Preparing for Doomsday: Financial Services After a No-Deal Brexit
Ioannis G. Asimakopoulos (University of Luxembourg)
They say that real life writes the best plots, and that could not be more true than in the case of Brexit. And while the majority of MPs in Westminster do not favour a no deal Brexit, and while economic interests advise against it (Ringe, 2017), accidents do happen and can well happen in this case. In this vein, the following brief analysis touches upon the consequences of a no deal Brexit for financial services and sketches the latest developments as regards the contagion measures that are being put in place for such a scenario (for an analysis of all scenarios, see European Parliament, 2017). In a nutshell, EEA customers and firms should in principle face no big problems since the UK is putting transitional laws in place, but UK customers and firms would be immediately cut off from the single market after Brexit in the absence of any similar measures taken by the EU Member States.
Leaving the EU would mean leaving the Single Market. The most important reflection of the access to the Single Market, is so-called ‘passporting’. Passporting allows for providers of financial services to offer their products across the market as long as they are registered and licensed in one EU Member State market (the idea of ‘home State control’). In real terms that means that a US-based or a Singapore-based provider can set up its operations in London, and through its London-subsidiary operate across the EU. These operations can be undertaken directly or through the establishment of branches across the EU. Indicatively, the top-5 US investment banks (Goldman Sachs, JP Morgan, Citigroup, Morgan Stanley, Bank of America Merrill Lynch) concentrate about 90% of their operations in London (Schoenmaker 2016a). In a no deal scenario, a London-based subsidiary would not suffice and an additional subsidiary in one of the EU-27 countries would be required. Distribution through subsidiaries is much more costly than distribution through branches.
- Financial Firms
With that in mind, the UK passed the European Union (withdrawal) Act 2018, which transfers EU law, including that relating to financial services, to the UK statute book on exit day. It also gives Ministers powers to amend the law to ensure that there is a fully functioning financial services regulatory framework at the point of exit. UK firms in the EEA will be treated according to the abovementioned rules. All EEA firms operating in the UK will, in principle, be treated as third countries. However, it has been confirmed that the UK may diverge from this approach in order to ensure that ‘a functioning legislative regime is in place, to minimise disruption and avoid material unintended consequences for the continuity of financial services provision, to protect the existing rights of UK consumers, or to ensure financial stability’ (HM Treasury, 2018).
Consequently, temporary regimes would be introduced in most areas of financial services. One of the government’s key commitments is to introduce a Temporary Permissions Regime (TPR) that will allow EEA firms currently passporting into the UK to continue operating in the UK for up to three years after Brexit, while they apply for full authorisation from UK regulators; the government’s draft legislation, the Financial Conduct Authority’s (FCA) approach to TPRand Prudential Regulation Authority’s (PRA) expectationsare already out. Similar temporary regimes will be provided for EEA electronic money and payment institutions, registered account information service providers, and EEA funds that are marketed into the UK. Alongside these, the FCA is preparing the Financial Services Contracts Regime(FSCR), which allows EEA firms to conduct an orderly exit from the UK market by running off regulated business. The FSCR will apply automatically to EEA firms who have regulated business in the UK to run off, and either do not enter the temporary permissions regime, or exit the regime without full UK authorisation.
Unless the EU acts to maintain continuity, then UK financial services firms passporting into the EEA will lose the ability to do that at the point of exit, which may have implications for their ability to meet contractual obligations with EEA-based clients. This would affect primarily the banking sector rather than the insurance sector, which is largely based on a subsidiary-based structure (Schoenmaker 2016b).
In general, the FCA will allow European banks, insurance companies and online money institutions to continue operating in the UK — provided they are authorised in their home country — without breaking British laws. They will be able to transfer property, rights or liabilities under a pre-existing contract but will not be able to accept new business after March 29 (Financial Times, 8 January 2019 (a)). In contrast, EU institutions have yet to announce any transitional measures apart from the ones relating to clearing houses and uncleared derivative contracts.
