Report: Brexit & the City: some initial reflections

January 2021 • Topic: Rebooting UK capital markets post Brexit • by William Wright

In the past few weeks, it has been quite surprising to see how many people appear to be surprised that the UK’s financial services industry / the City ended up with so little from the Brexit deal, or that there would be an immediate impact on some parts of the industry. This short paper summarises where we are, how we got here, and where we might go from here. In short:

• financial services was always going to end up with a ‘No Deal+’ Brexit;
• the decision to largely exclude the industry from the negotiations was a deliberate decision by the UK (though this should not be confused with the UK getting what it wanted);
• this approach was compounded over the past few years by the politics of the Brexit negotiations;
• the short-term impact is pretty binary and negative for some sectors but has probably been overstated for the industry as a whole;
• it is probably unwise to invest too much hope in a ‘deal’ on financial services in the next few months;
• post-Brexit the UK has an opportunity and imperative to recalibrate and reinvigorate its own markets and it will have to work hard in the coming years to avoid structural damage to the City’s international position.

1) Where are we?

As we have been warning for the past year, financial services has ended up with a ‘No Deal+’ Brexit: in other words, virtually nothing. There is very little of substance on finance services in the trade deal itself, and the blow has been softened a little with two equivalence decisions (clearing and settlement). To be clear, this is a lot better than a straight ‘No Deal’ Brexit, which would have caused significant economic and market disruption, and poisoned the political relationship between the UK and the EU.

• A thin deal: the text on financial services agreement is boilerplate stuff: a broad agreement to apply international standards, non-discrimination on the basis of nationality of firms established in each other’s markets; and some visa-free business travel. Unlike the UK-Japan trade deal, there is no formal structure for regulatory cooperation (yet). The agreement contains a non-binding declaration to develop a framework for future cooperation in the next few months. It was something of an understatement when the Prime Minister said ‘perhaps we didn’t get quite as much as we would have hoped’ on financial services.

• Equivalence: outside of the agreement itself, the UK has equivalence in just two areas (clearing and settlement): in both cases this is because the EU considered it was in the EU’s interests to grant equivalence, and in both cases it is time-limited. This is worse than our expectation that the EU would offer equivalence in clearing, settlement, share trading and derivatives trading, as well as a suite of more technical / less controversial areas of equivalence.

• Australian-style: the irony is that while the UK government insisted last year that it had nothing to fear from an ‘Australian-style’ trade deal (euphemism for ‘No Deal’), in financial services it has ended up with what might be described as ‘Australia minus’: Australia, more than 10,000 miles from London, officially has better access to EU financial markets than the UK (it has equivalence in 19 areas, just behind Canada on 20 and the US on 23).

• Shooting itself in the foot? This outcome has inevitably triggered a widespread response that the City has been hung out to dry, thrown under a bus, and sacrificed in favour of fishing etc. Some sectors may feel that way but overall we don’t think it has – as we’ve argued before – but if you’re surprised then you haven’t been paying attention.

2) How did we get here?

A deliberate approach: most importantly, the outcome for financial services is the direct result of a series of deliberate decisions by the UK government (though that should not be confused with ‘the UK got what it wanted’). Here are four specific ‘deliberate’ decisions taken by the UK that have steered us to where we are:

• Get Brexit done: there is no such thing as a comprehensive trade deal in financial services apart from the EU itself, which has taken decades to create and which is far from complete. Including financial services in the negotiations would have consumed so much time and political capital that it would have jeopardised a goods-only deal and the government’s top priority of ‘getting Brexit done’.

• Cause and effect: once you decide to leave the single market & end free movement of people, you effectively close down the possibility of a ‘deal’ in financial services. That decision was taken in September 2016 by Theresa May and the direction of travel has been set ever since.

• Big enough to cope: it’s far easier for a bank or an asset manager to adapt to Brexit by relocating part of its business to the EU than it is for a car manufacturer. While it is a huge headache and additional costs for many firms, this has been government policy for years: David Davis MP told the industry that it was strong enough to stand on its own two feet and didn’t need special government support in October 2016 when he was Brexit secretary.

