their revenue from EU-related business. At a minimum, Brexit will make it harder to trade with the EU from London. A particularly messy split could sever some links and disrupt business. In private talks between firms and their government supervisors, and in political negotiations between a new U.K. prime minister and new political leaders in Brussels, five subjects could spell the difference between a modest and a major hit.
Equivalence of Regulations
The EU rebuffed the U.K.’s plan for “mutual recognition" of each other’s regulations, which would have allowed banks with bases in London to continue providing services in the EU with few disruptions. That leaves regulatory “equivalence,” or the EU recognizing that U.K. laws and oversight are as strict as its own. But the equivalence framework comes with limits and possible headaches. It’s scattered over many pieces of legislation and opens doors to only some parts of the finance industry, leaving out deposit-taking and lending. And since it’s granted explicitly by the EU, equivalence can be withdrawn at short notice. The U.K. wants some assurance that British firms can’t be cut off overnight. Officials in Brussels withdrew equivalence for Swiss stock exchanges in June in part to show Britain that it won’t bend easily.
Cross-Border Bookings
Losing privileged access to the EU market will mean that U.K. banks must stand up new European units. The extent and cost of that would decline significantly if -- as banks hope -- EU watchdogs allow them to route business back to London from their EU-based entities. Such transactions, known as back-to-back trades, are used to shift derivatives and securities trades among a bank’s legal entities, allowing it to consolidate business in a global or regional hub that may need less capital to manage risks centrally. The European Banking Authority, which coordinates standards across the bloc, recommends that back-to-back trading continue to be permitted after Brexit. But the European Central Bank’s supervisory arm has warned that it won’t tolerate European offices that are mere “empty shells.”
Location of Clearinghouses
London is particularly protective of its dominance in the crucial business of clearing euro-denominated derivatives. The location of clearinghouses emerged as one of the first flash points following the 2016 Brexit vote, with French and German politicians laying claim to the business and saying it must be located in the euro area. The finance industry has pressed for EU and U.K. regulators to cooperate on supervision of clearinghouses to avoid the higher costs that would probably result if the business were split between London and the euro area. Policy makers in Brussels insist that only as a last resort would clearing of euro-denominated contracts be forced inside the bloc; they also said EU derivatives traders can continue using clearinghouses in the U.K. for 12 months even in a worst-case "no-deal Brexit." The London Stock Exchange Group Plc, owner of the dominant clearinghouse, has seen its share price double since Brexit.
Delegation
U.K. asset managers were spooked when the European Securities and Markets Authority outlined how many senior staffers they would need to keep in the EU in order to hold a license. Such delegation rules are particularly important to so-called UCITS funds, which are officially based and sold in the EU but can be managed from New York, Hong Kong or elsewhere. While regulators said they merely want to keep firms from setting up “letterbox entities,” the industry saw the move as a way to steal business from the U.K. There was also a push in Brussels to give ESMA the formal power to intervene on delegation models, but policy makers backed away from the idea. Asset managers are lobbying hard to avoid a stricter regime, which could cause large-scale relocation of senior managers from London.
Contracts and Data
Without any action by regulators, long-term financial contracts between U.K. and EU parties could be disrupted by Brexit. At issue is the ability of firms to amend existing contracts or continue servicing them over their life. The problem concerns 26 trillion pounds of uncleared derivative contracts along with 9 million insurance policyholders, according to the Bank of England statistics as of March. U.K. regulators want a coordinated governmental response to ensure so-called contract continuity. Their EU counterparts instead are pushing companies to make their own preparations and, if necessary, revise or reword contracts, a process known as re-papering. The EU approach could accelerate the shifting of business from the U.K. to the continent. Andrew Bailey, head of the U.K.’s Financial Conduct Authority, wants mitigating actions by regulators to ensure the continued flow of large amounts of data between the EU and the U.K.
The Reference Shelf
- QuickTake explainers on passporting and equivalence, the clearing business, Brexit basics and the meaning of a "no-deal Brexit."
- What’s next in the Brexit saga.
- Global firms are delaying the transfer of several billion euros of capital outside the U.K., despite regulatory pressure.
- How the London Stock Exchange batted away the Brexit blues.
- London’s reign as the world’s capital of capital is at risk, the Economist reports.
- Oliver Wyman’s report on the impact of Brexit on U.K. financial services.
- A Bloomberg Opinion editorial on what the next prime minister needs to do about Brexit.
- The City of London is also worried about drunken traders, writes Bloomberg Opinion columnist Elisa Martinuzzi.
©2019 Bloomberg L.P.
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