Brexit: The Future of London Financial Services
By Simon Hull, Head of Financial Services at BJSS
On the 24th December 2020, after four long years and the expected last minute drama and brinkmanship, the UK Government announced a trade deal with the EU that came into effect on the 1st January.
There was a sigh of relief for financial services firms who feared the worst outcome of a no-deal Brexit. A deal that provides tariff-free trade with the EU is a positive for the economy and the corporate clients of financial services firms.
However, Boris Johnson himself admitted the deal failed to meet his ambitions for financial services. As the details of the future trading relationship with the EU emerged, it was clear this was far from the end of the story.
LOSS OF PASSPORTING
It’s hard to underestimate the importance of the financial services industry to the UK. It contributed 6.9% of total GDP in 2019 and, according to a new report on behalf of the City of London Corporation, a record £75Bn in tax receipts (11.6% of total).
The deal did not include any provision to maintain the financial services passporting system that had allowed UK based financial services firms frictionless access to EU markets, and vice versa.
Instead, this has been replaced by the concept of equivalence. Equivalence is an EU concept that allows the recognition of non-EU regulatory regimes to be equivalent to a corresponding EU regime. When equivalence is granted, cross-border business can proceed.
WHAT DOES THIS MEAN ON DAY ONE?
As things stand, the EU has granted equivalence in areas deemed vital for financial stability, such as the key financial infrastructure of London clearing houses which manage trillions of dollars of derivatives contacts daily. Equivalence excludes some services such as retail banking, so UK retail banks have already closed the accounts of EU-based customers. This is not ideal during a time of prolonged low net interest margins (NIM) for the banking industry.
For most other business activities, the ability to serve EU clients from the UK depends on an equivalence being granted some time in the future. However, financial services firms have been preparing for the full range of Brexit scenarios for the last four years. Since this time, EU-based subsidiaries have been established with key functions such as risk and finance. Firms have already moved 7,500 jobs and £1.2 trillion of assets from the UK to the EU, according to EY’s Brexit tracker, to avoid any disruption in servicing EU-based clients. It is therefore expected that clients will continue to be served without significant issues from a combination of UK and EU entities.
WHAT HAPPENS NEXT?
The future trading relationship for financial services companies remains unclear. It is subject to ongoing negotiation to grant equivalence for the range of activities performed in the UK. The lack of equivalency impacts both access and also the friction and cost of doing business.
To grant equivalence for certain business activities, the European Commission performs an assessment after which equivalence can be granted, either partially or in full, and for a certain time limit. This is a tried and tested process that enables the EU and its global trading partners to work together.
Lack of equivalence could lead to inefficiencies and fragmentation in certain areas of the market, such as trading of EU-denominated securities. Euro-denominated trading in some asset classes such as equities is expected to leave London, for example. However, London Portfolio Managers can still manage EU based funds.
Even with equivalence granted, the degree of additional friction and cost entailed still needs to be understood. This could have a direct bearing on the viability of certain business lines. In the digital age, the rules regarding data sharing will also be critical in understanding the impact on business operations.
Reduced cross-border people mobility and the loss of mutual recognition of professional qualifications is another issue that will be closely monitored and could have long term implications for business operating models.
Equivalence can also be withdrawn at one-month’s notice, so even if granted, there will be ongoing uncertainty, which must be mitigated through contingency planning such as being ready to service business from EU locations.
The big issue the EU has with equivalence, and the reason it is not as straightforward as it may seem to grant it is the potential for future divergence. It is granted based on the regulatory and supervisory regimes at a point in time, but these regimes could subsequently diverge. An element of reassurance and trust is needed, something that has not always been present through the four years of negotiation. The European Commission seeks further clarification on this point before it will make additional equivalence assessments.
The Christmas Eve deal does talk about a stable regulatory co-operative framework, so there is a starting position to give hope that a positive spirit of close cooperation will exist.
However, “taking back control” has been a key theme for Brexit. The UK Government will want to use the newly acquired sovereign power to review current regulations, and changes will inevitably follow. Rishi Sunak said that Britain will look to “do things a bit differently” on financial services. Still, at the time of writing, there have been no details released on how this may look.
There is also pressure to move more UK based business activity to the EU. The European supervisory authorities would like to see this. Major EU financial hubs such as Frankfurt and Paris would love to make some more ground on London, which remains Europe’s top financial centre.
What has been committed is that the EU and UK plan to work closely in early 2021 to establish a memorandum of understanding for financial services by March. I would expect a data adequacy decision to enable sharing and safeguarding of personal data, access for trading EU-listed shares to avoid market fragmentation and derivatives trading to be high on the agenda.
WHAT CAN FINANCIAL FIRMS DO?
For UK firms, the regulatory and business uncertainty remains. The ability to monitor, interpret and react to changes in rules will be critical. While the equivalence determination for various activities will be eagerly awaited, firms must plan for both outcomes. If equivalence is granted for an activity, there remains a possible impact on business and operation models, and the future threat of it being revoked.
On a more positive note, as the UK starts to use their newfound regulatory freedom to identify areas to change, this could present opportunities to existing UK businesses where they offer competitive advantage. For example, the government have stated they plan to make London more attractive as a listing destination.
At BJSS we work closely with financial services clients to help them solve these challenges. We have worked on many regulatory projects where we have acted as strategic advisors to clients to help them interpret and plan a course of action as regulation changes. We then build adaptable business and technology models that enable them to do this quickly and seamlessly.