No Sleep Till Brexit: The City Scrambles to Deal With Quitting the EU
(Bloomberg Businessweek) -- As soon as Justin Urquhart Stewart arrived at his office on the morning of Oct. 18, he huddled with his money managers and research chiefs. This was supposed to be a big day in the runup to Brexit. U.K. Prime Minister Theresa May was supposed to make progress with European Union leaders on the last outstanding terms of Britain’s departure from the bloc on March 29. And financial institutions such as Seven Investment Management LLP, a London-based firm Urquhart Stewart co-founded 17 years ago, were supposed to finally get some clarity on a process that’s thrown their industry off balance for two years.
Yet everything that was supposed to happen didn’t happen—except for some talk about extending U.K. membership in the bloc in all but name for another year. Urquhart Stewart sighed. It was another kick-the-can moment. More political drama was bound to follow.
The meeting over, Urquhart Stewart walked the floor of Seven Investment, which manages £14 billion ($18.3 billion) for middle-class British households. Phones were ringing, coffee was brewing, keyboards were clicking. Proudly old-fashioned, the firm’s male employees must still wear neckties. Urquhart Stewart, sporting red braces and cufflinks in the shape of his company’s logo, exuded the confidence of a 63-year-old pro who’s weathered his share of market crises in the City of London.
But he’s really worried about Brexit. For the past few months, his team has diversified portfolios to lessen their exposure to the U.K. economy, prepared trades to hedge a potential steep drop in the pound, and even developed scripts to guide the firm’s relationship managers when they counsel anxious customers on this unprecedented process. Looming over everything is the increasing possibility that Britain will break away from the EU with no transition to lessen the turmoil. What’s to be done then?
“In normally moving markets I’ve got companies, I’ve got foreign exchange, I’ve got economic issues, and I’ve got political behavior within given norms,” Urquhart Stewart said. “Now I’ve got political behavior that is outside given norms, and that is having really dramatic effects that I can’t measure. So we huddle every day, and later we’re going to sit down and go through this in more detail and see what we can come up with to keep things safe.”
Ever since U.K. and EU leaders deadlocked in Brexit talks this spring, there’s been a lot of huddling and brainstorming and war gaming in the City of London. The prospect of severing 45 years of regulatory integration in one fell swoop has jolted the world’s biggest international finance hub. Elements long taken for granted, such as market access and the integrity of contracts between buyers and sellers, are suddenly in flux. Everyone is trying to gauge what this means for their businesses. Money managers are worried about losing European clients. Bankers are scrambling to send more traders and sales staff to new outposts in the EU. Lawyers are confronting the Herculean task of transferring trillions of dollars of derivatives contracts to Paris and Frankfurt from London. And regulators are concerned that a hard Brexit may jeopardize financial stability.
“Many in the City didn’t believe that a no-deal scenario was possible—they thought it was just rhetoric,” said Alasdair Haynes, the chairman of Aquis Exchange, a London-based equities trading firm. “Now the reality is sinking in.”
As the clock ticks down, financial firms are watching for any sign that a deal may be coming. On Oct. 31, the pound rallied after U.K. Brexit Secretary Dominic Raab predicted a deal with the EU will be finalized by Nov. 21. He made the statement in a letter sent to a Parliamentary committee on Oct. 24. Meanwhile, it appeared that U.K. financial services firms may obtain continuing access to EU markets post-Brexit after negotiators from both sides reached an agreement to align British regulations with those of the bloc, the Times of London reported, citing unidentified sources. Suddenly, the situation for the City has become very fluid.
Even if May bridges the warring factions in her party and reaches a deal with Brussels, the City is still going to feel the pain, say bankers, money managers, and finance experts interviewed for this article. For decades, London has profited from the forces making the world’s capital markets more open, liquid, and efficient. The financial-services industry employs more than 1 million people, generates almost £70 billion in annual taxes, and delivers a trade surplus of £58 billion.