Under EU legislation it is possible for fund managers to delegate portfolio management services to a third party in another country, including countries outside the EU. In relation to funds and managers authorised under the relevant EU legislation, there are requirements for cooperation between the supervisory authorities in the relevant EU member state and the non-EU country concerned. The UK authorities are ready to agree cooperation arrangements with their EU counterparts as soon as is possible, and unless the EU confirms it does not intend to put such arrangements in place, asset management firms can continue to plan on the basis that the delegation model will continue.
Next to passporting, the macroeconomic fallout from Brexit would also damage the performance of banks and insurers, which could reduce economic growth, lead to lower interest rates, and ultimately affect the business model of banks in the UK and the EU. Lower interest rates would also impact insurance firms (Schoenmaker 2016b).
- Financial Market Infrastructures
Payment Systems. Given the amount of euro-denominated finance carried out in the UK, it is important that London, within the EEA, has direct access to the infrastructure for wholesale payments (TARGET2). UK banks and other designated financial institutions are permitted to be direct participants in TARGET2 even though the Bank of England does not participate. However, if the UK were to leave the EU and not join the EEA, then banks in the UK could no longer be direct members of TARGET2. They would have to operate through subsidiaries (or perhaps branches assuming the UK is deemed ‘equivalent’ in terms of regulation) within the EEA (Armstrong, 2016). This would make euro banking via the UK more expensive, and London less attractive as a destination for non-EEA banks to establish their EU headquarters.
CCPs. Central counterparties (CCPs) are important for the settlement of securities and derivatives transactions. There are three clearing houses operating in the UK: CME Europe, LCH.Clearnet Group Ltd, and the London Metal Exchange Limited. LCH has by far the biggest share of euro-denominated clearing in the UK (Batsaikhan, 2016). There will be no need for UK-based clearing members using UK central counterparties (CCPs) to take any action as a result of EU exit. However, without EU action, EEA clearing members and trading venues will no longer be able to use UK CCPs to provide their clearing services. In addition, EEA customers could no longer meet the requirement to centrally clear for some products that are in scope of the clearing obligation by clearing through UK CCPs, such as interest rate swaps (HM Treasury, 2018). To avoid these consequences, EU Member States have agreed to provide a one-year transitional period during which equivalence rights would be provided in order to temporarily maintain EU companies’ access to UK-based clearing houses (Financial Times, 12 December 2018). Similar transitional arrangements are to be made as regards the settlement of derivative contracts, which would otherwise risk of remaining uncleared (Financial Times, 8 November 2018). Further, UK CCPs might not be granted access to TARGET2, which might lead them, especially LCH, to leave the UK (Schoenmaker 2016a).
CSDs. The UK’s Central Securities Depository (CSD) currently provides services to both the UK and Irish markets. For customers settling UK securities at the UK CSD there will be no change as a result of exit. If no action is taken by the EU authorities and EU countries, EU securities may no longer be able to be directly settled in the UK. To ensure that there is no significant impact on UK customers of non-UK CSDs, transitional arrangements will be established until both equivalence and recognition decisions are made (HM Treasury, 2018).
Settlement finality rules. There will be no need to take any action for Financial Market Infrastructures (FMIs) that are already designated on Exit day under the UK Settlement Finality Regulations (SFR). When the UK leaves the EU, it will no longer be a part of the EU Settlement Finality Directive (SFD) framework, which allows designated FMIs to benefit from protections from insolvency actions. The government has announced that it intends to bring forward legislation to continue protections granted by the SFR, which implement the SFD. This legislation would allow designations of FMIs that are outside of the UK and give powers to the Bank of England to designate these FMIs. This legislation will also provide for a temporary regime that would enable certain non-UK FMIs to continue to benefit from UK protections currently provided for by the EU Settlement Finality Directive. Without EU action to designate UK FMIs, EU settlement finality protection for UK FMIs will cease to be in place (HM Treasury, 2018).
Trading venues. Without action from the EU, UK trading venues would no longer qualify as EU trading venues. This means that EEA firms may not be able to be members of UK venues. UK venues will also not be eligible venues for EEA firms to execute certain equity and derivatives trades. This may prevent EEA firms from being able to trade in certain derivatives, where there is no alternative venue available in the EU. This would reduce market liquidity in the UK and EU. EU market operators that currently passport into the UK do not have to be recognised by the FCA in order to have UK firms participate in their markets. However, EU market operators who undertake regulated activities in the UK should seek recognition as a Recognised Overseas Investment Exchange. In addition, UK-based firms may also no longer be able to undertake certain equity and derivatives trades on EEA trading venues. However, alternative UK and international venues exist, and would be available for UK market participants (HM Treasury, 2018).
