The City’s vast financial services sector benefited hugely from the creation of the euro, despite the UK not being a member. Now, a large part of that business is at risk.

Trade deal or no trade deal, the UK’s all-important financial services sector, which accounts for more than one-tenth of the UK’s tax revenues and one-fifth of its service exports, is almost certain to lose its current access to the EU market when the withdrawal agreement transition period comes to an end, on December 31. And Brussels appears to have little intention of granting the sector equivalence status any time soon. 

This has enraged City of London grandees. Miles Celic, chief executive of the City’s most powerful lobby group, CityUK, recently told parliament’s Business, Energy and Industrial Strategy Select Committee that Brussels had unnecessarily damaged the UK’s financial services sector.

“We’ve seen a regrettable politicisation of what ought to be technical decisions on the European side. The equivalence process has unfortunately become politicised and companies will look at this, consider there is uncertainty, consider there is a cost and, particularly with some foreign companies, they may decide for now that the United States or Asia is a better bet, certainly in the short or medium term.”

Sidelining the City

With the exception of a select group of hedge fund managers, most big City firms and institutions never wanted Brexit. They knew, or at least feared, it would undermine London’s position as a global financial center. Now that Brexit is happening, the City has found itself in the unfamiliar position of having its needs largely ignored by the government of the day. William Russel, the 692nd Lord Mayor of London, complained just a few weeks ago that the UK government had “missed the point” of the City of London throughout the Brexit negotiations.

The consequences could be stark. The Bank of England’s Financial Policy Committee warned on Friday that while UK banks remain resilient in the face of risks posed by Brexit and the virus crisis, financial services could face “disruption” when the transition period ends.

“Most risks to UK financial stability that could arise from disruption to the provision of cross-border financial services at the end of the transition period have been mitigated. The mitigation of these risks reflects extensive preparations made by authorities and the private sector over a number of years.

“However, financial stability is not the same as market stability or the avoidance of any disruption to users of financial services. Some market volatility and disruption to financial services, particularly to EU-based clients, could arise.

“Market volatility could be reinforced in the event that some derivative users are not fully ready to trade with EU counterparties or on EU or EU-recognised trading venues. Financial institutions should continue taking measures to minimise disruption.”

Almost half (43%) of the $9.4 trillion in daily global derivatives trades tracked by the Bank for International Settlements take place in the UK. A large chunk of them are euro-denominated. Barring a last-minute decision by the EU to grant the UK’s financial services industry equivalence status, which is extremely unlikely, some of these trades will have to be executed inside the bloc or in a country with “equivalent” standards, such as the U.S.

Is the Market Ready?

“Some business, as a result of that, will need to transfer,” said Bank of England Deputy Governor Jon Cunliffe on Friday. “The question is: is the market ready, have people made the right preparations for that? There may be some who are unprepared and in many cases there are other routes for them, but it’s impossible to know unless and until we get there exactly what the impact will be.”

Not exactly comforting words, especially given that the BoE estimates that around US$200 billion of daily trading in interest rate swaps in London — roughly a sixth of the total — will be impacted by the new restrictions on trading location. The UK, for its part, has stipulated that UK-regulated banks must use derivatives platforms in London, making trades between UK and EU counterparties impossible.

The Bank of England estimates a third — or £10 billion — of financial services exports to the EU will be lost because of Brexit. Another £10 billion pound could be in jeopardy if EU access is limited from January.

It’s likely to be the biggest setback the City of London has suffered since the square mile reinvented itself as a haven of the “eurodollar” business in the 1950s. UK-based banks, in particular the Midland Bank (now part of HSBC), with the tacit support of the Bank of England, effectively created an unregulated offshore market for U.S. dollars in London that enabled other countries to squirrel away their dollar-denominated earnings, often to evade U.S. oversight. Large U.S. banks also moved their international operations to the City, drawn by the possibility of avoiding U.S. financial regulations.

In the 1990s, the City became a central cog in the mushrooming global derivatives business. By the end of that decade, most derivative deals denominated in the newly created euro were taking place in London’s Square Mile, where the necessary financial infrastructure and know-how already existed.  

Firms were also attracted by the UK government and Bank of England’s “light touch” approach to regulation. By having a large base in the City, global banks and hedge funds got the best of both worlds: they got both EU “passporting rights” — that is, the ability to trade across Europe — while operating in an autonomous city within a city that allowed them to engage in activities that would be beyond the pale in most other jurisdictions. It’s no coincidence that just about every major global financial scam and scandal of the past decade, including Libor, Forex, MF Global, the London Whale and rampant gold and oil-price rigging, took place in London.