Deal or no deal, Brexit throws sand into those gears—“frictional costs,” in the words of Matthew Chamberlain, the chief executive officer of the London Metal Exchange. Plus there’s the economic toll of a divorce. On Oct. 26, Royal Bank of Scotland Group Plc set aside £100 million to cover the fallout from a recession or other adverse effects from Brexit. No matter what happens, it’s hard to see how the City comes out of this ahead. “Inevitably we are going to lose some business,” said Catherine McGuinness, the chairman of the policy and resources committee at the City of London Corporation, which governs the financial district.
With five months left to go, there are still many possible outcomes, including a snap election and the installation of Labour Party firebrand Jeremy Corbyn in 10 Downing Street, a scenario that frightens City denizens even more than Brexit. One thing does seem certain—if Britain drops out of the EU with no deal, the City of London will swerve from a trajectory set in the 1960s. That’s when its financial engineers created Eurodollar bonds, debt denominated in U.S. currency that could be issued by any company outside the U.S. These handy instruments helped drive globalization and channeled a river of money through London. After Margaret Thatcher deregulated financial services in the so-called Big Bang of 1986, the City became the undisputed gateway to what would become the world’s biggest trading bloc, the European Union.
Now that the U.K. is opting for isolation, the City’s role as a portal to Europe will diminish for years to come, say economic historians. If there’s no deal, U.K.-based firms would face severe restrictions on EU-related business, and half the City’s revenue tied to the bloc, or £20 billion in annual revenue, would be at risk of slipping away, according to consulting firm Oliver Wyman. So, too, would 35,000 jobs and £5 billion in tax revenue. And perhaps most poignant, there would be a chilling effect on new investment in the industry.
“It would be a defining moment,” said Emmanuel Mourlon-Druol, an economic historian and author at the University of Glasgow. “And the damage wouldn’t just be financial—it’s also a question of reputation. The U.K. government would be seen as unreliable, incompetent, and unaware of the consequences of its decisions.”
Taking in the Square Mile on a radiant autumn day it’s hard to believe a place this vibrant might lose its swagger. The cone-shaped Gherkin tower, once a lonely symbol of the City’s prosperity, is now surrounded by construction cranes erecting taller neighbors shaped like trapezoids and parallelograms. Across from the stone ramparts of the Bank of England, men and women socialize in the area’s hottest new club, The Ned, a palatial former lending house where guests sip cocktails inside a giant vault. And everywhere you can see the symbiosis of the City’s heritage and a digital future. On weekday afternoons, dealers wearing suits take their positions on the red sofas of the trading ring at the London Metal Exchange and buy and sell copper, aluminum, and tin the old-fashioned way—with their voices and hand signals. One floor below, table-tennis-playing entrepreneurs are hatching financial startups in a cushy WeWork-like space.
It’s possible, of course, that at the last minute British and EU leaders will strike a deal, and this crucible will come to an anticlimactic end. Remember the brinkmanship that preceded the resolution of the Greek debt crisis in July 2015 and dispelled fears of “Grexit.” Optimists say there’s too much at stake for both sides to let the U.K. crash out of the bloc.
Stephen Jen, CEO of Eurizon Slj Capital Ltd., a London hedge fund, is betting both sides will come to terms in December. He’s told clients that his valuation model shows the pound’s fair value at $1.55, 22 percent higher than its price on Oct. 31. “I just can’t imagine that after so many months of negotiations we wind up with no deal,” Jen said. “Brexit cannot be seen as a success from the European side, so there has to be a struggle. And Brussels is playing this quite well.”
