In a DerivSource podcast, James Doyle, partner in the international capital debt markets team at Hogan Lovells, discusses legal and regulatory issues in the post-Brexit derivatives landscape, and what might happen to London’s status as a dominant financial hub. Listen to the podcast.
The financial services industry as a whole could have done without Brexit. Firms are having to deal with a lot of new regulation already, and now they need to spend time considering and adjusting their business to deal with Brexit. However, the financial services industry will adapt, just as it has adapted to challenges in the past.
One of the biggest changes will be to do with existing regulation. Derivatives contracts entered into in the UK are subject to European Union law, either directly, or by rules that have been implemented into English or Scottish law. If and when the UK leaves the EU, derivatives firms will have to look at how regulation affects these contracts and what needs to change. In particular, everyone will be watching how regulations such as EMIR are going to take effect in the UK.
London’s Status Will Not Change Overnight
London has long rivaled New York as one of the most important financial hubs in the world. About 40% of the world’s currency trades, worth $5 trillion a day notional value, is traded in London. The UK also accounts for about half of the OTC $600 trillion market.
It is unlikely that London will lose that status overnight. There is a huge volume of expertise and infrastructure within the London market, which will be very difficult to replace quickly. Local regulators will also want to ensure there is an orderly transition. There are a number of very important, large financial markets within the EU, but it is expected that any shifts in the balance of power will be gradual and happen over a longer timeframe. How much of that expertise and infrastructure moves to the mainland will depend on the details of the deal negotiated between the UK and the EU.
“There is a huge volume of expertise and infrastructure within the London market, which will be very difficult to replace quickly.”
Some have suggested financial institutions could set up new headquarters in a city with access to the single market, and outsource professional services to London-based operations. While this idea is intriguing, local regulators would need to decide how such a setup would work in practice. Firms would need to have a real presence in the jurisdiction where they are regulated, and risk management will have to take place in that jurisdiction. Outsourcing will feature, but firms will have to have more than just a brass plate in the new location.
Indeed, it will not be a one-size-fits-all approach. Regulators will need to decide what is satisfactory, and depending on particular circumstances, firms may come up with different arrangements.
Changing Roles of Regulators
The roles of regulators are also going to change. The UK Financial Conduct Authority (FCA) has played an integral role in developing EMIR and other initiatives, making sure they achieve the regulators’ aims, but also work for the industry in a practical sense. Once the UK leaves the EU, other regulators will have to take up that mantle, which is no easy task. Meanwhile, within the UK, the FCA will continue to look rigorously at the financial services industry—it’s unlikely we will start to see less stringent regulation in the UK just because the UK has left the EU.
Depending on the deal that eventually gets struck with the EU, there may some sort of equivalence standards put in place. The UK could end up with the same level of regulation as regards derivatives infrastructure as it had as part of the EU, but without the added benefit of having a voice at the table in developing this legislation.
What Does Brexit Mean for Passporting Rights?
The UK-EU deal could take many forms. There is the so called “Norwegian model”—becoming part of the European Economic Area (EEA) with some of the benefits of EU membership like access to the single market, but also being subject to some of the requirements of the single market such as freedom of movement. That may or may not be attractive, given the political climate.
Alternatively, the UK could enter into a bilateral trade agreement with the EU and other countries around the world. The terms would depend on the coming negotiations, but could conceivably involve access to the single market or parts of it. The question will be at what cost, and whether that position is politically palatable. Also, once Article 50 is invoked, it will be extremely challenging to negotiate and implement such complex agreements in the short two-year timeframe before the UK officially exits the EU.
The last option would be a full exit from the EU, with the UK falling back on World Trade Organisation rules. This is a default option, which means the UK is not subject to any European Union law, but it would mean there is no access to the single market, and therefore would not achieve the benefits of passporting that many people are looking to maintain.
In the end, the UK will probably negotiate its own way in terms of how it deals with the EU and other countries, rather than adopting an existing approach such as the Norwegian model. In two or three years, there could be a new “UK model”, which includes a mixture of many different options.
