Brexit has inflicted significant damage on the UK financial sector. Since the end of transition period last year, almost 6 billion EUR of EU share trading has shifted from London to the continent, leaving London with half its usual trading volume. Moreover, 1.2 trillion GBP of assets and 7,500 jobs have already been transferred to the EU, whilst a further 4 billion GBP of insurance premium income that would typically be handled in London is also set to move to EU venues. At present, Brexit appears not to be solely negative for the sector as it may yet provide an opportunity to reinvent London’s financial sector free from EU regulation.
The EU is not the only beneficiary of the UK financial sector’s misfortune, however. In the US, trading in swaps used to hedge against euro and sterling interest rate movements has doubled in the opening weeks of 2021 – whilst the US’s share of global trading in dollar swaps rose to 48% from 36% versus the final months of 2020. Considering the UK’s longstanding dominant position in global derivatives and foreign exchange trading (global shares respectively stood at 48% and 43% in 2019), the US has benefitted from Brexit’s impact on the UK’s financial sector.
These are just some of the immediate impacts of Brexit on the financial sector, which for decades has benefited from unfettered access to the single market. The damage could, to some extent, be reduced by equivalence, a status that allows EU entities to carry out financial activities in non-EU venues. So far, however, the EU has refused to reciprocate the UK’s decision to grant the EU financial sector equivalence status. Out of 40 different financial areas where London is seeking market access, only 2 areas were granted an 18-months equivalence. In contrast, US clearing houses were offered open-ended equivalence, effectively inviting the US to compete for business that previously had gone to London.
Brussel’s insistence on not granting the equivalence may be partly motivated by politics, as withholding equivalence can increase the EU’s bargaining power in any future negotiations with the UK. For the most part however, the EU’s position is supported by economic concerns. Firstly, the EU has been running a large trade deficit in financial services, importing 26.1 billion GBP worth of services each year. Furthermore, the EU may be looking to reduce its reliance on UK financial services. Indeed, in 2019, the UK was responsible for 84% of EU derivatives trading, 82% of EU foreign exchange trading and 42% of EU asset management.
As a result of these factors, the UK may not expect to be granted favourable equivalence decisions in the foreseeable future. In an extreme, yet unlikely, situation Brussels could also withdraw existing delegation rights for 2 trillion GBP of EU funds to be managed from London, thus diverting financial assets from London to EU hubs such as Frankfurt. Were this to happen, London could potentially lose a significant proportion of its capital and have its status as a premier financial hub challenged. Given that assets dictate demand for financial services such as trading and liquidity management, banks ranging from the UK’s Barclays to big US investment banks, such as Goldman Sachs, might be expected to transfer jobs to the continent or reduce UK-based hiring. However, it should be noted that this is a worst-case scenario.
Nevertheless, London’s status as a financial hub should not be completely disregarded in the post-Brexit era. Sitting at the heart of the ‘follow the sun’ trading network, London remains the top destination for funds and capital in the European time zones. An impressive breadth of financial-related industries and services readily accessible coupled with the fact that English law remains the global lingua franca for international contracts further serves to illustrate the long-term potential the city possesses.
In addition, London’s dominance in European capital markets, which dates as far back as the 1960s with the establishment of Eurobond markets, is unlikely to be affected in the short run. London’s capital market is much larger than the combined size of the EU27’s capital markets. Expressed in a percentage of the EU27’s GDP, London’s capital market represents 171%, whilst the EU’s amounts to just 87%. Additionally, the EU’s capital markets are fragmented along countries’ borders with some being underdeveloped. In comparison, London’s market offers a deep pool of liquidity that benefits from synergies. It attracts financial activities such as insurance underwriting, derivatives and FX trading which in turn attracts fund managers seeking more competitive pricing and services than are available elsewhere.
Above all, being outside of the EU could bring potential benefits for the UK financial sector. Notably, it would allow London to diverge from EU regulation. However, this would potentially limit any equivalence negotiations. Some expected changes in regulation include scrapping Mifid 2 regulation (a framework that standardises regulation across the EU with the intention of improving investor protections) which has been argued to hinder equity research. Furthermore, there may be a relaxing of the Solvency 2 regime (regulation covering EU insurers’ capital reserves) to free up capital in pension funds, and reforming listing rules to attract technology firms to London. Whilst dislocation from the EU has already, and will likely continue to, incur varied costs, Brexit is unlikely to be an end to London’s status as a financial capital. Rather Brexit provides an opportunity for the financial sector that may yet be a boon.
By Nicky Lau
Sector Head: James Float