Perhaps, but big banks can’t afford to wait on political breakthroughs. And the U.K. government isn’t even pushing to maintain the status quo for lenders after Brexit. To ensure they can continue serving European customers with little disruption no matter what, some may be preparing to ratchet up their long-standing Brexit plans. JPMorgan Chase & Co., for one, has long said it would shift several dozen employees to Dublin or Paris or other European cities. The idea was to establish an appropriate presence in EU markets but maintain the bulk of trading operations in London. But now top executives at JPMorgan are discussing whether to dispatch more senior traders and compliance personnel to Paris or other locales, according to people familiar with the bank’s Brexit planning. The London trading floor is buzzing with speculation that an escalation is in the works, say the people, who declined to be identified talking about internal matters. A JPMorgan spokesman said that the bank, which has been preparing for a hard Brexit for two years, isn’t ramping up its plans.
Goldman Sachs Group Inc. and Standard Chartered Plc are already increasing the number of people they’re dispatching to Frankfurt. Commonwealth Bank of Australia said this week that it’s setting up a subsidiary in Amsterdam, and people familiar with its plan say there will be positions there for as many as 50 traders, research analysts, corporate bankers, and sales staff. French President Emmanuel Macron and his fellow European leaders have wooed City institutions with tax incentives and promises to streamline regulations. For the past two years, regulators at the European Central Bank and other agencies have pressed institutions to do more than set up “empty shells” in the bloc. Even so, the recent moves suggest there’s now a bigger shift of trading operations in the works.
“In some initial Brexit planning, firms were thinking they would be more reliant on London-based people,” said Andrew Gray, a partner at PwC who advises financial-services companies on Brexit. “Some firms have shifted their plans and may be looking for commercial opportunities. Can they take a bigger share of business in the EU because they are more ready than competitors?”
Banks are also rushing to figure out how a hard Brexit will affect as much as £69 trillion in derivatives contracts with EU counterparties that are processed through U.K. clearinghouses. For the past two years, market participants assumed that lawmakers on both sides of the English Channel would make sure that come March 29 derivatives would continue to function as if Brexit wasn’t happening. The reason was simple—corporations around the world use interest-rate swaps and similar contracts to minimize their exposure to adverse moves in the capital markets. London-based LCH Ltd., the world’s biggest clearinghouse for interest-rate swaps, processes contracts worth more than $3 trillion in notional value every day. The last thing anyone wanted to do was upset this marketplace.
Yet that’s precisely what might happen in a no-deal Brexit. Under EU rules, market participants in the bloc have to process derivatives through a clearinghouse based in a member state or through one in a foreign country that has been approved by EU authorities. So unless a stopgap is adopted, market players will have to transfer their contracts from London to clearinghouses in Paris or Frankfurt or close them out. “That will be disruptive and costly,” the Bank of England's Financial Policy Committee said on Oct. 3. “Timely action by EU authorities is needed to mitigate risks to financial stability.”
Frustrations are mounting on the lack of clarity on the issue. At a breakfast symposium in October, a senior executive at UBS Group AG said the derivatives issue must be resolved well before the March 29 exit because LCH requires 90 days’ notice before transferring contracts. But the banker expressed bewilderment at the alphabet soup of regulatory agencies in the EU bureaucracy. “December 28 is the drop-dead date, not March 29, so who is the decision-maker?” he asked the morning’s featured speaker, Andreas Dombret, a former member of the executive board at Deutsche Bundesbank.
Dombret, an unflappable mandarin who’s done stints at Rothschild and Bank of America Corp., acknowledged the query with a smile. “There are so many important questions that we have to answer,” Dombret told the meeting, which was hosted by Zeb, a German consulting firm. While he was not speaking in an official capacity, Dombret suggested that European technocrats were quietly toiling on their own set of emergency measures. “I don’t see a financial stability risk,” Dombret said. “This event has been coming for a long time.”
In recent days, EU officials have been trying to reassure the markets that they won’t let a no-deal Brexit disrupt derivatives clearing. On Oct. 30, Valdis Dombrovskis, a vice president on the European Commission who oversees financial services, said that companies in the EU would be able to continue using British clearinghouses after March 29 even if there was no transition.
