Market liquidity is essential to the creation of an efficient and effective capital market. Capital markets enable credit providers (investors) to price the credit they provide as short-term (because the bond they own can be sold tomorrow), whilst issuers get long-term funding (since they are indifferent to the fact that the bond has been bought and sold). The deeper and more liquid the market, the more effectively this process works.
Liquidity, in turn, is provided by dealers. In particular, dealers who are prepared both to buy and sell securities in their own name, and to promise to buy and sell securities to market participants in order to keep markets liquid (often referred to as ‘market makers’). These dealers are sometimes traditional banks, sometimes investment banks, and sometimes specialist trading businesses. In general, the larger the positions that these dealers are prepared to take, and the longer they are prepared to hold them for, the more liquid the market will be – they are, in effect, the buyers and sellers of last resort, and their presence emboldens other market participants. However, since all securities dealers are (by definition) regulated investment firms, they cannot take risk or hold positions unless they have enough regulatory capital to do so. Thus, a good proxy for the liquidity of a market is the amount of capital which dealers in that market have available to support their trading inventories, and the size of the inventory which that capital can support.
The liquidity of a market is therefore proportional to the size of the trading inventories of the market makers.
But the fact is that European banks and firms are reducing the amount of capital committed to supporting market liquidity, and their ability to leverage that capital is, at the same time, being reduced.
After the financial crisis, bank regulators significantly increased the capital requirements for banks engaging in market-making activity. This increase resulted in a corresponding decline in bank trading positions, and therefore in market liquidity, globally. Policy-makers argued that this reduction was a net benefit to the financial system, since the reduced prospects of a crisis resulting from increased capital more than offset the resulting loss of market efficiency.
The cost of reduction
However, the interesting question for us is the gross cost of that reduction. Bank of England researchers estimated that the resulting increase in costs of trading in the bond markets resulted in GDP being 0.2 per cent smaller than it would otherwise have been
A further point that the Bank of England researchers made was that bond and loan markets are closely connected, since bond markets, being public, are generally used as reference points for the pricing of loan finance. Thus a widening of spreads in the bond markets will tend to drive up bank loan rates. This means that an inefficient bond market will tend to have a detrimental effect on costs of business finance even in regions (such as continental Europe) where business is predominantly loan-financed rather than bond-financed.
More importantly, those EU firms which are global market participants face a choice as to where to allocate their increasingly scarce capital. The less open the EU market is, the less liquid it will be, and the less likely it is that non-EU firms will wish to (or be able to) commit capital to that market.
In general, the more liquid the market, the less important intermediary capital is. For example, an investor in highly sought after short-term US treasury paper will be confident that they will be able to find buyers for that instrument regardless of the capacity of the market. Therefore, in the bonds of larger governments, the most liquid equity markets, and the bonds of a few very large corporates the need for intermediation is reduced and there has been a move towards fast, electronic trading. This does not, however, apply to the equities of smaller firms, nor even for the equities of big companies, where liquidity in times of market turbulence may be at risk in the absence of intermediaries. In corporate bond markets, which are generally highly illiquid, the effect is even greater.
The upshot: if European firms are deprived of access to the intermediaries in the London market, which is by far the largest and most open capital market in Europe, the question of where and to whom they can sell these instruments will become important.
The EU and the world
If the supply of capital within Europe is unable to meet the demands of European businesses, the EU should make sure that its markets are as open as possible to capital providers from elsewhere in the world. Such an approach would, however, give EU legislators and regulators – who worry that increased non-EU participation in EU capital markets will undermine regulatory standards – cause for concern. These concerns, and the measures put in place to address them, will determine how open Europe’s capital markets will be post-Brexit.
While London was embedded within the EU, the focus of EU policy-makers was on improving EU market regulation, with measures to prevent market abuse and improve business conduct, for example. However, some argue that the effect of these measures was a soft closing of the EU’s markets, with firms required to obtain EU authorisation and subject themselves to EU rules in order to be permitted to participate in European markets.
