Part 1 – Introduction
Part 2 – Regulated financial services
Part 3 – Funds and Payment services/FinTech
In my final post in this series looking at what Brexit could like for the UK financial services industry, I will take a more general look at the potential structural impact of Brexit upon both the UK and EU financial markets.
This is an incredibly broad area so I intend to focus somewhat more narrowly on some of the more recent regulatory developments covering, for example, the authorisation of central clearing counterparties (or “CCPs”).
I also intend to touch very briefly upon the impact of Brexit on the current system of prudential regulation and, in particular, capital requirements under the Capital Requirements Directive IV (“CRD IV”).
In the wake of the financial crisis, there have been various global regulatory initiatives undertaken to ensure that the underlying causes of the crises are addressed. As part of a package of measures in this area, the EU enacted the European Market Infrastructure Regulation (“EMIR”). EMIR has introduced several requirements for participants within the over-the-counter (or “OTC”) derivatives market which are intended to mitigate the perceived risk of entering into these types of financial instrument. EMIR, among other things, mandates that all derivative trades be reported to an authorised trade repository, that parties exchange more (and better quality) collateral to more fully mitigate against counterparty exposure and, perhaps most significantly, that certain types of trades be centrally cleared through an EU-authorised CCP.
Given the both the size of the market and the extent of cross-border trading in these instruments, these requirements necessarily form part of a much broader and, for the most part, harmonized, system of global market infrastructure regulation. Similar rules apply, for example, in the United States under Dodd-Frank.
The UK is, by some considerable distance, the most popular European venue in which to trade derivatives with over 40% of the almost $10 billion daily notional trading volume (across all currencies) taking place in London. Clearly any regulatory or legal impediments to trading these instruments would have a considerable impact upon the City’s current dominant market position.
Upon Brexit, the UK would no longer be subject to EMIR. In order therefore to ensure that UK-based firms are able to access the EEA market, the UK would, again, be reliant upon a determination on regulatory equivalence being reached by the European Commission. The determination is again predicated on an equivalent level of regulation of supervision, as well as the granting of reciprocal access to the UK’s market to EEA member states.
In my view, it is very likely that such a determination will be swiftly achieved. Unlike, for example, AIFMD, the equivalence assessment process is well established and affirmative determinations in respect of several third-country market infrastructure regimes (including those in the US, Switzerland and Japan) have already been made, allowing CCPs in each of these countries to provide clearing services to the EU market.
Additionally, although the UK would no longer be required to implement EMIR, I would consider it very unlikely that it would not be replaced with a broadly equivalent framework given both the global harmonisation in this area and the commercial imperative to do so. My assumption would be that the necessary legislative changes would be prioritised and quickly implemented by the UK in order to ensure a speedy determination on equivalence.
While the overall impact of Brexit in this area is likely to be limited, there is one interesting point which may prove quite contentious during negotiations. As mentioned above, the City currently dominates the derivatives trading market, including in Euro-denominated transactions. This has been a topic of some controversy in recent years as the ECB had originally demanded that Euro-denominated trades should only be permitted to be cleared within the Eurozone. Following a challenge by the UK, the EU General Court ruled in the UK’s favour stating that the ECB was acting ultra vires in establishing such a requirement.
Following Brexit, I would consider it likely that the EU would attempt to reintroduce a similar requirement. It remains to be seen whether the UK would retain any ability to challenge this in the same manner as previously. It may be that the loss of Euro-denominated clearing is an inevitable trade-off in return for the EU’s cooperation in other areas.
Summary – Given the dominance of the City in this market and the globally harmonised nature of market infrastructure regulation, we are unlikely to see much significant change following Brexit. However, the issue of Euro-denominated clearing remains politically charged and I would expect that the EU will attempt to wrest this market back from the UK.
One of the more important responses to the financial crisis was the development of Basel III, a globally agreed framework for an enhanced and more comprehensive system of standards around capital and leverage.
CRD IV, an EU legislative package which seeks to implements Basel III, contains prudential rules for banks, building societies and investment firms established within the EEA and which includes requirements on capital, leverage and liquidity as well as a framework around enhanced corporate governance and regulatory reporting. Firms’ compliance with these requirements are supervised by prudential regulators or supervisors in their own member state, which is then recognised by the supervisors in each other EU member state in which that firm operates.
Upon Brexit, the question would again centre around whether or not the replacement UK regime is considered to be equivalent.
In this area, I see potentially the most scope for regulatory arbitrage. As we have seen in previous posts, determinations on regulatory equivalence should be considered vital to ensure that UK-based firms continue to have access to the single market, albeit on a more restricted and conditional basis. If the UK seeks to deviate from certain aspects of CRD IV in order to make itself more appealing to foreign firms, it could conceivably do so by diverging from the EU on these rules (e.g. by imposing less stringent requirements on leverage). As such, a determination on equivalence may be more difficult to achieve.
What would this mean in practical terms?
As a non-equivalent “third-country”, it could mean that UK firms with EU-based subsidiaries are required to create separate EU-based holding companies for these subsidiaries. These holding companies would then be subject to the prudential requirements under CRD IV in the member state in which they are based. This could result in the application of increased and overlapping prudential requirements across the firm’s group. UK firms would necessarily bear the increased operational and compliance costs, as well as potentially being subject to increased capital requirements across the entire group structure.
I expect that the industry will lobby the Government quite heavily on this point. While a more liberal regulatory environment in the UK might be of some benefit to attracting inward investment, it poses difficulties for local financial institutions already feeling the strain of persistent low interest rates and myriad legacy issues from the financial crisis.
The outcome? I haven’t got a clue…
Summary – Prudential supervision post-Brexit is likely to be an intensely politically charged issue. Expect the Government to signal some moves toward a lighter-touch framework with far-reaching and potentially adverse implications for local firms.
Thank you for reading this series.
You may also be interested in my article on Brexit and bank resolution which can be found here.
I am always very keen to hear alternative points of view or to enter into debate on any of these issues. I am also very happy to receive suggestions for future articles.
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