Preparing for the Post-Brexit Landscape
The British decision to withdraw from the EU represents the most significant shift in UK politics in a half-century. Although the terms for a successful withdrawal are not yet finalised, the British government’s current approach does not include an equivalent customs partnership with the EU. Brexit therefore poses a significant risk to the UK-based financial services sector as financial services firms may be left without direct, frictionless access to the EU marketplace.
The current outlook (and the approach preferred by the UK government) will leave financial services firms with no direct, frictionless access to the EU market. The UK government is seemingly pursuing an approach that will result in the UK not forming an equivalent customs partnership with the EU prior to leaving the existing union.
Currently, the UK benefits from the EU “Passporting” regime which allows a dually-authorised firm in an EEA country (including the UK) to provide cross-border services or advice in another EEA country or to set up a branch in an EEA state. If the UK leaves the EU without finalised terms for future integration or relationships, UK firms that have been providing services to European clients under the Passporting regime will have to cease certain activities or relocate entities, offices and staff to Europe.
Figure 1: UK-based firms and their ties to the EU
If the UK proceeds with Brexit as currently proposed, financial services firms must then confront four key questions:
- Where should these firms relocate to?
- How will the trading workflow of financial services firms have to change?
- How will existing relationships with clients, suppliers, vendors and counterparts change?
- How will Brexit impact the macroeconomics that make London an economic hub for financial services?
Relocation: suitable financial services capitals
If the UK exits the Passporting regime, UK-based firms may not be able to provide financial services to European clients and their associated portfolios. Banks and firms that wish to continue to provide services to those clients will need to establish new, or utilise, to a greater extent, existing European entities.
Firms that have established headquarters in UK but operate across Europe will be confronted by long-term operational decisions: will London or Europe constitute the base for all future activity? Access to European clients requires a duly authorised European entity but London has mature infrastructure, support services and experienced staff. 
One approach would be the adoption of a “hub and spoke” approach where a new central hub would be established for all services. Many European cities have been considered and discarded, highlighting the unique combinations of factors that drove London to its position of prominence. For instance, Paris has unpopular labour laws and mandates an average of 36 hours worked per week. Amsterdam caps bonuses at 20% of annual salary and Brussels has a staggeringly high corporate tax rate of 40%, although it is due to be reduced to 29% in 2020.
That being said two frontrunners, Frankfurt and Dublin, have emerged. Of the two, Frankfurt has the most overt support as UBS, JP Morgan and Goldman Sachs have all purchased office space in preparation for a move. Frankfurt has the benefit of supervisory stability and influence as the European Central Bank (ECB) is also located in the city. However, the relative strength of German employment law and the high level of German employment make a proposed move an expensive proposition.
Already a centre for the European tech sector, Dublin has an English speaking population, low corporate and personal tax rates, and an educated work force. Numerous investment funds are already domiciled in Ireland. However, the city does not have the infrastructural support of Frankfurt: there is an on-going housing and schooling shortage and a very high cost of living.
Figure 2: Financial Services Firms’ Potential Post-Brexit Locations
As of the time of writing, no senior leadership roles have been transferred from London and firms including JP Morgan, Goldman Sachs, Société Générale and CA-CIB are still appointing new senior positions in the British capital. However, transfers for operational and non-managerial staff have already begun. UBS moved 200 employees to Frankfurt, Standard Chartered moved 20 jobs to Frankfurt and Goldman Sachs relocated 70 employees to Stockholm.
What is noticeable in these numbers is that they do not mirror the thousands of jobs that analysts and commentators predicted would be lost prior to the referendum vote; some estimations went so far as to say that 10,500 jobs would be lost on the first day alone. Current projections put the numbers of jobs lost at less than 5,000 over the course of the withdrawal, but this number may shrink further. Banks are suggesting that any dramatic job losses would occur over a decade and would therefore not come as a sharp shock.