London’s Loss, Frankfurt’s Gain

Now that the passporting rights enjoyed by UK-based lenders are about to expire, part of the business will have to go elsewhere. Most large financial firms have already moved some of their assets and jobs from London to the EU. In September, JPMorgan Chase announced that it is moving €230 billion of assets to Frankfurt. Morgan Stanley and Goldman Sachs have also shifted assets from London to Frankfurt. In total, some €1.3 trillion of assets have so far been relocated to the EU since the 2016 Brexit referendum, according to EY.

Frankfurt has emerged as the biggest beneficiary of this process, ahead of Paris, Milan, Dublin and Amsterdam. The Bundesbank estimates that non-German banks could end up moving €675 billion euros — roughly half of the total — to Frankfurt, which also happens to be home to the European Central Bank’s HQ.

To a certain extent, the City of London can console itself with the fact that far fewer jobs in the City have been uprooted than was initially predicted. Some forecasts reached as high as 75,0000, whereas in reality fewer than 8,000 jobs have been moved to the mainland, according to EY. 

Another crumb of comfort for the City is that its domination of the global clearings industry remains in tact — for now! Clearing is where an exchange serves as an intermediary between financial trades, collecting collateral and standing between derivatives and swaps traders to prevent a default from spiraling out of control. At least that’s the (as yet largely untested) theory.

The City is home to the world’s largest clearing-house, LCH, which clears almost €1 trillion in euro-denominated derivatives a day. London’s clearing houses facilitate almost four times the volume of euro-denominated derivative trades than their counterparts in France and Germany combined, despite the fact it isn’t part of the common currency. This has long been a cause of rancour in Brussels, Paris and beyond. Now that the UK is no longer even part of the EU, the ECB and certain European governments want to seize a sizeable piece of that action, for largely justifiable reasons.

The problem is that trying to relocate the UK’s vast clearing operations to EU-based exchanges is a heinously complex, time-consuming undertaking. It essentially involves rolling over millions of financial contracts, some worth billions of pounds or euros and many of them somewhat exotic in nature, into a completely different jurisdiction with an entirely different legal system. There was no way of getting it done before the end of the standstill period, on December 31, so the European Commission opted to grant equivalence for UK clearing houses until mid-2022.

A Temporary Reprieve

But it is only a temporary reprieve, intended to grant just enough time for: (1) trading venues in Paris, Berlin and elsewhere to improve their infrastructure and expand their capacity; (2) EU market participants (in the words of EU financial services chief Valdis Dombrovskis) “to reduce their excessive exposures to UK-based CCPs.” 

The transfer of clearing operations from London to the EU will almost certainly increase costs for financial players, who will have to trade euro-denominated financial instruments across numerous trading venues rather than in one place. The more immediate concern, though, is the disruption that could occur as UK and EU counterparties are prevented from trading with one another. Big players in the industry such as Goldman Sachs and the London Stock Exchange’s Turquoise Europe platform have tried to minimise the risk of disruption by creating new mirror trading venues on the continent.

But there is no historic precedent for what is about to occur. This is uncharted terrain for all parties involved. And the complexity and contagion risks are high. The chief executive of the International Swaps and Derivatives Association (ISDA) Scott O’Malia recently warned that a lack of equivalence could exacerbate liquidity fragmentation in Europe’s derivative markets, precisely at a time when markets would likely be facing considerable strain and uncertainty resulting from Brexit.

For the City of London the risks are further compounded by the Covid-induced work-from-home revolution, which has left London’s skyscrapers largely deserted and a once-thriving office scene facing crisis. Just over a year ago, the City of London Corporation was looking to lure new business from China, by repositioning the City as a major offshore hub for the renminbi currency and laying the red carpet down for more Chinese asset management firms. But even that plan now lies in tatters after China’s imposition of the security law on Hong Kong sparked a major diplomatic row between London and Beijing.

In the end, the City will probably reinvent itself, as it always has done. Last week, a defiant BoE Governor, Andrew Bailey, said:

“London is a global financial centre, has been for a very, very long time, and will continue to be so.” 

But it will probably be a diminished one, which is perhaps not such a bad thing if it leads to a healthy rebalancing of the UK economy toward more productive sectors and away from the current hyper-financialized rentier regime. It might also mean fewer financial crimes with global reverberations. But the transition is likely to be bumpy.