Brexit: Clear As Mud...Staring At The Precipice

Sunday 25th November saw the European approval of the BREXIT ‘deal’ and plan as to how Europe and the UK will transition toward a British exit from Europe. So far the output from the EU/UK negotiations, on the surface, appear to maintain the status quo and in principal buys businesses time to adapt. Financial Services still has significant uncertainties which will need resolution, but the key issue is whether this deal actually goes through UK Parliament. Watching developments this week it appears - at this moment in time - unlikelyIt seems that financial institutions and those involved in European Markets need to plan for the worst case - ‘falling off a cliff’ in that it can no longer use European Passport to access European Markets. Also, in light of comments made by Mark Carney and the Bank of England, it appears firms need to ‘Brexit Proof’ their businesses. With respect to some of the scope of a Brexit programme, we have explored at a high level, some of the key challenges.

Why does Passporting matter?

In a nutshell, Passporting allows financial institutions (FI) which are authorised within any EU jurisdiction to transact with each other with limited additional permissions. EU banking rules also allow ranges of products and services to be offered across the EU. There is the ability to gain access to the European markets using the ‘Third Country’ regime, however, this limits the scope of the permissions and what activities can be conducted. See the example table below:

?? = Not clear

To put the table in context, if the UK were to use the ‘Third Country’ regime to conduct Financial Services activities say, for example, in a debt issuance for a large European Corporate, the following would likely apply:

  1. Advice would have to be given by the European entity of an FI
  2. Any loans within a structure would have to be conducted via the European entity of an FI
  3. The UK entity could issue debt on behalf of the Corporate for the international Bond Markets
  4. FX activities would have to be conducted via the European FI
  5. The hedge may be able to be executed via the UK entity, however, complications arise further down the transaction lifecycle should the hedge products fall under MIFIR. This will be expanded on later.  

Key Decisions for Firms

So what does this mean? Some firms have already come out and stated they are moving their European ‘Centres’ into the Eurozone. How can you have a firm’s European Head Quarters located outside Europe? This makes sense on the surface, however, many firms were either not that advanced in the early nineties or simply did not have the structure/technology to deal with Multi-Entity requirements. Haven’t we been here before albeit with a different capital regime, no Target 2, no central clearing for Derivative and other product sets……?

Booking Model

Given the EU Banking rulebook, it’s fairly clear-cut: you will have to have a European entity to transact with a European Institution (unless granted Equivalence). The key question going forward is, by product set where do firms want to hold their risk and what is the most effective use of capital/across entities for where the risk is held? Do they have global books?  As a result, and in addition, how do firms manage liquidity? Where are the cash and asset pools? And what Central Banks Cash raising ability is required across the EU and within the UK? The alternative here being commercial bank money (liquidity regime impact).

If you go back to the nineties, some firms used to hold their risk in the UK but use their European entities to access the local markets. Some had very creative tech solutions to move net positions or used total return swaps to move risk and maximise balance sheet usage and exploit differences in tax regimes.   

The markets have evolved significantly since those days with the introduction of central clearing for what were largely OTC products, (derivatives, financing products and securities products traded on Platforms or Exchanges), TARGET II for cash and securities, access to central bank money to name a few. In addition, access to Exchanges and Domestic and European Trading Platforms (e.g. MTS) means firms will have to ensure memberships are held with the European entities. This means the resultant clearing membership will need to be held with a European entity in all likelihood.

If firms want to back to back that risk back to the UK, it would mean an OTC transaction of sorts - which would likely attract less favourable capital treatment. This then points to holding the risk within the EU unless the UK come up with some incentive which is counter-intuitive. To move positions on an OTC basis also flies in the face of what every regulator has set out to achieve under Dodd Frank and EMIR. This will mean most firms face entity enablement programmes/projects thus ensuring their existing operational capability is on par with their existing booking model. 

On the flip side, UK based institutions, if they want to maintain access to European domestic markets and products will have to look at their own entity structure or make the decision to transact via a European entity on an OTC basis.

In summary, this really points to one very large business case/maths equation e.g:

Cost of maintaining status quo (book across locations +/- Captial + Entity enablement + clearing) versus -  (Entity enablement +/- premises costs + cost of move + redundancy + migration +/- tax differentials). This would need to be measured in payback period/shareholder value requirements.

People who come up with creative solutions to the above (similar to the ’90s) will be able to exploit the situation rather than just absorb the cost as part of a ‘stay in business’ strategy.

Central Counterparty (CCP) Clearing

One of the significant impacts to the markets would be that under a UK exit from the EU, under MIFIR it could affect the EU firm’s ability to remain members of UK CCP clearing. (e.g. LCH) and vice-versa - UK Institutions remaining members of European Clearing Houses (e.g. Eurex). This will affect both Derivative and Securities Clearing.  In the event of a no deal scenario, there could be a gap between the UK achieving ’Equivalence/Third Country Status’.  In that scenario, there would be a huge operational challenge to potentially migrate from one Central Counterparty to another. These would be huge project undertakings for participants within the market involving trillions worth of contracts.

Also under the Capital Requirements Regime (CRR), this would lead to additional exposure costs for UK based cleared products to European base FI’s. This could lead to systemic risk should firms decide to shut down exposures in one and move to another using a transactional basis. It should be noted that both ESMA and ISDA currently have only suggested mitigating actions. Amongst these (but not limited to) being:

  • Working with the respective CCP’s trade repositories etc in advance for ‘contingency planning’ for taking in membership applications
  • The EU should consider law changes to soften the blow of a no deal and create a ‘temporary regime’ – whatever shape and form that takes
  • EMSA develop a proposal to manage the transition
  • The EU should provide transparency surrounding mitigating actions it’s taking which become effective post BREXIT.

Not overly comforting at this stage given where we are in the timeline.

Whatever the outcome, in the immediate short term there is likely to be a significant resource demand

Other issues/impacts include:

  • Impacts on non-financial counterparties who are clients of UK firms where they have traded Exchange Traded Derivatives (ETD) on UK regulated markets 
  • European firms will lose their exemptions from clearing and margin requirement for OTC Derivative products with their UK affiliates (again a booking model driver). This will impact intra-group exposure management
  • EU Institutions will not necessarily be able to transact on UK Trading venues
  • EU Institutions CRR impacts as a result of exposures to UK Credit Institutions
  • Trade transparency and Transaction reporting impacts due to changes in assets caught under MIFIR.

Entity Enablement

If you look across the entire transactional lifecycle, a lot of firms have gaps in entity functionality. Capability for a UK booking model and access into Europe does not mean that functionality is the same or replicated across entities or architectures. Some have different systems in different locations to access local markets (granted Target 2 for cash and securities may have addressed some of this), but a lot of firms still run multiple access points and branch structures. Firms will need to look at the booking model across the entire transaction lifecycle. This challenge is more prevalent in UK firms having to enable a European entity. What Trading (brokers, market access…..) settlement and clearing relationships need changing?

What governance, risk and control changes are required in the first, second, first and third lines of defence in line with the EBA’s vision to avoid ‘name-plating’?

For firms wanting to manage their risk in a UK based entity, how do positions and balances move on a net basis to remove settlement and clearing duplicity across products?


These are just some of the challenges. A lot of organisations have taken the approach that there would be a transitionary state. If Theresa May fails to get agreement on the overall plan, which includes the business ‘transition’, there is a lot to be considered in a very short space of time. This includes Regulators, Market bodies, Financial and Non-Financial Institutions to name a few if the worst case happens. This could also lead to a temporary spike in resource demand in Q1 2019.

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