Brexit has significant implications for the impact of those measures. The ‘soft closing’ which was designed to protect EU markets now runs the risk of isolating them from the largest financial centre in Europe. The EU has taken the view that the UK is not a special case, and that, post-Brexit, EU law should be enforced in the same manner as it was before.
This problem is enhanced by the (understandable) tendency in Brussels to look holistically at EU-UK arrangements and attempt to eke out negotiating levers in every aspect of regulation. In particular, it believes that, since access to EU customers is a priority for UK firms, the denial of such access is a potential negotiating tool for the EU.
However, the EU’s own equivalence rules would make it extremely difficult for Europe to apply actively discriminatory measures to the UK without applying equivalent measures to American, Asian and other foreign firms. As such, any ‘raising of the drawbridge’ against the UK would mean raising the drawbridge to international finance in general.
In the immediate aftermath of the Brexit referendum, many in Europe hoped that the problem would resolve itself by financial firms relocating from London to the EU. It now seems unlikely that this will happen, at least in the short-term. Firms are establishing subsidiaries in the EU and will book transactions with EU counterparts with those subsidiaries, but their guiding minds will remain in London. This configuration may change over time but is unlikely to do so immediately. Consequently, there is scope to examine the fundamental issue which will face EU financial services policy-makers post-Brexit: how open should EU capital markets be to non-EU participants?
The case for closed markets
The argument for a closed approach is borne of a desire to protect Europe from exogenous shocks. After Brexit, unless the British have a change of heart and pursue a much closer relationship than currently envisioned, the EU will be in the uncomfortable position of having no regulatory control over the financial market its economy relies on for access to global capital markets. This situation is by no means unique – Canada, Mexico, Russia and many other major economies are all in the same position – but it will significantly alter the EU’s perception of its own role in the financial world. This loss of control is also viewed – correctly – in Brussels as a significant reduction in the ability of EU regulators to protect EU citizens. It would be difficult for European policy-makers to simply accept this outcome as a fait accompli – there is too much at stake.
Viewed from this perspective, a closed EU capital market has its attractions. The fewer the direct links between EU and UK financial firms, the lower the risk of contagion were a crisis to hit London. And if EU banks could be persuaded to deal only with other EU banks on EU trading platforms, then the EU could regard itself as having restored its sovereignty in this area.
The case for open markets
A closed market approach has drawbacks, however. For one, an insulated EU capital market would be too small to finance the EU economy efficiently. EU companies, savings institutions and other market users would be forced to relocate a significant proportion of their activities outside of the EU to enable continued access to global markets. Flows of inward financial investment into EU economies, which currently enter via the London market, run the risk of being diverted away from the EU.
To complicate matters further, capital markets in the EU are currently supervised by national, member-state, authorities, and there is no collective desire to move to an EU-wide model. There is a logic to this approach – different member-states have different fund-raising and investment needs and, indeed, ideologies and outlooks on financial markets. The core issues mirror those in the macro-economic sphere. How much risk sharing is necessary and how much risk reduction does there need to be as a pre-requisite? There is no scientific answer to this question; it is inherently political.
The departure of the UK will affect non-euro member-states the most in respect of their relationship with the EU’s banking and capital markets unions. The British played a key role in the design of the mechanism by which non-euro member-states could join the banking union, if they so choose. While the CMU is not a euro-related project, the sensitivities of countries such as the Czech Republic, Denmark, Poland and Sweden have to be accounted for, even in the absence of a loud voice fighting their corner. More importantly, it is a gross oversimplification to reduce EU protagonists to France, Germany and the departing UK. Luxembourg, the Netherlands and Ireland are examples of countries with important interests in the development of European capital markets.
Conversely, if the EU were to embrace the underlying logic of the CMU proposals, it would facilitate the access of large global financial institutions to the EU market. That would create a significant EU market, substantially expand the proportion of global financial activity under the EU’s direct regulatory control, and amplify the EU’s voice in global financial forums. However, this approach would significantly enhance the links between the EU and global markets, and therefore expose the EU to financial crises that arose elsewhere. Also, such an approach would result in significant pressure being exerted on the EU to accommodate its regulatory approach to global standards, and thereby to reduce its scope for idiosyncratic policy measures.
