1. The City of London outside the European Economic Area
Part of London’s attractiveness as an international financial centre is its access to the internal market of the wider European Economic Area (EEA). By using a UK licence as a European passport, foreign financial firms can offer their financial services throughout the EEA. London as a financial centre is also home to the bulk of euro-denominated trading with access to euro-settlement and clearing systems. If the UK cannot secure a ‘Norway’ deal and stay within EEA, the UK will lose the passporting rights and access to the euro settlement and clearing systems.
In an earlier blog post, we discussed the impact of Brexit on banking and insurance and concluded that the insurance industry makes very limited use of the passport. Here, we analyse the impact on wholesale banking and securities and derivatives trading. France’s President Hollande has already said that the City of London should no longer be able to clear euro-denominated trades after Brexit (FT, 2016).
Our findings on wholesale banking and trading are indicative. The early numbers suggest that up to half of the total UK banking system relates to wholesale banking in the City of London. Wholesale banking covers the full remit of trading and derivatives activities and takes place in several currencies (dollar, euro and sterling). Next, we find that, in particular, the over-the-counter (OTC) derivatives markets might be affected, as 70 percent of euro-denominated OTC interest rate derivatives are traded in London.
2. The passport
The internal market is underpinned by a framework of directives and regulations. A firm with a licence in its home member state is permitted via a passport market access in other EEA countries. The most important directives for banking and trading are:
- the Capital Requirements Directive (CRD IV, 2013/36/EU) for banking
- the Markets in Financial Instruments Directive (MiFID, 2004/39/EC) for investment services
- the Alternative Investment Fund Managers Directive (AIFMD, 2011/61/EU) for hedge funds and private equity
- the Prospectus Directive (2010/73/EC) for issuing securities
- the Undertakings for the Collective Investment in Transferable Securities Directive (UCITS, 2009/65/EC) for marketing and trading investment funds
To give an example of how the passport works, we illustrate how the passport works legally with the Capital Requirements Directive (CRD IV), the legal framework for credit institutions (banks). The passport consists of several elements of the CRD IV:
- Licence: Title III of CRD IV (Articles 8 to 21) specifies the requirements for access to the activity of credit institutions. The main element is authorisation by the home supervisor, which provides the single licence.
- Freedom of establishment: Title V (Articles 33-39) contains the provisions on the freedom of establishment and the freedom to provide services. It means that if a credit institution is authorised in one member state, it has the freedom to establish a branch in (or to provide services to) any other EEA member state without prior approval. The credit institution only needs to notify the host-country supervisor.
- Home supervision: Title VII sets out the principles of prudential supervision, which predominantly give powers to the home supervisor with some very limited powers for the host supervisor in the area of liquidity supervision. As these powers of liquidity supervision are related to the operations in different currencies, the new European banking supervision framework has decided to give up these host-country powers within the euro area, which uses the single currency (Schoenmaker and Veron, 2016).
This system of full access based on a single passport provided by the home-country supervisor is limited to the EEA. So if the UK were to leave the EEA, UK licensed banks (whether or not headquartered in the UK) would need to obtain an extra licence from the host supervisor in an EEA member state in order to offer financial services in that member state.
An extra licence would be necessary for all forms of cross-border services, ie through the establishment of a branch or subsidiary or through the direct offering of cross-border services. The UK would then become a third country, which would need to find a point of access into the EEA for business. Similarly, EEA financial institutions would need to apply for a licence to enter the UK. The passport system in the other EU financial services directives is similar to the CRD IV.
Given the amount of euro-denominated finance carried out in the UK, it is important that London, within the EEA, has direct access to the infrastructure for wholesale payments (TARGET2) and clearing (LCH-Clearnet) in euros. TARGET2, the payments system for the euro area, permits national central banks, banks and designated financial institutions within the EEA to join even if they are outside the euro area (Armstrong, 2016). UK banks and other designated financial institutions are permitted to be direct participants in TARGET2 even though the Bank of England does not participate.
Armstrong (2016) argues that if the UK were to leave the EU and not join the EEA, then banks in the UK could no longer be direct members of TARGET2. They would have to operate through subsidiaries (or perhaps branches assuming the UK is deemed ‘equivalent’ in terms of regulation) within the EEA. This would make euro banking via the UK more expensive. It would also erode the attraction of London as a destination for non-EEA banks to establish their EU headquarters.
