One might be forgiven for thinking that the debate on the future of financial services in Europe after Brexit is exclusively the reflection of a struggle to win or retain business on both sides of the Channel. The reality is somewhat more complex. Beyond the unsurprising confrontation of different economic interests, the debate has several dimensions that need to be brought together to get a sense of where the European financial services industry is headed.
Financial services firms based in the UK generate today circa £ 150 bn. per annum of revenues and, if ancillary services are included, £ 225 bn. These numbers represent respectively 8% and 12% of British GDP. It is estimated that up to 20 % of the revenues of the City of London are related to services sold into the EU single market and will therefore be impacted.
Four key issues…
Among the numerous questions raised by Brexit, four will be key to shaping tomorrow’s landscape for financial services in Europe.
1. What legal regime will prevail after Brexit for City of London firms to service the EU 27 single market?
City of London firms selling services into the EU single market have relied so far on the so-called European financial passport. A European passport is an authorisation granted by the financial regulator of a member state that is valid throughout the Union. Financial passports are granted at a very granular level: according to the Financial Conduct Authority, 5,500 City-based firms rely today on 336,421 passports to conduct business in the European Union.
By definition, an authorisation granted by a UK financial authority after Brexit will not be an authorisation granted by a regulator of a member state. Therefore financial activities authorised only by the British regulator will lose, from the day of Brexit, their passport status to access the EU single market.
In theory, a so-called “third country equivalence regime” could also give UK regulated firms access to the EU market. But EU 27 authorities are working to adapt the regime as it was always intended to be a tool to open the EU market for incremental (and relatively marginal) business from third countries but not to be the main mechanism to regulate financial activity. It must also be noted that if the UK wanted to benefit from the EU equivalence regime, it would need to follow the future evolutions of European financial regulation and become a European regulation taker when it used to be a regulation maker. Given the momentum of British political life, this does not seem to be a likely scenario.
All in all, the predictability of the future third country equivalence regime and of its implementation is not sufficient for City firms to serve as the legal basis of the deployment of their EU business after Brexit. This leaves City of London firms conducting business in the EU only with the choice of relocatingto the EU their operations requiring a passport.
2. Will the European economy be able to access the financial services it needs without London after Brexit?
Capital markets funding services are based on the ability of issuers to access the pools of investors they need via investment banking teams analysing, selling and trading their securities. Given that there is no such thing as a “London financial market”, a “Paris financial market” or a “Frankfurt financial market” but rather different global markets for different financial products, the fact that investment banking teams relocate from London to an EU 27 financial centre will have no impact on their ability to service investors and issuers and, therefore, on market liquidity nor on the cost of funding of issuers. This is also the case for hedging services and derivatives’ trading : four EU banks are among the world main derivatives players and those banks will continue to service their customers from their home country after Brexit. It can also be expected that their American, Swiss or British competitors will choose to relocate to cities based in EU 27 member states. Provision of hedging services to the European economy after Brexit will therefore not be impacted, notwithstanding the question of the continuity of existing contracts that needs to be addressed carefully.
What is true for investment banking activity is also true for commercial banking, insurance and asset management : City professionals face without doubt a significant, and potentially costly, challenge to reorganise their operations to be able to service their EU clients after Brexit. But, in a world of abundant capital and high competition between financial services providers, this will have a limited impact for their customers (for instance, the direct provision of loans by UK-domiciled banks to euro area non-financial firms, stood at the end of 2016 at 1% (€ 67bn) of total loans
3. What substance will be required by national regulators from City firms relocating their activities in EU 27 member states?
What will be the substance of the relocation of financial services firms moving from London to an EU 27 city? What will European national regulators require from those firms? Will a light local implementation with the bulk of the functions still operated from London be considered sufficient or will national authorities require a complete local implementation to grant an authorisation? In short, will a simple letter-box located in the EU suffice or will there be an EU-wide requirement for a minimum level of substance of operations?
This question is the topic of an important debate between EU 27 national regulators and it has led the three European Supervisory Authorities (ESMA, EIOPA and EBA) to issue strong principles against the lowering of authorisation standards, “empty shells” and “letter boxes”. Whether the issuance of those principles will prove sufficient to address the temptation that some EU national regulators might have to attract business by lowering standards will determine to a significant extent the materiality of the relocation of City firms towards the EU 27. More generally, it will be a test of the ability of the European Union to put European rules above the specific economic interests of its member states.
4. What organisation for the clearing of euro-denominated financial products after Brexit?
The clearing of euro-denominated derivatives products is today highly concentrated in London, where LCH Ltd., owned by the London Stock Exchange, is the dominant player with a 70% market share and a daily activity of more than € 800bn for euro-denominated
European regulators’ clearing dilemma is to strike the right balance between a principle of free competition that would effectively lead to the clearing of euro-denominated financial products to remain concentrated in London (clearing has a strong economy of scale dimension for customers as the higher the concentration of positions in one clearing house, the more cost-effective the process) and a financial stability objective that pushes European regulators to want to see the activity relocated in the Eurozone so that they can regulate and supervise it.
The proposal made on 13 June 2017 by the European Commission to review the European Market Infrastructure
Towards the emergence of a multi-polar financial system…
London will remain Europe's main financial centre post-Brexit, but the previous trend towards the concentration of the European financial industry in a single centre will be reverted. The extent of this phenomenon will depend on the outcome of the debate between European regulators on the substance they should require from City firms relocating to the EU 27 to grant a passport. In any case, Brexit will not have a significant impact on the ability of the European economy to access the financial services it needs or on the cost of funding of European corporates and households.
Publications related to Brexit
Institut Friedland, « The day after: post-Brexit dynamics of European finance », October 2016 : “The day after: post-Brexit dynamics of European finance”.
Institut Friedland, « European financial services after Brexit », July 2017 : “European financial services after Brexit”.
Armour J. & Eidenmüller H. (Eds), Negociating Brexit, Beck-Hart-Nomos Publishing, August 2017.
