Brexit white paper and what it means for financial services

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24 AUGUST 2018

On Thursday 12th July, the British government published its Brexit ‘White Paper’ following a tortuous weekend at Chequers, the Prime Minister’s country retreat. After two years of kicking the can down the road, the UK finally has a negotiating position that spells out its vision of what the future EU relationship should look like. This is only a starting position, and Michel Barnier at the European Commission will undoubtedly seek to water it down with further concessions. Nonetheless, it is important to analyse the document not only to assess its implications for financial services, but also because it tells us what the Government’s priorities in the negotiations are.

For the City and the financial service industry, the document contains three core areas of interest:

1.Facilitated Customs Area
Firstly, the White Paper proposes a “Facilitated Customs Area”, which would only cover trade in goods, including agri-food. The Customs Union in all but name, the system would involve a complex tariff collection process whereby the UK would collect tariffs on incoming goods bound for the EU on behalf of the Commission, whilst retaining the ability to set its own trade policy for goods whose final destination would be the UK. The myriad of confusion during the initial implementation phase of any new tariff system provides significant business opportunities surrounding regulatory compliance. Already, the private sector has bought 80% of all Brexit related consultancy advice, compared to 20% for the public sector. Government bodies will likely need to spend more on consulting services advice once Britain’s final deal is clear.

2. Loss of passporting rights
Secondly, the government’s plans for the service sector are significantly more disruptive. Despite constituting almost 80% of GDP, securing frictionless access for the City has been discarded in favour of the possibility of “regulatory flexibility” and the “potential trading opportunities outside of the EU” . What this means in practice, is that the likely outcome of any Brexit deal will be highly disruptive for financial services, as European market access is significantly curtailed. The UK will be treated as an average third-party country; and the government itself recognises “that the UK and the EU will not have current levels of access to each other’s markets”. In short, London is likely to lose its ‘passporting’ rights, which currently grant it unhindered access to the European market. The new regulatory regime relies on securing “equivalence” instead of the ‘mutual recognition’ desired by the City. Affirmation of equivalence is reliant on continual conformation to EU regulation, and any violations can lead to its revocation with only thirty days’ notice. Moreover, the equivalence option does not entirely match the financial passport for market access, leaving banks especially vulnerable to EU regulation that have specific location and delegation requirements.

This loss of market access has implications for financial services;

Relocation, efficacy and costs
Oliver Wyman estimates that 40-50% of EU related business could be at risk of leaving the City under a loss of mutual market access scenario. New entrants would be disincentivised to use London as a base for their European market activities, and smaller firms with limited exposure to the EU market may decide to abandon their European business altogether, instead of opening a subsidiary.

Europe benefits from London’s significant locational economies of scale: financial service firms are clustered together and there are numerous auxiliary services (lawyers etc) nearby. Any fragmentation of this ecosystem will have negative productivity implications for all parties, as the benefits of economies of scale diminish. A recent report has highlighted how the size of a bank directly relates to a lower cost-income ratio, because it benefits from scale economies. Across the financial sector it is estimated that an increase in the cost-income ratio (from industry fragmentation), would cost banks £1.625bn in corporate cost increases. This cost would ultimately be transferred onto the client.

Moreover, banks and insurance providers are likely to have to hold higher levels of capital to satisfy both sets of regulators, consequently increasing their costs. Utilising Solvency II, UCITS Directive and the AIFMD, EU regulators are likely to prevent insurers and fund managers from simply opening an EU ‘letterbox’ office to pass the subsidiary test. They will be required to move key staff and sufficient capital at all levels to satisfy regulatory compliance. In turn, these would impact the ability and costs to European based clients when securing credit.