Figure 3: Where UK Banking Jobs Might Be Heading
The debate over relocation will no doubt evolve as details of the final Brexit deal become clearer and as the UK begins to redefine their legal and economic relationship with the EU. Although financial services firms may hold out hope that not all their staff and services will necessitate a move to Europe, in light of the costs, time pressures and uncertainties associated with leaving London, firms need to start planning for an unceremonious and unsupported Brexit. Pre-emptively establishing new entities is a relatively straightforward manner of reducing risk.
How Will The Trading Workflow of Financial Services Firms Adapt?
Regardless of the location of their operations, financial services firm must maintain the ability to trade securities and manage portfolios. For UK-based firms looking to provide services to European clients, securing Passporting rights is essential. Many believed that firms engaging in back-to-back trading could maintain a minimal office presence in a European city but still keep their substantive operations and decision-making hubs in London. However, the ECB clarified that they would not tolerate any ‘brass-plate’ or ‘letter box’ entities and reasonable levels of local staff and risk management would necessitate their approval. Firms looking to maintain their primary European headquarters in the UK will need to weigh their appetite for risk accordingly.
Following the Brexit vote, the ECB declared that it would move to ensure that all Euro clearing will occur within the Eurozone. A previous attempt in 2015 to restrict Euro clearing was rejected by the European Court of Justice largely due to arguments made on behalf of British interests. A second attempt post-Brexit would likely see greater success although there are concerns amongst European banking leaders and politicians that the market would not tolerate a situation where London would suddenly cease clearing operations.
Even if the ECB allows euro clearing to continue outside of the Eurozone, another issue looms for European banks. Under EMIR, OTC derivatives must be cleared by a Central Counterparty Clearing House (CCP). Currently, the LCH and authorised UK-based clearing houses can clear securities under the MiFIR regulations. However, once the UK leaves the EU, UK-based clearing houses will instead be seen as third-country entities and would not be approved under MiFIR/MiFID II. While a country can be deemed equivalent under the various EU regulations, the process is lengthy. There is currently no plan to have an equivalency assessment of the UK completed by the end of the transition period and no guarantee that such an assessment would be successful, leading to a regulatory obligation to clear trades but an inability to do so compliantly in the UK.
The impact of Brexit on global FX could be just as dramatic as firms may look to move trading activity out of London. $5 trillion a day is traded and booked in London’s currency markets but Passporting requirements and changes to clearing could threaten the continued vibrancy of that market.
London FX’s market is broadly driven by low latency trading with major banks attesting that up to 90% of FX trades are conducted on electronic systems in one way or another, with around 1/3 of trades involving no human intervention at all. The quantity of trading occurring with no human interaction places demands on the network infrastructure, which is difficult to quickly and cheaply replicate.
Interestingly, trading venues have acknowledged a relatively straightforward approach to operating post-Brexit. While the European Banking Authority (EBA) has said that banks are not permitted to ‘brass-plate’ their European operations, trading venues are already setting up subsidiaries in Europe while still maintaining operations in the UK; both TradeWeb and MarketAxess have established themselves in Amsterdam to continue providing services to European clients. Having access to trading venues cannot be underestimated as under MiFID II, certain Equity instruments, Interest Rate Swaps and Credit Default Swaps must be traded on an European Economic Area trading venue.
Delivering services across a new international border?
For financial services firms, questions of location, staffing, trading and clearing are intricately complex. The question of how those firms will interact with their clients, suppliers, vendors and counterparties is a new obstacle entirely.
If a firm no longer has a cross-border licence to provide or perform those contracted services through the Passporting regime, a number of important contractual questions arise. Would it be illegal for the firm to exercise rights or perform obligations under a contract with a European counterparty? How will the obligations under the contract be enforced and how can these contracts be changed?
It is possible that these questions will be addressed head-on in the final withdrawal bill and grandfather potential problems with existing contractual relationships into the post-EU legal landscape. Rather than wait for an answer to these questions, many UK firms are looking to transfer existing contracts to a European entity which would constitute a painful and lengthy re-papering process.
