By Professor Stuart Weinstein
Faculty of Business and Law, Coventry University
What will be the impact of Brexit on the financial services sector and the City of London?
The most immediate concern is instability in the sense that markets and businesses abhor uncertainty. Unless clarity is had, and had fairly soon, the long term impact of the Brexit referendum could weaken the attractiveness of the United Kingdom (UK) as a global centre for banking operations.
Already within days of the outcome of the vote there has been talk of a number of the large United States banks exploring contingency plans to move some of their operations from London to cities based in European Union Member States. And it is not only the American banks that are thinking of moving jobs out of London. At least one British multinational bank headquartered in London is considering moving 1,000 jobs involved with Euroclearing from London to Paris if the UK leaves the Single Market.
What is the Single Market and why is it so attractive to the UK’s financial services industry?
The Single Market refers to the European Union (EU) as one territory without any internal borders or other regulatory obstacles to the free movement of goods and services. Leaving the Single Market means that UK banks would lose “passporting” rights to operate in the EU, and that tariffs would have to be paid for services, thereby making UK financial services exports to the EU uncompetitive.
Norway and Switzerland offer some answers to the dilemma.
Access to the European Economic Area is referred to as the Norwegian model where “passporting” is allowed because Norway enjoys this arrangement with the EU although it is not a member of the EU.
Contrast this with the Swiss model where Switzerland is a member of the European Free Trade Association but not a member of the EU. Swiss banks unlike Norway don’t enjoy “passporting”.
Moreover, both Norway and Switzerland have to provide free movement of persons to citizens of the EU, a point likely to be re-examined in Switzerland after they had a 2014 referendum voting for quotas on immigration from EU countries reminiscent of a major point of contention in the UK referendum.
Absent a Norwegian or Swiss style deal, the UK would have to enter into bilateral agreements with the remaining 27 Member States of the EU to ensure access to financial markets.
Compounding the problem is the fact that many overseas banks (particularly the American banks) have used London as their gateway to the EU. If the ability to be regulated by UK banking authorities impinges on access to the Single Market, these companies will explore other options.
Such options include:
- moving some operations from London to cities based within the EU;
- ensuring that they have all appropriate regulatory approvals to operate in the Single Market;
- a EU licence to operate outside the UK – in time for Brexit.
The loss of passporting rights could mean as little as banks having to set up a “brass plate subsidiary” in the EU to process business essentially still done in London, or as much as prompting the UK to lose large amounts of business to the EU. The answer to this is not clear at this point.
Remaining in the European Economic Area means that the UK would have to adapt all EU financial rules and many other regulations, and it would lose its ability to block those they find onerous or unattractive. This would impede the UK from setting up a “third way” for the financial services market that could offer regulatory arbitrage options to attract business from EU capital markets (Frankfurt, Dublin, Amsterdam or Paris) and those in other parts of the world (Hong Kong, New York, Singapore and Tokyo).
In the absence of “passporting”, one solution would be to find common ground in specific areas of financial services regulation between the European Commission and ESMA (the EU’s financial authority, European Securities and Market Authority), on the one hand, and the UK’s regulatory players (e.g. the Financial Conduct Authority, Prudential Regulation Authority, the Bank of England and the Competition and Markets Authority).
This task of finding “equivalencies” between jurisdictions is cumbersome and painstaking. First, it is not clear that the EU as a whole wants to reach such “equivalency” recognition, and may decide it is better to let individual EU member states to negotiate their own deals with the UK. In any case, negotiating equivalencies can take years as evidenced by the four year disharmony between the United States and the EU on derivatives regulation.
Moreover, assuming “equivalencies” are found between the EU and post-Brexit UK regulatory regimes in the financial services sector, will this translate into allowing for mutual recognition cross-border of their respective regulated entities in the other jurisdictions?
This would not be “passporting” but perhaps something more akin to the resolution reached in the United States-European Union derivatives impasse whereby the European Commission and the United States recognise each other’s regulated central clearing counterparties provided they are registered in their counterpart jurisdictions.
This approach would be in line with the approach taken by the EU’s Markets in Financial Instruments Directive II (MIFID 2) rules to be introduced in January 2017 toward non-European Economic Area institutions, which force these financial services providers to have equivalent levels of regulation in their home country before doing business across the EU.
One area of particular trouble to the future of London as a global financial services centre is most likely to be in the euro-clearing business.
The trading of euro-based securities spans trillions of euros of derivatives deals as well as the ‘repo’ market providing short-term funding for banks (approximately 2 trillion euros of which is based in London). On top of this, there is foreign exchange trading in the currency itself. “The European Central Bank wants oversight of this business for a practical reason: if any disaster were to hit these markets like the 2008 collapse of Lehman Brothers bank in the United States, it would be responsible for dealing with the crisis.” 
In 2015, the UK was successful in challenging a European Central Bank (ECB) decision to force clearing houses settling euro-denominated contracts to relocate to the euro-zone. A settlement was reached thereafter where “in return for providing euro funding to help cope with such a crisis, the Bank of England will grant the ECB its longstanding demand of greater information on the workings of London’s clearing houses and more influence over their supervision.” The location policy of the ECB has never been implemented but is a sure thing to happen in the event of a Brexit.
Uuriintuya Batsaikhan, of the economic think-tank Bruegel, has suggested that the direct economic impact of shifting clearing houses to the Continent would likely be small in terms of lost revenue and jobs to the UK, however, a bigger hit will come to the UK’s role in respect of central clearing counterparties. “Central clearing counterparties will be wary of the fact that, as a non-Member State of the EU, it would have no legal means to enforce the ECB to credibly commit to the liquidity swap agreement. Such legal uncertainty would mean significant risks in an event of a liquidity crisis.”
In this regard, it is entirely likely that the ECB will want to assert its jurisdictional control over all euro-denominated activities of clearing houses that are a systemic risk to the functioning of the euro-area. As such, it can be expected that the ECB will act to impose the “location” requirement again or to amend the Treaty on the Functioning of the EU to specifically seek restrictive power in respect of the securities clearing systems that will “lock-out” a post-Brexit UK.
How this all plays out over the next couple of years is unclear. However, one thing is certain, turmoil will characterise the situation for the immediate future. And that is not good for anyone.
 Martin Arnold and Laura Noonan, “Will foreign banks leave the UK after Brexit?”: http://www.bbc.co.uk/news/business-36629745
 Capital Economics, The economic impact of ‘Brexit’, February 2016: https://woodfordfunds.com/economic-impact-brexit-report/#financial-services-and-the-city
 John O’Donnell, Huw Jones and John Geddie, Brexit risks taking multi-trillion euro trading from London, 1 April 2016, Reuters: http://uk.reuters.com/article/us-britain-eu-euros-idUKKCN0WY5DB
 Alex Barker, Claire Jones, BoE and ECB settle four-year battle over City clearing houses: Deal protects London’s role in single market outside the euro and gives Brussels greater supervision, 29 March 2015, Financial Times: https://next.ft.com/content/4a244974-d608-11e4-a598-00144feab7de
 Izabella Kaminska, Brexit and the UK’s euro-clearing exposure, 9 June 2016, Financial Times: http://ftalphaville.ft.com/2016/06/09/2165556/brexit-and-the-uks-euro-clearing-exposure/