Impact of a reduction in market activity on market liquidity
European governments and businesses rely on London’s deep pools of liquidity to secure cheap credit in its capital markets. The governor of the Bank of England, Mark Carney, described the City as “Europe’s investment banker”, with over half the equity and debt raised by Eurozone companies being issued in the UK. The White Paper poses a risk to these liquidity pools; because it threatens to fragment market activity throughout Europe, raising costs for all parties. The same report evidences that the existence of a greater number of market makers, and correspondingly larger balance sheet sizes, results in lower liquidity risk premiums, and so cheaper credit for corporates. Therefore, if there is a reduction in market activity from London, the accompanying reduction in balance sheet sizes and market liquidity will increase the cost of raising finance for all parties across Europe.

Derivatives, Clearing and Contract continuity
London’s dominance of the Euro denominated derivatives trade may be under threat now that it is clear the government aiming for a sharp break from the current EU financial regulatory regime. It is improbable that the EU will have any future regulatory oversight over UK financial services, therefore Euro-derivatives clearing (of which 75% is cleared through London) is unlikely to continue in its current form. The EU has already walked back from its threat to force these Euro denominated swaps to take place onshore after Brexit. However, it is likely to want to maintain some regulatory oversight over an area that is systemically important to European financial stability, the White Paper does not address this. Another risk is that any protectionism by the ECB over Euro-denominated swaps would cause the Federal Reserve to follow suit, and demand all dollar-denominated derivatives are cleared through mainland USA. Again, any fragmentation of open markets pushes up costs for all parties involved.

Moreover, the Paper does not address the legal continuity of £26tn of derivatives contracts and 36m insurance contracts, which, unless a deal is agreed pose a serious risk to Europe’s financial stability. Whilst there is significant uncertainty, some lawyers have argued that existing English contract law, the international law of acquired rights and the EU’s right to property provide sufficient protection. There is also a joint Bank of England/ECB working group attempting to provide clarity over the contracts issue.

3. Ending free movement
Whilst the White Paper does not go into significant detail over migration, it is clear that freedom of movement will end after the UK leaves the EU. This is of serious concern for the City, given that almost 11% of the City’s workforce is constituted by non-British Europeans, and that the UK possesses structural skill shortages of highly skilled financial professionals. More details on the specifics of the UK’s future migration policy will be known in a separate immigration White Paper, due to be published in Autumn 2018. Nonetheless, it is looking more likely that this migration policy will resemble current visa arrangements with close non-EU allies, with scope for visa free short-term business travel.

Conclusion, future shift towards emerging markets? (esp. China)
In the longer term, the now likely loss of access to the EU Single Market is likely to lead the City to attempt to offset this through a stronger emphasis on in emerging markets. London is quickly becoming the principal offshore centre for listings of the Renminbi, as China seeks to dislodge the US Dollar as the global reserve currency. For example, London already accounts for 62% of RMB payments outside of China, giving the City a firm “first mover advantage over New York”, whilst in October 2014 London hosted the first ever issuance of foreign denominated debt in Renminbi. This business is only likely to continue, as the City needs to account for a decline in EU market activity. Whether emerging market can compensate equally for this shift appears unlikely at present. Perhaps the City will have to compete harder for business with less moral scruples, as seen by the controversial softening of listing rules to make it more attractive to the Saudi Aramco IPO.

As explained throughout, the government’s plans for a clean break from European financial markets are not reassuring for the City, and financial services. Firstly, it may undermine the significant economies of scale and deep pools of liquidity that exist in the London markets. Secondly, serious uncertainty remains not only over contract continuity, but also over whether the City can maintain its pre-eminence as a hub for Euro-denominated derivatives clearing. Finally, the ending of freedom of movement also threatens the ability of firms to recruit highly skilled staff and to move them seamlessly throughout Europe.


Financial Times, Management consultancy clients torn over when to act on Brexit, 18th January 2018
Statement from HM Government (Chequers), 6th July 2018
Oliver Wyman, ‘The Impact of the UK’s Exit from the EU on the UK-based Financial Services Sector’, 2016
PWC, ‘The impact of Brexit on Financial Services in Europe’, 2018, p.20
Financial Times, ‘Carney warns EU against freezing out the City’, 30th November 2016 Ibid, 24
Financial Times, A plausible vision for the City of London’s future, 12th July 2018