CRAs and TRs. The government intends to give the FCA powers to authorise and regulate both UK and non-UK Credit Rating Agencies (CRAs) and Trade Repositories (TRs). The government intends to grant powers to the FCA to allow UK CRAs and TRs to convert their existing EU authorisation into a UK authorisation, so UK customers of both UK CRAs and TRs that convert will not have to take any action. If no action is taken by the EU, EEA firms will no longer be able to access these UK firms.
How customers of financial services firms will be affected will depend on where they are based, where their firm is based and under what regulatory authorisations they operate, and the services that that they access (HM Treasury, 2018).
UK-based customers of UK-based providers. For UK-based customers accessing domestic services in the UK provided entirely by UK-based providers, there is unlikely to be any change as a result of exit. Some EEA firms that provide deposit taking and retail banking services in the UK do so via a UK-authorised subsidiary. There will be no change to their UK authorisation as a result of the UK leaving the EU, and they will be able to continue providing services (list of UK-authorised subsidiaries). UK-based payment services providers would lose direct access to central payments infrastructure – such as TARGET2 and the Single Euro Payments Area (SEPA) – meaning customers could face increased costs and slower processing times for Euro transactions (especially for lower value transactions). However, a government’s decision to align national and European legislation might save them from this consequence. The cost of card payments between the UK and EU will likely increase, and these cross-border payments will no longer be covered by the surcharging ban (which prevents businesses from being able to charge consumers for using a specific payment method) (HM Treasury, 2018).
UK-based customers of EEA-based providers. For UK-based customers of EEA firms operating in the UK (without a subsidiary structure) the temporary permissions regimes will enable these firms to continue to provide those services to UK customers for up to three years after exit. During that time, they can apply for UK authorisation if they want to continue operating in the UK after this three-year transition period.
EEA-based customers of UK-based providers. By contrast, in the absence of action from the EU, EEA-based customers of UK firms currently passporting into the EEA, including UK citizens living in the EEA, may lose the ability to access existing lending and deposit services, insurance contracts (such as a life insurance contracts and annuities) due to UK firms losing their rights to passport into the EEA, affecting the ability of their EEA customers to continue accessing their services. This could impact these firms’ ability to continue to service their existing products.
The government has committed to putting in place unilateral action, if necessary, to resolve these issues as far as possible on the UK side, such as the commitment to continue to treat prospectuses that are valid in the UK before exit as valid for the remainder of the 12 months from their date of approval, including where that includes a period after the UK exits the EU. However, the UK authorities are not able through unilateral action to fully address risks to the EEA customers of UK firms currently providing services into the EEA using the financial services passport. In the latter case, setting up an EEA subsidiary might be the only solution.
If a no deal Brexit happens, transitional measures will be put in place to avoid disruption in the provision of financial services. And whilst the UK has already announced or is already consulting on these contingency plans, the EU has yet to take any contingency measures except for clearing houses and uncleared derivative contracts. In general, though, the City has been preparing for a no deal scenario. However, even if Doomsday never happens, the uncertainty underlying such a scenario and the related contingency plans have already cost the UK almost £800bn in staff, operations and customer funds to Europe since the Brexit referendum (EY, 2019). And whilst the clock is ticking, one thing is for sure: with or without a deal, London’s pre-eminence will be shaken (Financial Times, 8 January 2019 (b)), but London itself will not be overtaken by any other EU capital – at least not any time soon.
Ioannis G. Asimakopoulos is a doctoral researcher and teaching assistant in Financial Law at the University of Luxembourg since February 2017. He is currently also a research fellow at the House of Finance, Goethe University of Frankfurt, and a junior researcher at the European Banking Institute. Ioannis studied law in Greece (LL.B., 2014) and completed an MSc in International Economics and Finance at the Athens University of Economics and Business (2016) and a Master’s in Corporate Law at Christ’s College, University of Cambridge (MCL, 2016).