• Too important to cede: the City is widely seen in government and by supervisors to be too important to be tied to a market and regulatory framework in which it has no say (‘to be regulated by email from Brussels’). That the financial services industry is 200 times bigger than fishing in the UK is more of a reason – not less – to exclude it from the deal and to ensure that the UK can regulate the industry as it sees fit. Intriguingly, this has opened up a divide between the industry and its supervisors: many people in the industry are agnostic as to where the rules come from and would prefer for economic and operational reasons for the UK to remain closely aligned to the EU. Supervisors and regulators, however, are less keen to be tied to a rulebook in which they have no say. As Andrew Bailey said last week, it would be ‘problematic’ to sign up to equivalence if it meant becoming a rule-taker.

An accidental outcome: while the exclusion of financial services from the deal was largely the result of deliberate decisions, there are some more accidental reasons for ending up where we are:

• Asking for the moon: from the beginning, the UK set unrealistic expectations and was asking for the moon. The Bank of England’s proposal of mutual recognition of standards in exchange for access was dismissed out of hand by the EU. Equally, talk of inventing a new form of equivalence – super, enhanced, reformed, permanent, or comprehensive – for the benefit of a country that had decided to leave the EU was doomed from the start (though, funnily enough, may now be resurrected by the EU).

• British exceptionalism: a hubristic approach in the first few years after the referendum didn’t help. Arguments like ‘the EU needs the City more than the City needs the EU’ or ‘they wouldn’t dream of cutting off EU companies from the City’ had the disadvantage of being wrong and poisoning the negotiations at the same time.

• Cakeism: the UK and the EU have taken a different approach to equivalence from the start. The UK has simultaneously argued that equivalence should be a strictly technical exercise, that it should be granted ‘day one’ equivalence across the board because its rulebook would be exactly the same as the EU’s on the day after the end of the transition period, and that it wanted to diverge over time. The EU has argued that equivalence is about long-term alignment and convergence (so it can’t offer equivalence until the UK explains how far and when it wants to diverge). The EU has also treated it as a political process, even if it has never quite admitted as much. It has also moved the goalposts in some areas, arguing that it cannot agree equivalence because it is in the process of updating its own rulebook.

• The politics of banking: the City has struggled to make its voice heard in government since the referendum. It was not welcome in No 10 (where it was seen as being too close to the Remain campaign), it had to compete with more sensitive sectors (such as cars, pharma, and fishing), it doesn’t win many votes on the doorstep, and was not united in its ‘ask’ of government because different firms / sectors have very different interests.

• Powerplay: all trade deals are an expression of economic power and in some key areas the EU had the City over a barrel: it knew that most UK-based firms would move whatever they needed to move to the EU in order to continue to do business with EU clients. The EU wants to repatriate some business and build its own capacity: it sees Brexit as a once in a generation opportunity to rewind the clock 20 years. If the UK had got a ‘deal’ or lots of equivalence, fewer firms would have moved less stuff to the EU. Like it or not, the EU’s approach has worked so far.

3) So, what is the problem?

• The end of the world? Many of the headlines over the past week have suggested that Brexit has been a disaster for the UK and for the City, or that the UK has shot itself in the foot while simultaneously shooting the ball into the back of its own net. Yes, in sectors like trading in EU stocks, the inevitable shift in activity from the UK has been binary and painful. But, most importantly, the end of the transition did not cause significant market disruption or financial instability, and there have been no reports of any significant operational failures. This is testament to the huge amount of work that hundreds of firms and regulators have put into contingency planning over the past four years. In simple terms, Brexit now means that some EU business that used to be conducted in London will have to move, a lot will be largely unaffected, but there is a significant amount of activity where it is less clear cut.

• A limited economic impact: the immediate economic impact has (at least so far) been relatively limited. Some sectors of the industry have been torpedoed by the deal / lack of deal, but for most sectors it is a an expensive and wasteful but manageable headache. Those firms directly affected by the binary outcomes from the lack of agreement have incurred significant additional costs. Platforms like Aquis, Cboe Europe, Turquoise or Liquidnet can no longer trade EU27 stocks in London so have had to set up platforms in the EU with duplicate costs and staffing. For many firms in asset management and insurance, it has been a legal / administrative exercise. The biggest economic impact has been for banks and investment banks which had significant EU operations previously headquartered in London.