The process of transferring existing contracts will be complicated unless there is an initial analysis of the firm’s existing contracts and whether they are, on a case-by-case basis, impacted by the new regulatory regime based on the underlying service and client. A firm will need to assess every contract it is party to determine whether the contract in question is for a service that is exported or imported and therefore impacted by cross-border rules. Only once these assessments are completed, the firm can start the process of engaging with clients to determine new relationships. Clients may need to be moved to a new entity, which will require additional contractual documentation to ensure that adequate compliance, KYC, AML, and risk management is in place. Additionally, if the newly established European entities do not share their British predecessors’ credit ratings and are therefore seen as having poor credit worthiness, they will be commensurately less popular parties to trade with, ultimately producing poorer results for the underlying clients.
A firm may need to select new suppliers and vendors, especially if the vendor is not offering services outside of the EU. Depending on what is agreed upon regarding the export of services between the EU and the UK, providing a services may no longer be affordable or even legal. The provision of cross-border services will only be complicated by the new data protection rules that firms will operate under, such as the General Data Protection Regulation (GDPR) which will make it far harder for firms to move data between the UK and the EU, as the UK will not have ‘adequate’ data protection under the regulation.
As the UK is currently compliant with EU data protection rules there is a good likelihood that the UK would be assessed to have adequate protection and therefore able to transfer personal data to and from the EU. That being said, there is no guarantee of a successful assessment or even a timeline for a proposed assessment process. As such, firms looking to move data between the EU and the UK face uncertainty, and likely heightened regulatory scrutiny.
Market shocks and capital realignment
The UK is a global financial centre with a material portion of business coming directly from EU clients or from activity related to the EU, such as trading in EU equities or clearing Euro-denominated derivatives. Currently around £200 billion in revenue is generated annually through financial services, of which around £50 billion is related to the EU.
Financial services firms may decide that their cross-border activity is no longer worth the cost of relocating offices, moving and hiring new staff, establishing new entities, re-papering clients and ensuring regulatory compliance, which all require huge investments of time and money. While all firms will have to analyse their exposure, it is likely that financial services firms with limited cross-border exposure may have to withdraw their cross-border client business. Such a decision, combined with a decoupling of EU and UK clients, will lead to reduced or fragmented levels of capital available in London, which could lead to clients experiencing an asymmetry of service. European capital will relocate to whichever city ends up replacing London as the new hub for European trading and UK clients would additionally see a reduction in the quality of received services.
This market shrinkage, especially in wholesale and investment banking capacity, could also precipitate a short-term reduction in market making activity, which adversely impact the depth of market liquidity, and therefore the ability for financial services users to trade and the cost of finance. In the event of this instability, firms would need to reconsider where they trade as well as where the available liquidity is across their European and British entities. As entities come to grips with an evolving landscape, ensuring prudent risk management would be essential.
Transition Period: Uncertainty and risk
Following the triggering of Article 50, the UK will leave the EU at 11pm March 29th 2019 but it is now broadly recognised that not all details will have been finalised by that date and a further transition period will be implemented until 31st December 2020. Crucially, during this period, financial services will continue as if the UK was still part of the EU and firms will be subject to EU regulations while still enjoying the benefits of the passporting regime.
Figure 4: Brexit’s Possible Timelines
While the transition period would present a greater window for firms to engage with the issues highlighted in this article, and determine how they wish to confront the challenges set out, the reality for firms is that they can’t begin to take advantage of the transition period until it is clear what they are transitioning to. 
It is not clear, though it appears likely that it will not be available until October 2018, when guidance will become available on the future regulatory regime that the UK will be operating under and how UK based financial services firms will be interfacing with the EU.
Uncertainty over the timing and particulars of Brexit complicate any attempt to effectively and definitively manage the competing complex demands. As such for firms, the only approach they can take is to prepare for the plan that is currently proposed by the UK government. In such a scenario, where the UK financial services sector has no framework in place to engage with the EU, firms will need to have engaged with and answered the above questions before the transition period even begins. Of course, even if firms start now, the lead time to implement some of the necessary changes, such as the registration, approval and staffing of new EU entities, can far exceed the time allowed by the transition period. Firms may need to make decisions without final certainty, and remain agile in their approach to managing their own internal Brexit transition, in order to avoid any interruptions to their service.