“Should we need to act, we would only do so to the extent necessary to address financial stability risks,” Dombrovskis told the Financial Times.
As welcome as such relief might be, the measure would be temporary and subject to “strict conditionality,” the commissioner said. Moreover, Brussels is still weighing a number of other restrictions that are likely to increase costs and hassle for banks and traders. “It’s not an ideal situation,” said Sarah Jane Mahmud, a Bloomberg Intelligence senior government analyst in London.
There’s a danger that the prospect of a hard Brexit is already taking a toll on another invaluable City asset—its reputation as an outstanding place to do business. Three years ago, Eric Daniel and Damien Regnier, a pair of French money managers who made their careers at Citigroup Inc. and Deutsche Bank, formed their own investment fund around a novel strategy involving convertible securities. They had 15 institutional clients and €45 million ($51 million) to start with, and, after registering their fund in Luxembourg, they settled on three potential locations for their headquarters: Paris, London, or Luxembourg. The Grand Duchy had the most efficient regulatory environment, and Paris was where most of their clients were based, but, like so many ventures with global aspirations, they chose London. “In terms of the business development atmosphere it was the opposite of Paris—dynamic, stable, efficient,” said Regnier, a chatty man with longish hair.
Today, the Tyndaris Convertible Fund manages €385 million from an office adorned with abstract art on London’s Savile Row. It’s been easy to connect with customers using the Eurostar to Paris. But for the past two years, Daniel and Regnier have become chagrined by the instability and inefficiency wrought by Brexit. The irony of Macron’s push to make Paris more business-friendly isn’t lost on them. “If we were to launch today, we would keep the fund registered in Luxembourg and open an office there or in Paris,” Regnier said.
Even if there is a deal, that will only mark the end of phase one in this story. The negotiations that have been causing so much trouble these past months will cap only the U.K.’s separation from the EU. Both sides will then have until December 2020 to forge a comprehensive agreement that defines their future relationship, including financial services. While many Britons may have voted for Brexit to escape the bloc’s onerous business rules, the City could wind up entangled in even more red tape. That’s because London will have to reconstruct its regulatory connections with Brussels, and while much of that may look the same as now, there could also be variations, which adds complexity. Moreover, the 27 remaining members of the EU could introduce new rules unilaterally.
“Everyone thinks we’re going to end up with a bonfire of the regulations,” said Gina Miller, the money manager who successfully sued for parliamentary approval of Brexit and is campaigning for a second referendum. “But we’ll have to maintain some form of alignment. Uncertainty won’t be off the table for years.”
The question now is if there’s no deal come December, will there be wild swings in the markets?
Luke Pledger is no soothsayer, but he is a currency trader. On the morning of Oct. 18, Pledger, who manages the sterling desks at BGC Partners Inc., is monitoring the impact of May’s lack of progress in Brussels. The trading floor at BGC, an interdealer broker that plays middleman for the world’s biggest banks on transactions involving derivatives, currencies, and other securities, is humming. Traders on the currency desks, phones in each ear, are shouting numbers at one another while bells ring and screens flash with prices. A stand filled with burritos and tanks of coffee is parked steps off the floor.
It’s actually a pretty mellow day in the market, Pledger said. There’s a feeling on the floor that a no-deal Brexit has been predominantly priced into the pound-U.S. dollar trade ever since May’s talks with EU leaders broke down in Salzburg, Austria, on Sept. 21, he said. In recent days, the threat to May’s leadership has piled more pressure on the currency.
As for the best-case scenario, Pledger said that’s easy. “We’d wind up with regulatory equivalence, no issues on derivatives clearing, participation in the single market and also the ability to forge our own trade agreements, and a low corporate tax environment,” the trader said. “That would be Christmas.” He paused for a moment. “But I don’t believe we’re going to get that.” —With Lisa Pham, Viren Vaghela, Will Hadfield, and Silla Brush
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