• Fishing vs finance: while the obvious comparison has been drawn between finance (7% of GDP, 1.1m jobs, 11% of tax receipts) and fishing (0.4% of GDP, 12,000 jobs), much of the industry has not been affected at all or only marginally. Around 50% of the revenues in banking and finance in the UK are domestic and aren’t going anywhere. The remaining half is split roughly equally between EU business (not all of which will be affected by Brexit) and the rest of world business. If you assume that 10% of the industry’s business in the UK has to move to the EU over time (and the ECB says that around 11% of total bank assets in the UK have moved or will move), that would translate into around 1% of total UK tax receipts potentially lost as a result of Brexit. That’s a big number, but not the end of the world.

• Relocation: given the uncertainty around Brexit over the past five years it was inevitable that some business would relocate regardless of the outcome of the negotiations. Our research suggests that more than 400 financial services firms in the UK have moved something somewhere to the EU in response to Brexit (we will be updating this analysis in March). These moves range from expanding an existing local presence or moving the domicile of some investment funds at one end of the spectrum, to moving hundreds of billions of dollars and hundreds of staff at the other.

• Brexodus? The absence of a deal means that the substance of these relocations will probably increase in the next few months. Our analysis of jobs lost tallies with research by EY at about 7,500 so far with another few thousand new jobs created in the EU. For all the commentary that this is a lot lower than previous forecasts, it is in line with the Bank of England’s forecasts back in 2017 of up to 10,000 jobs on ‘day one’. And it should be stressed that we see this as a first wave, and that over time this number is likely to increase. In June 2016 we estimated that in the medium-term something like 35,000 to 50,000 jobs may have to move and we think the lower end of that range is still a reasonable forecast.

• The known unknowns: there are two big unknowns around the future impact of Brexit on the City. First, to what extent will the rest of world business conducted in London yesterday in its capacity as a gateway to the EU continue to be conducted in London tomorrow? One way of measuring this is to look at the distribution of assets across the EU from banks outside the EU – in other words, where US, Swiss, Japanese, Canadian etc banks choose to locate their business in the EU. As of the end of 2019, three quarters of these assets (€3.1 trillion) were in the UK and just a quarter were in the EU27. From the relocations we know about, this ratio has probably already fallen to 60% / 40% and may eventually fall below 50% / 50%.

• The EU’s response: second, how will the EU’s position on Brexit and the City evolve? We think the EU is more likely to feel emboldened by the past few months than to offer any gifts back to London. It has successfully repatriated EU equity trading and some derivatives trading, and relocated hundreds of firms, hundreds of billions in assets and thousands of jobs. The bigger threat for the UK in the medium term is that the EU tries to force more business to relocate. For example, it has been explicit with the granting of equivalence for clearing that it expects firms to increase their local clearing activity in the EU (which may in turn lead to more trading activity moving with it). It is also reviewing potential changes to the delegation regime in asset management, which may eventually force more of the management of assets (rather than merely the domicile of an investment fund) to relocate. It is likely that the EU will use the next few months to clarify what can and cannot be done from London.

What happens next?

We are where we are with Brexit, whether you like it or not. Here are some initial thoughts on the outlook for the next few months and how the UK can respond to Brexit in the longer term. For a more detailed analysis of these options, please refer to a playbook of 25 recommendations from our recent report on ‘Beyond Brexit’:

• Deal or No Deal? The trade deal includes a non-binding commitment for the EU and the UK to agree a memorandum of understanding on future cooperation by the end of March. It would be dangerous to set expectations too high as to what this might include, and suggestions that it may lead to a deal with significant amounts of additional access for the City are unrealistic. On equivalence, having just repatriated a significant chunk of business from the UK, the EU is unlikely to let it head back to London anytime soon by granting equivalence for equity and derivatives trading.

