Regardless of how current Brexit negotiations progress in Brussels between the United Kingdom (UK) and the European Union (EU), Teresa May’s government will start to issue next month some instructions to UK-based companies on the actions they need to take in the event of a no-deal Brexit. Even if no-deal had the lowest feasibility probability among all the different scenarios financial institutions tried to price, this eventuality is growing.
As the clock runs down, it appears vital to get a refined view on what sort of impacts the actors currently involved face in what we could probably call an upcoming new European banking union landscape.
Historically considered as one of the largest global financial centres in the world, how financial trades will occur in London next April 1st, 2019?
What is sure is that all the different steps of a transaction will be affected, from trading to execution, booking, clearing and reporting: nothing will be the same anymore as the whole trade workflow could heavily get impacted.
1. Pre-trade impacts:
It starts with all the pre-trade aspects, where a London-based sales representative could not be able to pick up the phone to an EU client at all, as under MiFID II directive the reception and transmission of orders in relation to one or more financial instruments is considered as a regulated investment service. In case of no-deal, all UK-based banks will lose the EU’s passporting rights, hence could not be able to operate those services unless some specific agreements are found.
Because legal regimes are different from one country to another, most EU countries require a UK dealer to get a licence if its salespeople want to serve clients in that jurisdiction. That is why we are currently seeing some banks reorganising themselves and moving out some sales representatives in its European entities to carry on serving EU clients hence avoiding licencing burden.
Same thing from a legal papering perspective, in case there is no equivalence after a no-deal where EU clients deal with UK-based dealers, all the contracts (incl. ISDA contracts) will need to be repapered and signed with EU legal entities dealers to be able to serve EU clients.
2. Trading Execution and booking impacts:
Once the previous pre-trade aspects will get resolved, banks will have to deal with execution issues and the back-to-back trading techniques. Today, when a dealer enters in series of trades with EU clients, it usually books all these positions in a local trading book to be able to offset them more easily and to enter mirroring internal trades to transfer the risk of such positions to a London based trading book. With passporting rights lost, European Central Banks (ECB) made it clear that the EU entities will have to retain some risks instead of sending them all back to London. That means that EU entities will have to scale up their balance sheets to get the additional sum of regulatory capital required for retaining such risks. Tomorrow, the way in which the booking model will be defined to support the booking and the risk management of transactions undertaken with EU clients will be the main driver of impacts for banks.
Also, truth to be told, some liquidity issues could appear soon, especially with products that need to be executed electronically on Multilateral Trading Platforms (MTF) / Organised Trading Facility (OTF) like swaps that needs to satisfy MiFIR’s electronic trading requirement. Today, dealer-to-client trading is dominated by two London-based MTFs: Bloomberg and Tradeweb. In case of a no-deal scenario, those platforms will lose their EU authorisations, hence, they both decided to set up entities in the Netherlands. And Amsterdam is not a random choice, simply because this EU country offers a more flexible jurisdiction that can allow a non-EU dealer to respond to quote requests and execute on its platform (country’s overseas persons exemption runs in the Netherlands). Depending on licenses equivalence, EU clients could need to be onboarded on both UK and EU MTFs to get access to the full range of products they currently deal with to overcome liquidity dry-up of such required products.
3. Clearing impacts:
The current commercial battle we can witness between main UK (e.g. LCH.Clearnet) and European (e.g. Eurex) Central Counterparties (CCPs) confirm that the legal access to clearing solutions post-Brexit is key in the current negotiation. CCPs process most of the world’s trade in the $530tn market for derivatives contracts, cushioning their users from the risk of default and associated legal and trading problems. Regardless of Brexit deal outcomes, the UK and EU regulatory bodies recently decided to temporarily allow banks and companies on both sides to use UK/EU-based clearing houses without specific permission. Still, post-temporary permissions, some agreements between both jurisdictions will need to be agreed on in order to find equivalent recognitions between UK and EU CCPs. Post-Brexit, LCH.Clearnet which currently dominates the interest rate swaps clearing business could lose authorisation to clear for EU clients if no equivalency status is found by becoming a third-country CCP. Hence, EU clients could have to clear new trades locally and remaining existing positions in the UK, splitting their positions between several CCPs, drying up liquidity and incurring extra margin payments for their fragmented positions, and increasing associated capital costs.
4. Reporting impacts:
Another main impact of Brexit could be found around the activity of transactions reporting via Trade Repositories (TR) and Automated Reporting Mechanisms (ARMs). As the main principles of the European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Regulations (MiFIR) regulations will still be valid in a no-deal Brexit world (until arrangements between jurisdictions are found), existing architecture workflows to report transactions to EU regulators will be affected. A TR is an entity that centrally collects and maintains the records of over-the-counter (OTC) derivatives, under EMIR in Europe. DTCC, which holds data for around four-fifths of the global derivatives market and currently UK-based, set up an office in Dublin to ensure that post-Brexit, its EU clients will be able to carry on complying with their EMIR duties. Same challenges will apply to ARMs logic where some arrangements to obtain EU authorisation are required to carry on servicing EU clients.
Despite temporary permission regimes appearing on both UK and EU sides regarding certain trades’ aspects, all the financial actors in the industry are impacted including sell and buy-side, brokerage companies, trading venues, clearing houses and servicing firms. A disorderly exit from the EU clearly increases the risk of a serious breakdown in cross-border financial services in March 2019, especially regarding the normal continuity for financial operations lifecycle.