Post-trade: From the EEC to Here
This posting is the second article in a series being run by Thomas Murray Data Services. It focuses on the context in which the terms of Brexit will be finalised between the UK and the EU as regards post-trade financial services.
In order to understand the possible implications of Brexit on the post-trade area of financial services, it is essential to grasp the current relationship between the UK and the EU in this segment. By understanding the historical context and the policy details, we can more accurately form an opinion of what the implications of leaving the European Union might be.
The UK is the largest financial centre in Europe, conducting over 75% of Europe’s capital market business. The City of London has played an integral role in shaping the EU regulations that govern capital markets, and also in how they play out. The nature of these relationships will certainly change when Brexit occurs.
As well as striving to create a single market for securities, the EU has sought to increase significantly the regulation of financial market infrastructures (FMIs), impose strict liability upon custodian banks for loss of assets, and improve the management of derivatives administration and risks. The core objective is protecting investor’s assets from actions by financial institutions that could cause unnecessary losses for reasons other than adverse market price movement. However, these regulations do have their drawbacks; their cumbersome nature and stringent requirements have heavily increased operational and compliance costs for banks.
Prior to the financial crises of 2007-9, there had been considerable progress made to integrate European capital markets, in line with broad movements towards convergence of regulation and market practice globally. For the EU, the objective coincided with work being done to establish a single market in goods and services. This process was fundamental to the European Union’s further development; it survived the financial crises, but the context of implementation became utterly different.
From 1992-2007 the social, economic and political direction of the European Union was focused on The Single Europe Act (SEA). This aimed to overcome the variety of legal, technical, fiscal and physical barriers to make member states' economies completely interdependent through the creation of a single market. The Maastricht Treaty of 1992 formally created the EU, and led to the circulation of the euro currency in 2002 in 19 of the 28 member states.
The period of acute global financial crises (2007-2009) transformed the nature of how the EU would set about establishing the single market. The crises highlighted the growing interdependence of member states, which was an explicit policy goal; and the importance of having adequate risk measures in place to prevent, if possible, and contain future crises.
By 2009-2010, reducing systemic financial risk in this ever closer union moved to the forefront of the EU’s agenda. Much work was put into developing risk-averse legislation that would guard against such a crisis re-occurring. This had then to take place in the context of global policy written by G20 in Pittsburgh, without sacrificing the essential goal of forming the single market.
The UK voted to leave the EU in June. As of yet, the implications of the decision are uncertain, and this uncertainty has been highlighted through volatile movements in world markets, notably the foreign exchange rate for sterling, and a slowdown in the UK’s economy. Indeed, interest rates have been lowered by the Bank of England to a mere 0.25% in an effort to minimise the economic slowdown.
Formal procedures to exit the EU will occur when the government triggers Article 50 of the Lisbon Treaty. The separation process itself is limited to two years. The start date remains undetermined, all of which generates prolonged uncertainty in the UKs financial markets. Brussels officials are likely to be mindful of the potential threat of the UK leaving the EU hindering or possibly even fracturing the integration achieved so far in European markets. At minimum, this concern is likely to hover over the Brexit negotiations.
Negotiations are key
Bearing in mind that government policy has not yet been formulated, let alone the EU response to it, it is early days. Nonetheless, one must exercise the mind by considering various frameworks for the new relationship. Each would entail disruption to the financial services sector:
1. European Economic Area (EEA) Arrangement
One option would be to leave the EU but remain a member of the EEA, much like Norway. This would be the least disruptive to the financial services sector, and would enable the UK to continue to benefit from many of the EU passporting and trade agreements. This would seem unlikely, because it would require the acceptance of free movement of people and continued contributions to the EU budget. This would be hard to sell to voters, as these were the central objections to EU membership.
2. European Free Trade Agreement (EFTA)
The UK could apply to join EFTA and operate on terms equivalent to Switzerland’s. This would enable the UK to continue to access the single market, but would entail bilateral negotiations on a sector by sector basis. Also, this arrangement relies on a unanimous agreement by the existing member-states, Switzerland, Norway, Iceland and Liechtenstein. This may not be easily obtained. The UK is a far larger economy than the other four nations, which would shift the balance of power within EFTA. These countries may view the arrival of a large member as a good thing, or on the contrary not in their interests at all.
3. World Trade Organisation (WTO) Agreement
Another option, perhaps the more likely of the three, would be for the UK to leave the EEA entirely and join the EU Customs Union (similar to Turkey). It would then access the EU market under WTO rules. The UK would be considered a ‘third country regime’ by EU legislation. This term was incorporated into some regulations for non-EU entities that operate an equivalent regulatory regime, under the terms of which Brussels would grant the applicant reciprocal but not complete access to European Union capital markets.
These three scenarios would require the UK to continue to comply with EU legislation to continue to access the single market. There would be no “bonfire of regulations,” as has been proclaimed by some Brexit campaigners before the Referendum took place. Third-country status has only been tested in a limited fashion; the implications for access would likely be different per regulation.
The following papers in this series of first thoughts on Brexit will discuss the different regulations in force that today frame the post-trade industry.