City blues

It has been a source of huge frustration to the financial services industry that it was side-lined during the Brexit negotiations with ministers apparently fixated on securing a deal for the fishing industry. It is a sign of the madness which has infected policymaking over recent years that an industry which – to one decimal place – accounts for 0% of GDP and which employs around 12,000 people, was prioritised over one which accounts for almost 7% of GDP; employs almost 1.4 million people and generates an external surplus which offsets a large chunk of the deficit in merchandise trade. Since the start of 2021 the British financial services industry no longer has unfettered access to its client base in the EU. Whilst there are many who would wish to see the City taken down a peg or two, the industry is of such a scale that a threat to the business model does have potentially major economic implications.

Recent events raise three obvious questions: (i) why did the British government fail to protect an industry in which it enjoys a significant comparative advantage; (ii) how has the nature of trade in financial services changed and (iii) what is likely to happen in future?

Why were financial services excluded from the Brexit negotiations?

The government apparently believed the City was big enough to look after itself, being as it is one of the largest financial hubs in the world. It was believed that the breadth and depth of services on offer could not be replicated elsewhere in the EU and that it made sense for the UK to defend its interests in other areas. I have long thought that this view was criminally complacent. Immediately after the 2016 referendum banks started to make provisions to continue conducting business on the assumption that they would no longer have access to the single market. I did point out in 2017 that financial institutions were not waiting around for government to make a decision. If ministers had been listening to what bankers told them, they would have realised just how much contingency planning was going on and how prepared they were to move business out of London.

How has the nature of financial services trade changed?

Access to the EU single market for financial services is governed by passporting rights. This means that once a firm is authorised in one EU state it can trade freely in any other with minimal additional authorisation. Passporting is based on the single EU rulebook for financial services and is not available for firms based in countries outside of the EU and the EEA, which face significant regulatory barriers to EU market access. As it is now treated as a third country for EU trading purposes, UK-based firms must now rely on regulatory equivalence in order to access the wider market. This works on the principle that the EU considers UK laws as having the same intent and produce broadly the same outcomes as those of the EU. But whilst it does give the UK market access, the degree of coverage is more limited than passporting and it can be unilaterally withdrawn with just 30 days’ notice which is no basis for long-term planning.

Where do we go from here?

For all that the Brexit trade treaty was signed last December, negotiations on financial services are far from done. Both sides intend to agree a Memorandum of Understanding by March 2021 to establish a framework which preserves financial stability, market integrity and the protection of investors and consumers. The issue of how to deal with equivalence determination is also likely to come up.

None of this disguises the fact that in the early weeks of 2021, the UK finds itself skating on very thin ice. It has seen its access to the EU market significantly reduced. Worse still, the EU appears engaged in a form of “land grab” to onshore as much financial services business as possible in a bid to reduce dependence on London as it ultimately attempts to form its own capital market union. To the extent that Brexit was sold as a project to enhance the UK’s global interests, British politicians can hardly complain when the EU responds by looking out for its own interests. It is hard to avoid the view that the City has been hung out to dry, but the fault for this lies squarely with politicians who either did not understand or (worse) ignored the industry and did not look out for British interests during negotiations.

 

There has been a lot of chatter about the erosion of the City’s position since the start of the year. One of the more well-publicised items was the news that Amsterdam’s trading volume in stocks exceeded that of London in January (chart 1). On the one hand the direct impact of this is marginal. It will not cost many jobs because trading is largely done electronically. Nor will there be a significant loss of tax revenue due to the fact that this is a low margin business. But it is symbolic. London does not have an inalienable right to remain the EU’s financial market place and we do have to wonder whether companies planning to list in Europe will necessarily see London as the go-to place in future. According to research by the think-tank New Financial at the end of 2019, 75% of all non-EU bank assets in the EU were held in the UK. By end-2020 it estimates that this share fell to 65% and it is likely to fall further in future. In addition, other parts of the industry are loosening their ties to London with trading of European carbon futures also set to move to Amsterdam.

In a speech last week, BoE Governor Andrew Bailey bemoaned the current state of affairs. He noted that “the UK has granted equivalence to the EU in some areas, but the EU has not done likewise to the UK.” Bailey also noted that the EU is attempting to hold the UK to “a standard that the EU holds no other country to and would, I suspect, not agree to be held to itself.” He concluded that the UK cannot allow itself to be a rule taker in financial services given that the assets of the sector are ten times that of UK GDP. Bailey is no tub-thumping Brexiteer and the BoE has consistently warned of the risks to London’s financial position resulting from Brexit. It will give him no pleasure to point out that its worst fears have been realised.

There is no doubt that the current arrangement on financial services trade is detrimental to the City’s interests. New Financial notes that there are 39 different types of equivalence arrangement but reckons that the UK has so far been granted two compared to 23 in force between the US and EU (chart 2). Matters do not appear likely to improve anytime soon since the EU has no incentive to offer the UK a better deal without a compromise in other areas which would undermine the regulatory independence that many politicians were seeking. Chancellor Rishi Sunak recently suggested that the City could use this opportunity to generate a 1986-style Big Bang 2.0 but this is not a view shared by Andrew Bailey, who noted last week that the UK should not “create a low regulation, high risk, anything goes financial centre and system. We have an overwhelming body of evidence that such an approach is not in our own interests, let alone anyone else’s.”

Quite what happens next is unclear. London still has advantages in terms of its network of related services and is still home to the global insurance industry. It also has a head start in fintech and has made great strides in green finance which put it ahead of many continental financial centres. But although the UK possesses large and deep financial markets only half the City’s wholesale business is derived from UK customers, with 25% coming from the EU. I have been making the point for many years that since financial services are a global industry, the threats to London also emanate from New York and Asia. Although the City is not about to collapse, it is difficult to see how a business that depends on barrier-free trade will enjoy the same pre-eminence as before. There were many in the City who voted for Brexit in 2016. I warned them at the time to be careful what they wished for. Now they may be about to reap what they sowed.