European markets – open or closed?
It appears that there are good arguments for both open and closed European financial markets. However, this is a false dichotomy. It is true that maintaining an open approach to financial markets would expose the EU to global market fluctuations. But it is not true that maintaining a closed approach would protect it from those fluctuations. When the US’s secondary mortgage securitisation market went into meltdown in 2007-8, the result was not a regional collapse in the US, but a more general collapse in credit markets worldwide. Indeed, a closed market strategy which produced a thin and anaemic market would probably leave that market more, rather than less, vulnerable to external shocks.
Closed markets are not the answer. However, fully open markets threaten the EU with a complete loss of regulatory control. The answer must therefore be a compromise that gives Europe some involvement in the formulation and implementation of regulation in the London markets. The British authorities should not be resistant to the EU having that involvement, any more than they are resistant to the EU having a voice in global financial regulation: the EU has legitimate interests and is one of the largest customers of the London market. Conversely, if the EU is satisfied it has sufficient say in the regulation of London, there ceases to be any good reason to place obstacles in the way of London firms servicing EU clients.
The obvious mechanism for a co-operation agreement of this kind would be a joint policy-making forum between the UK and the EU regulatory authorities, with formal structures in place governing supervision and enforcement of institutions active in both markets. While informal arrangements do exist – such as those the UK have with the US – they only work because they have been developed over many years and are well understood by market participants. If such an arrangement is to be created between the EU and UK from scratch, over a short period, it would be preferable if it were accompanied by some degree of formality – if only to reassure market participants.
The EU may resist such entanglement by relying on equivalence. Equivalence has the enormous advantage of autonomy – the EU can declare a counterparty to be equivalent or not as it sees fit. This creates the possibility of equivalence being used as a tool to obtain indirect regulatory involvement in third countries – the idea being that a third country can be persuaded to adopt EU rules under the threat of lost equivalence. However, equivalence is a big stick but a small carrot. It can be used as regulatory leverage in those circumstances where equivalence is currently in place, is relied upon significantly by market participants, and where the threat of derecognition would have a significant negative effect on the third country concerned. (Although the attempt to use this weapon against Switzerland in 2018 over equity trading is widely regarded as having been a failure). However, once equivalence has been refused, market participants will make other arrangements to execute the business in question. And once such arrangements have been made, it is unlikely that obtaining equivalence will be a significant policy objective for the relevant government in the future. The more easily banks and others can deal with EU clients without equivalence, the less valuable the offer of equivalence becomes as a bargaining chip.
A policy conundrum
The EU has already demonstrated that a deep, liquid and globally connected capital market is important for the European economy. More importantly, the days of financial autarky are gone, and Europe cannot bring them back. Europe must accept that its future is as a participant in the regulation of global financial markets, and seek to maximise its involvement in those markets, and its voice in their regulation.
There are a number of aspects to this. One is full participation in the global standard-setting bodies for bank, securities and accounting regulation – in Basel, the International Organisation of Securities Commissions (IOSCO), International Accounting Standards Board (IASB) and other venues – with the concomitant obligation to implement those standards domestically. Another is involvement in the existing transatlantic dialogue with US regulators and standard-setters. The most important aspect, however, is the relationship with the UK, and in particular the regulators and supervisors of the London markets. Regardless of the legal form of the arrangement, the EU needs to ensure regular exchange of information, deep supervisory co-operation and joint policy-making on new issues between EU and UK authorities. This could have been best managed through a mutual recognition arrangement – but such an arrangement was always a London pipe-dream; the EU will not accept mutual recognition in financial services, and there was never any chance of it being extended to an exiting country. In the absence of legally binding measures, formal, institutionalised co-operation should remain the ultimate objective of supervisors and regulators on both sides of the channel regardless of the legal form of the eventual settlement between the UK and the EU.
