WATCHING AND WAITING.
The City of London holds its breath as Brexit divorce proceedings begin. Gill Wadsworth reports.
June was a month of snaps and shocks. First the UK Prime Minister Theresa May called a snap election, which was shortly followed by a shock collapse of the Conservative majority. The result is that May’s idea to strengthen her negotiating position ahead of Brexit talks was doomed as her party went from strong and stable to weak and wobbly in a matter of weeks.
Even before the election the UK’s stance on Brexit was unclear. The electorate had been told that ‘no deal was better than a bad deal’ but there was no definition of what constituted a poor or positive outcome since targets and goals were not forthcoming.
The Brexit waters are now looking even muddier as it appears May is having to step away from her preferred ‘hard’ Brexit in favour of a more conciliatory position, although there is still limited information from government as to how it will proceed.
In the meantime, the financial services industry – one of the most important sectors to the UK economy and one that is heavily reliant on maintaining its place as a dominant force in Europe – must sit and wait.
Mike Amey, head of sterling portfolio management at fund manager Pimco, says he cannot discount the risk of yet another general election. “The main problem relates to governing with a minority, and the challenges of being held to ransom by small single policy focus groups,” he says. “There is a constant risk that the government fails and we face another general election.”
The major challenge is the immediacy with which May had to begin talks with Europe. Just 10 days after the election, Brexit negotiations commenced, leaving scant time for the UK to get its house in order.
Markets do not like uncertainty and that means fund managers are not happy. Noland Carter, chief investment officer and head of Heartwood Investment Management, says: “Before this election, the UK was on course for a hard but smooth Brexit. However, we may now be on course for a hard but rough landing.”
One positive outcome of the hung parliament and the suspected pullback from a ‘hard’ Brexit position, was markets behaving less erratically than they might have if the Conservatives had secured a majority. However, the outlook for the British economy, as managers predict a further fall in sterling, which means rising inflation, is bad news for consumers and presents challenges for domestically focused stocks.
“Understandably sterling has weakened amid all this uncertainty,” says Ariel Bezalel, manager of the Jupiter Strategic Bond Fund. “This additional drop in sterling would only serve to fuel inflationary fires, putting real incomes under further pressure. If you add the political uncertainty to the mix, retailers are going to feel the pinch as consumers cut back on their spending.”
Doom and gloom for consumers and some British business then, but the picture is no rosier for the financial sector which not only invests in the UK, but has headquarters in the country as well as large workforces and a regulatory regime that is almost irretrievably bound to the EU.
That regulatory interdependence though creates both challenges and opportunities. On one hand, a separation could enable the UK to build a regulatory framework that appears less onerous and more attractive for institutions. On the other hand, if the UK distances itself too much from the European regime it risks alienating itself and being seen as a rogue state.
PJ Di Giammarino, CEO of regulatory consultant JWG says, part of the UK’s strength is its harmonious regulation with Europe; any disruption messes with this equivalence. “The UK could be free to [invoke regulatory change] which makes eminent sense to the market but would that be equivalent? Whatever changes it makes, in theory, the European Commission could say that is anti-competitive and not equivalent,” he says.
Holding onto prized possessions
The UK is also battling a potentially hostile Europe, which holds all the cards, and some commentators are concerned that the EU may use regulation as a stick to beat the UK financial services sector.
“The EU should resist the temptation to punish the City,” says Rob Boardman, European CEO of equities broker ITG, says: “There needs to be interconnected and efficient capital markets, not artificial barriers to trade and investment. The EU should resist the temptation to erect a President Trump style wall around its Euro-denominated trading and clearing infrastructure.”
He adds: “The UK government and Brussels negotiators should plan specific measures to strengthen trade ties and promote financing for economic growth and prosperity.”
One hint that life could get harder is Brussels’ attention to Euro denominated clearing houses, which facilitate the trade of instruments such as derivatives between stakeholders. The City is a dominant player in this field employing some 100,000 people and clearing £1trn in transactions per day, and the European Securities and Markets Authority (ESMA) is anxious this dominance could be deemed inappropriate once the divorce is finalised.
ESMA stated: “When the United Kingdom exits the EU, there will therefore be a distinct shift in the proportion of such transactions being cleared in CCPs [central counterparty clearing houses] outside the EU’s jurisdiction, exacerbating the [regulatory] concerns. This implies significant challenges for safeguarding financial stability in the EU that need to be addressed.”
At the start of June, the regulator proposed a two-tier system which would allow smaller clearing houses to carry on their business uninterrupted, while larger ‘systemically important’ operations could be forced to move to the continent.
There is a looming threat that institutions – irrespective of their interests in clearing – may exodus the UK in favour of remaining part of the EU. Research from UBS Evidence Lab published in March found that in a survey of 600 financial businesses in Europe – of which 75% had operations in the UK – 10% would leave the UK entirely. Just over two fifths (41%) said they would ‘strongly reduce’ their UK capacity.
However, the European Commission is clear that it will not tolerate organisations simply building a shop front in the EU while maintaining operations on UK soil. Essentially, the message is you are fully in or you can stay out.
ESMA chair Stephen Maijoor said in a speech in May: “The EU27 have a shared interest in building a common approach to dealing with relocating firms that wish to continue to benefit from access to EU financial markets. Effective and efficient supervision by EU27 national authorities is not possible when relocated entities are empty shells.”
Just days before May and Brexit secretary David Davis were due to commence official talks with the EU, the UK still did not have an official majority government or coalition leaving it somewhat on the back foot.
With so much at stake for the financial services sector, an efficient, pragmatic and reasonable approach is called for on all sides, but since there is no precedent all the parties are feeling their way, and there is no escaping the sometimes fractious relationship between Britain and the EU.
As Pimco’s Amey concludes: “It may well be the case that British politics proceeds smoothly, but as we know, it has a habit of throwing up unexpected outcomes.”