• Formal cooperation: a more likely outcome is that the MOU will establish a more formal framework for regulatory cooperation between the UK and EU, along the lines of the agreement between UK and Japanese regulators or the regular dialogue between supervisors in the UK and US. Despite Brexit, cooperation between regulators in the UK and EU will be a fact of life given their proximity and inter-connected systems, but it needs a formal structure. The MOU may also include some revisions to the equivalence process, to make it more transparent and predictable (something the EU was not prepared to discuss until the UK had actually left), and some additional equivalence agreements in more technical / less controversial areas such as capital requirements, cross-border exposures, and audit.

• A false dichotomy: much of the Brexit debate has focused on the trade-off between access on the one hand and alignment / divergence on the other. We think this is a false dichotomy. While many firms are keen for the UK regime to stay broadly aligned with the EU for economic and operational reasons, this alignment is unlikely to gain any significant additional access for the UK. Instead, given where we are, it makes more sense for the UK to think in terms of treating the dislocation from Brexit as a sunk cost and take the hit on the chin.

• Access in hand: the relocation that has already taken place will provide most firms with the access they need to EU customers and markets on the other side of Brexit. With this access in hand, the UK will then be free to rethink and recalibrate its supervisory framework to the unique dynamic of the UK financial services industry. This selective divergence – what Rishi Sunak has called ‘the opportunity to do things slightly differently and better’ – is unlikely to be ‘Big Bang 2.0’ but instead will be more gradual and in many cases the future UK framework will look remarkably similar to the EU’s.

• Recalibration: the big opportunity and challenge for the UK on the other side of Brexit is where and how to recalibrate the framework that it has inherited from the EU and tailor it to the unique dynamic of the financial services industry in the UK. An EU framework covering 28 members states with vastly different financial sectors is inevitably more cumbersome. Now that the UK has more unitary control, there are plenty of areas where it can adjust its framework accordingly. Some examples include: rethinking Solvency II to help unlock the huge pools of long-term capital in the UK that are mainly invested in government bonds; reviewing the prudential supervision framework for UK banks to ensure they remain competitive; and addressing some of the rougher edges of EU regulations (aspects of Mifid II, PRIIPs etc).

• The bigger picture: there is a separate urgency and opportunity to reinvigorate capital markets in the UK. The UK listings review is focusing on how to encourage more tech and growth companies to list in the UK; there is a big opportunity to develop green finance and the fintech industry; and the UK will need capital markets to help rebuild the economy on the other side of Covid. To be clear, these are not areas where the UK was being held back by the EU (issues like the free float requirements for IPOs or dual class share structures are set by individual member states, not the EU). Instead, this highlights the role of Brexit and Covid as a catalyst for change: to challenge each sector of the industry to think ‘how could we do this better?’.

• A new world order? The EU is a big and addressable market on the UK’s doorstep and the barriers to trade in financial services will inevitably mean that some of the EU-related activity that was previously conducted in London will in future be conducted in the EU itself, but there is a danger in overstating the risk. In some sectors such as FX and derivatives trading, the UK has a share of more than 80% of EU activity and the vast majority of that will continue to stay in London.

• Future partners: Without the UK, the EU’s share of global capital markets activity falls from just over a fifth to about 13%, and in relative terms, that share will shrink in future as markets in Asia and North America grow faster. This raises the question of how closely the UK wants to remain aligned to the EU and sets the context for the UK global ambitions. While the geopolitical backdrop is acutely challenging, we think there is an opportunity to develop trade in financial services and closer partnerships with markets like the US (currently 27% of UK trade in financial services), Japan (6%), Switzerland (4%) and other smaller markets such as Singapore and Australia.

• Building on its strengths: in particular, the UK’s expertise and experience in key sectors – trading, derivatives, fintech – and its track record as an open international financial centre mean that it can and should play an important role in future in partnering with other countries to help shape global standards and develop new markets. Ultimately, while the UK cannot afford to be complacent, Brexit dents but does not fatally undermine the many factors that over decades have helped make London a dominant financial centre. While the EU is (not unreasonably) defining what business must be done in the EU, the UK should concentrate on being a financial centre where people want to do business.