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London loses the driving seat in financial regulation

May 5, 2017

Brexit is about to get ugly, politically and economically. And one of its ugliest bits will be the stupid Kabuki game between London and Brussels on the terms of their negotiation. It is tiring to see so much sweating over who sets the rules rather than what the rules are.

London is used to making rules. It is big. It is autonomous. It is connected. There is traditionally a British Commissioner overseeing the industry and the European Banking Authority is in London. When it comes to Finance, the City is the rule.

After Brexit, Brussels will call the shots in financial regulation. For all its weaknesses, the EU remains the “normative superpower.” And the City is no longer in the EU. Although the City is a power to be reckoned with, there is no way around No. 10 for this negotiation, unfortunately.

Whatever happens, the U.K will lose uninterrupted access to the biggest financial market in the world. “Being inside the EU cannot be the same as being outside.” That is the message from every capital, including Paris and Berlin. And without the so-called passporting, the City will lose thousands of well-paid jobs in the financial sector. Increasingly, the question is “how many.” More chillingly, London could lose power and connectivity.

Having the cherries, and eating them too?

Fighting the U.K’s corner, the Bank of England Governor Mark Carney called last week for a “mutual recognition” regulatory system, and on Monday the International Regulatory Strategy Group (IRSG) fleshed out how it could work in practice.

What is suggested is that the EU will open its market on the basis of “global rules,” including London, complete with a dispute resolution mechanism governed by “independent” regulators. Alternatively, this would be a bespoke deal for London. What Europe gets in return is presumably a “deep and liquid” market, or so the argument goes.

In this scheme, the City can grow in parallel to Europe, ensuring compatibility and access to the Single Market, without the U.K submitting to the jurisdiction of European regulators. But, that is cherry picking. And in certain European capitals, the notion that Europe will change to accommodate the City may appear somewhat, “fanciful.”

London could become a taker of financial regulation

For a very long time and very good reasons, London has been able to entertain fanciful ideas, not least because of its significance as one of the world’s most important financial centres, if not the most important. But, London could now become a taker of rules. Imagine that.

The first loss was the resignation of the British EU Commissioner Financial Services Commissioner Johnathan Hill in June 2016. Johnathan Hill was not just another Commissioner, he was the last important key holder of financial regulation on behalf of the U.K in Brussels. Now, a leaked European Parliament report confirms that the European Banking Authority will be relocating from London as soon as possible.

Founded in 2011, this vital financial institution conducts regular stress tests on EU’s financial sector. The EBA is located at London’s Canary Wharf district and, in fact, it’s lease agreement expires in December 2026 and the breakup clause could cost the agency €3,2 million, Financial News reported in December. But, it will go. The question is “where” not “if.”

“Where” not “if”

Luxemburg formally threw in its hat to inherit the EBA. In a letter to European Council President, Donald Tusk, Prime Minister Xavier Bettel of Luxembourg claims the Grand Duchy has the legal right to host the EBA, Reuters reports. Bettel makes reference to a 1965 ruling that commits the EU to locate agencies related to finance in Luxemburg. Of course, the EU has somewhat enlarged since 1965 and Luxemburg is the last in a long queue for one of the gems in the Brexit spoil.

In October 2016, the Irish government was the first to declare its interest, triggering rumors for Madrid, Warsaw, Frankfurt, Milan, and Amsterdam. Frankfurt’s main advantage is that it is already the host of the European Central Bank. That could also be seen as its main disadvantage. In any event, there are just too many contenders for this valuable City gem London is giving out for free.

Make no mistake: the City will lose a significant piece of regulatory oversight. Of course, that is not the end of the world. The City in its magnificence, size, and might could still cast its shadow over Europe. Right?

Divide and Rule (brokering)

Indeed, there is one thing working for London. There is no EU 27common front in financial regulation, particularly in brokering.

Brokering is that the matching of buyers and sellers for a commission. An example of what do these businesses do is allowing a Romanian manufacturer of car spares parts to a Finnish car service center, matching demand and supply. The idea is that the broker has a deeper knowledge of the market than any individual firm. Moreover, the broker adds value by ensuring the transaction is effectively risk-free.

The European Central Bank cannot oversee the EU 27 brokerage market since it has a mandate over the Eurozone alone. Therefore, the whole brokerage market remains under the jurisdiction of national financial regulators, with London being a global market leader.

London will, of course, need to have a window shop somewhere in Europe. Many countries are willing to play that role. In fact, City-based banks looking to relocate are offered a plethora of “regulatory sweeteners” from places like Frankfurt, Dublin, Luxembourg, Paris, and Madrid.

Spain is bolder than most, Reuters reports. The Spanish regulator (CNMV) could allow dealers to back-to-back 100% of their trade, while others are negotiating a smaller margin, Reuters reports. Germany’s Bafin will only consider back-to-back as an interim measure.

“Back-to-back” trading is about allowing securities to be physically traded in Europe while doing all the value-added work such as risk management and the transactions from London. That could litter Europe with “empty shell” offices, which are run from London. So, jobs will be lost, but not that many. Right?

Not everyone is stupid in Brussels

Perhaps. The response of the European Securities and Markets Authority (ESMA) to this regulatory race to the bottom is not yet clear.

The ECB is warning banks that “back-to-back” trading will not work and it is applying pressure to streamline national regulatory agencies. Evidence of success, if any, is not evident.

But, in the long run, U.K-based banks cannot count on Europe’s regulatory environment not growing apart from the U.K. One of the ideas contemplated by the European Commission is obliging banking firms with over €30bn in assets in the EU to set up a holding company within the bloc. In setting up shop in the EU, they will come under ECB’s supervision.

In time, the City could be cut off.

On May 31, the European Commission and the Vice-President of the European Commission, Valdis Dombrovskis, presented a second reflection paper on the European Monetary Union (EMU). Predictably that will not rule out the repatriation of clearinghouses to EU territory, after Brexit.

As the EU’s executive responsible for the portfolio of Financial Services, Dombrovskis told a press conference that some central counterparts (CCPs), or clearinghouses, “play an essential role” in European financial markets. Dombrovskis has emphasized that this reality is “particularly relevant” in the case of the UK, as 75% of euro derivative transactions are settled in the UK.

That is now a problem.

Still, if the U.K could make some time, perhaps the banks would stick around to follow the plot. But, the Conservative government is making that very hard. Mrs May has recently lost her stiff upper lip and goes out promising to fight Europe on the beaches. Meanwhile, banks and law firms buy office space in Dublin. Bankers are not really into drama.