By Nicolas Veron, March 2021
After orderly Brexit, a new European financial landscape starts to emerge
The United Kingdom’s exit from the European single market on January 1 has sent trade in goods plummeting amid much confusion. By contrast, Brexit was carried out in an orderly manner in the financial sector, despite significant movement of trading in shares and derivatives away from the City of London. After five years of radical uncertainty, it has become clear that the European Union and the United Kingdom will be taking separate paths on financial regulations, a financial “decoupling” that means significant loss of business for the City. Whether the EU financial sector can gain much of what London loses will depend on the European Union’s willingness to embrace further financial market integration.
Smart sequencing ensured orderly Brexit for the financial sector
Like the Y2K problem, the Brexit transition could have gone worse. It took more than luck to avoid financial instability along the way. First, financial firms on both sides of the Channel (and of the Irish Sea) worked hard and were able to pre-empt most of the operational challenges. Second, despite all the recurring high-stakes drama between the UK government and the European Commission, the technical cooperation between the authorities actually in charge of financial stability, primarily the Bank of England and the European Central Bank (ECB), appears to have run smoothly.
Third, the negotiators phased the process in a smart way. The Brexit Withdrawal Agreement of January 2020 helped reduce uncertainty by ensuring that the UK government would meet its financial obligations to the European Union, avoiding what would have been akin to selective default. That agreement kept the United Kingdom in the single market during the transition period beyond the country’s formal exit from the European Union on January 31, 2020. It also set a late-June deadline for the British government to extend the transition period beyond December 31, 2020. As London decided not to do so, that left six months of effective preparation. To be sure, whether an EU-UK Trade and Cooperation Agreement (TCA) would be concluded remained unknown until late December. But that mattered comparatively little for financial services, since trade agreements typically do not cover them much. By one count, the 1,259-page TCA (which is still unratified by the European Union) contains only six pages relevant for the financial sector.
The resulting legal environment for financial services between the European Union and the United Kingdom is unlikely to change much any time soon. Contrary to occasional portrayals in the United Kingdom, no bilateral negotiations on financial services are going on, except for a memorandum of understanding expected this month that is not expected to bind the parties on substance. From the EU perspective, the United Kingdom is now a “third country,” in other words an offshore financial center, following decades of onshore status. UK-registered financial firms have lost the right, or “passport,” to offer their services seamlessly anywhere in the EU single market. From a regulatory standpoint, they have no better access to that market than their peers in other third countries such as Japan, Singapore, or the United States.
The European Commission is unlikely to grant equivalence status to most UK financial market segments any time soon
Some segments of the financial sector in these other third countries actually have better single market access than British ones, because they are covered by a category in EU law allowing direct service provision by firms under a regulatory framework deemed “equivalent” to that in the European Union. The equivalence decision is at the European Commission’s discretion, even though it is based on a technical assessment. As a privilege and not a right, equivalence can be revoked on short notice.
So far the Commission has not granted the United Kingdom any such segment-specific equivalence, except in a time-limited manner for securities depositories until mid-2021 and clearing services until mid-2022. For the moment the Commission appears to be leaning against making the latter permanent. In most other market segments, the Commission will not likely grant equivalence to the United Kingdom in the foreseeable future. This may appear inconsistent with the fact that almost all current UK regulations stem from the existing EU body of law. But the UK authorities (including the Bank of England) have declined to commit to keeping that alignment intact.
The Commission’s inclination to reduce EU dependence on the City of London is understandable. No comparable dependence on an offshore financial center has existed anywhere in recent financial history. Such dependence entails financial stability risk. In a crisis, UK authorities would not necessarily respond in a way that preserves vital EU interests. Think of the Icelandic crisis of 2008, when Reykjavik protected the failing banks’ domestic depositors but not foreign ones. It is hardly absurd for the European Union to try to reduce such a risk, even if—as appears to happen with derivatives—some of the activity migrates from the United Kingdom to the United States or other third countries as a consequence, and not to the European Union.
At the same time, the argument that keeping EU liquidity pooled in London is more efficient than any alternative is unpersuasive given the European Union’s own vast size. In addition, the Commission also follows mercantilist impulses to lure activity away from London, even though these generally do not make economic sense. Added up, these factors provide little incentive for the European Commission to grant equivalence status to more UK financial market segments, unless some other high-level political motives come into play. None are apparent right now.
The UK is unlikely to regain lost advantage in the EU through financial regulatory competition
How the European Union and the United Kingdom will decouple will not be uniform across all parts of the financial system. Regulatory competition between them may become a “race to the bottom” or “to the top,” depending on market segments and the circumstances of the moment, without a uniform pattern. In any case, such labels are more a matter of judgment in financial regulation than in, say, tax competition. In some areas the European Union will be laxer, in others it will be the United Kingdom, as is presently the case between the European Union and the United States. For example, the European Union is more demanding than the United States on curbing bankers’ compensation but easier when it comes to enforcing securities laws or setting capital requirements for banks. At least some forthcoming UK financial regulatory decisions may be aimed at keeping or attracting financial institutions in London, but they are still not likely to offset the loss of passport to the EU single market.
All these permutations suggest that the medium-term outlook for the City of London is unpromising, although the COVID-19 situation makes all quantitative observations more difficult to interpret. Once an onshore financial center for the entire EU single market, and a competitive offshore center for the rest of the world, the City has been reduced to an onshore center for the United Kingdom only and has become offshore for the European Union. That implies a different, in all likelihood less powerful, set of synergies across the City of London’s financial activities.
The few relevant quantitative data points available reinforce this bleak view. Job offerings in British finance, as tracked by consultancy Morgan McKinley, have declined alarmingly since the 2016 Brexit referendum. The ECB (as bank supervisor) and national securities regulators coordinated by the European Securities and Markets Authority are tightening requirements for key personnel to reside mainly on EU territory rather than in the United Kingdom. As noted by Financial Times columnist Simon Kuper, many financial firms’ Brexit policy until this year had been to “sit tight and do nothing until post-Brexit arrangements for finance forced [their] hand.” That phase has ended. Firms that drag their feet face regulatory disruption, as happened to broker TP ICAP in late January. Tussles between regulators and regulated entities, rather than between the European Commission and the UK government, are where most of the financial-sector Brexit action is likely to be in 2021. These disputes typically happen behind closed doors, and the regulators typically hold most of the cards.
For all the optimistic talk in London of “Big Bang 2.0 or whatever,” the United Kingdom’s comparative advantage as the best location for financial business in the European time zone is unlikely to recover to its pre-Brexit level. The macroeconomic losses could be moderated or offset by cheaper currency and less expensive real estate in London, making the city a more attractive place to do nonfinancial business. Even so, a gap will likely remain for the UK government, which has for years depended heavily on financial-sector-related tax revenue.
The European Union stands to gain financial activity as a consequence of Brexit. How much and where is not clear yet. As some analysts had predicted, Amsterdam, Dublin, Frankfurt, Luxembourg, and Paris are the leaders for the relocation of international (non-EU) firms. Dublin and Luxembourg specialize in asset management, Frankfurt in investment banking, and Amsterdam in trading. But EU success in terms of financial services competitiveness and stability will depend on further market integration, the pace of which remains hard to predict. The European banking union is still only half built, because it lacks a consistent framework for bank crisis management and deposit insurance. The grand EU rhetoric on “capital markets union” has yielded little actual reform since its start in 2014. Events like the still-unfolding Wirecard saga may force additional steps toward market integration, even though a proactive approach would be preferable. The one near certainty is that London’s position in the European financial sector will be less than it used to be.