Boris Johnson’s adviser Dominic Cummings is fond of the concept of “different branches of history” — how a series of pivotal moments determined the course we travelled on and where we ended up.
Superficially, one might imagine that if and when the withdrawal agreement that the UK prime minister has negotiated with the European Union is enacted, the mist will clear for the UK’s finance sector.
But, as Cummings might put it, many branches will lie in store for the UK’s capital markets, which will each lead them in a different direction.
How EU member states react to the new circumstances will have a strong influence — especially, how successful they can be in their revived determination to complete Capital Markets Union. So will the commercial decisions of financial firms.
One of the most important forks in the road will be whether the UK stays in the Single Market. This looks unlikely, but by now if you still take anything involving Brexit as a certainty you have not been paying attention. Single Market membership would give firms continued access to EU markets through so-called passporting.
But if the UK leaves the Single Market, the decision tree blooms outwards, with various trade-offs and no clear end.
The UK could seek equivalence (with the EU recognising that the UK’s regime is equivalent to its own), or attempt to include financial services in a free trade agreement, or simply use World Trade Organisation rules.
Meanwhile, any UK decision to sign an agreement with another jurisdiction outside the EU could close off the possibility of closer European alignment. And the reverse applies: hugging close to the EU could hinder the UK’s ability to set different rules and strike deals with other countries, although trade deals tend not to involve much in the way of financial services anyway.
If the UK were to change its regulations on a particular issue, the EU would be likely to see this as a competitive threat and respond by toughening its rules, for example by requiring that more business serving EU clients take place on EU soil.
Rule-takers or rule-makers?
If those are the options for the government, what are they likely to hear from the regulator and the industry?
For its part, the Bank of England does not want to be a rule-taker.
The cynical view is that it is simply keen to hang on to its powers. It may also be a case of a politically aware organisation trying to sail with the prevailing winds. “[Governor Mark] Carney’s just very good and clever at picking up on political desires,” says John Cronin, financials analyst at brokerage Goodbody in Dublin.
But there is also logic to the Bank’s preference. “I absolutely have sympathy with what they’re saying,” says Kate Sumpter, a partner in Allen & Overy’s financial services regulatory practice in London. “They would prefer to be in a position to write their own rules if they are not in a position to influence them. While we have been a rule-taker as part of the EU, we’ve also had a very loud voice at the table, particularly in the financial services space.”
Nicolas Véron, senior fellow at think tank Bruegel in Brussels and at the Peterson Institute for International Economics in Washington, has less sympathy, in part because he thinks the EU would be unlikely to enact legislation particularly and specifically harmful to the UK.
As for the finance industry, it has had to prepare for a No Deal Brexit, but favours closer alignment with the EU. A close relationship would “give them the optionality to make a business-driven decision as to whether they maintain their two entities [or] collapse one entity into another,” says Vishal Vedi, a partner in risk advisory at Deloitte in London.
But strength of feeling over this may have waned because UK firms are already set up for a hard Brexit, with entities in EU countries able to conduct business there.
Some may think that if the UK aligns closely with Europe, this would obstruct their UK arms from opening up access to other markets.
So while the downside of a hard Brexit may now be limited, the downside of a soft one remains.
Meanwhile, the equivalence regime could get swept up by other political priorities and blown off course.
In June, negotiations between the EU and Switzerland over issues including legal jurisdiction and citizens’ rights deteriorated so much that the bloc let Swiss financial equivalence expire. The episode demonstrated the instability of this type of arrangement.
Still, Cronin thinks the EU will not rock the boat. “EU capital markets are best placed to progress and evolve to the extent that they remain open to and integrated with Britain, and I suspect that’s the view the EU has formed on this too,” he says.
One idea on the UK side has been an enhanced equivalence agreement, focused on making sure the outcome of rules rather than the rules themselves are aligned.
This would give the UK more flexibility and “is something the UK regulatory bodies are much more comfortable with,” says Vedi. This special equivalence regime could also involve a facility to protect against sudden withdrawal.
But the EU may not be accommodating. “Given the level of trust and political relationships between the UK and the EU right now, it’s very hard to see the EU offering equivalence on a purely technical, purely outcome-based approach,” says William Wright, managing director of think tank New Financial in London.
The only offer may be a stricter “line-by-line” equivalence. “That’s when the UK could be faced with quite a difficult choice,” says David Strachan, head of the Europe, Middle East and Africa centre for regulatory strategy at Deloitte in London.
How much capital markets business moves from London to the EU is likely to increase over time, regardless of the outcome of Brexit.
“Many firms that have set up operations in the EU as part of Brexit contingency plans have made various commitments to the EU about bolstering their presence on the Continent over the next year or two,” says Sumpter. “The European regulators accepted that it was not going to be physically possible to put in place a certain degree of changes in the time available. But they have expected firms to move to a longer term position over a time horizon.”
Even if UK firms retain passporting, what has been lost to London is unlikely to come back in the foreseeable future. Apart from their commitments to the EU, companies could fear political uncertainty in the UK, or find it inconvenient to wind back past relocations.
Bumpy journey
But what could affect the scale of relocation is the bumpiness of the political journey.
“Let’s say there’s an agreement that the UK will leave the single market in five years’ time, and this date is set in stone, and there are five years to prepare — that’s a very different scenario from the kind of drama we’ve had so far,” says Véron.
The transfer of activities may not be visible as job relocations. Investments and hires may be concentrated in the eurozone, where it is cheaper to employ people, while London operations face retrenchment.
“A lot of it will be dressed up as business-as-usual cost-cutting measures, redundancies from London,” says Sumpter. As for where activity is moving, European cities have found niche, in a multipolar eurozone for financial services (see chart).
Frankfurt has appealed to commercial and investment banks; it is the home of the European Central Bank. Dublin and Luxembourg are attractive to asset managers and alternative investors. Amsterdam has drawn brokers, exchanges and market infrastructure providers. Paris has attracted a range of business, although more in the form of secondary moves rather than main EU hubs. “Paris has perhaps emerged as the closest thing in terms of relocations to a mini-London, because it’s not dominated by any single sector,” says Wright.
The EU’s finance sector will be less concentrated once London is outside it, even taking into account that cities like Frankfurt and Dublin may reach a saturation point and that activity remains centred in just a handful of cities across 27 countries.
Many in the EU, both private sector players and in government, have been spurred by Brexit to reinvigorate the EU’s slow-moving project to complete the CMU. They are concerned about the EU losing its dominant financial centre and anxious that Europe should become self-sufficient.
“I think it could inject a little more urgency into this process, trying to iron out the remaining creases — and there are lots of them — in the single market, in banking and finance,” says Wright.
For the EU, this could certainly be a silver lining to the cloud of losing its biggest capital market.
For the UK finding a compromise between staying close to the EU and deepening relationships elsewhere looks difficult. GC