Moving to clearing, central counterparties (CCPs) are important for the settlement of securities and derivatives transactions. There are three clearing houses operating in the UK which are recognised by both the UK and the EU: CME Europe, a derivatives exchange and wholly-owned subsidiary of US-based CME group, LCH.Clearnet Group Ltd, majority owned and operated by the London Stock Exchange Group, and the London Metal Exchange Limited. Of the three clearing houses, LCH has by far the biggest share of euro-denominated clearing in the UK (Batsaikhan, 2016).
The European Central Bank initially exempted the UK entity of LCH from Target2 as part of its ‘location requirement’, but the Court of Justice of the EU (ECJ) subsequently decided that the ECB has no competence under the Treaty on the Functioning of the European Union (TFEU) to impose such requirements on the clearing houses. Furthermore, by imposing location requirements, the ECB violated the freedom of establishment, freedom to provide services and freedom of movement of capital in the single market (Batsaikhan, 2016; Armstrong, 2016). But outside the EEA, the UK would no longer have the protection of the TFEU and the ECJ. This is no problem for LCH.Clearnet Group itself, as it has major entities in New York, London and France (see Table 1). If needed, LCH can thus move its euro-denominated clearing business to Paris.
What is the size of London’s wholesale banking activity? Table 1 provides an overview of the total UK banking system. Most UK banking assets (£3,570 billion) are held by the major UK international banks: HSBC, RBS, Barclays and Standard Chartered. While Standard Chartered operates primarily in Asia, the first three are active in Europe. HSBC and RBS have already a subsidiary (and thus a licence) on the continent: HSBC in France and RBS in the Netherlands. Barclays operates through branches, for example, in Italy and France (Schoenmaker and Véron, 2016). So, only Barclays might need an extra licence to enter the EEA after Brexit. Based on the banks’ annual reports, we estimate that about one third of the total assets of the major UK banks relate to their trading and derivatives books in London, amounting to £1,180 billion.
The major domestic UK banks and other UK banks have most of their operations in the UK and concentrate on traditional banking business, with little or no trading or derivatives business.
Table 2 shows that £1,730 billion in assets in London is held by the major international investment banks, mainly from the US and Switzerland. These US and Swiss investment banks use London as a hub for their European operations (Goodhart and Schoenmaker, 2016). Table 3 indicates that 90 percent of European turnover and employees of the five large US investment banks (Goldman Sachs, JP Morgan, Citigroup, Morgan Stanley, Bank of America Merrill Lynch) are located in London. These investment banks use their UK passports (both the banking license under CRD IV and investment services license under MiFID) to conduct business throughout the EEA. These investment banks are currently looking for a new passport in the EEA.
At this stage, it is guesswork how much of their derivatives and securities trading and corporate finance business US investment banks might move to continental Europe. Early estimates indicate a minimum of 20 percent. At some point, the liquidity in certain markets might move to the continent, in which case part of the trading floor will also move (OTC derivatives are a case in point; see next section).
If the US investment banks relocate part of their operations to the euro area, the ECB will become their supervisor if their assets are greater than €30 billion. While it is appropriate that a large supervisor like the ECB would be responsible, rather than smaller national supervisors, the ECB will need to beef up its markets (derivatives and securities trading and corporate finance) expertise to do the job (Danielsson, Macrae and Zigrand, 2016).
In sum, Table 2 estimates that close to half (£3,750 billion) of the total UK banking system is related to wholesale banking in London. In the next section, we provide a breakdown of wholesale business by category (securities and derivatives) and currency (sterling, dollar and euro).
The final step for the assessment of the impact of Brexit on the City of London is an estimation of euro-denominated trading. At the outset, we stress that our calculations provide a preliminary assessment of the main market segments and should be interpreted with some caution. The main purpose of our preliminary calculations is to get an idea of the possible impact.
The main wholesale financial markets in London cover:
- Foreign exchange trading
- Private and public bond trading
- Equity trading
- Commodities trading
If access to euro clearing and settlement in London ceases, we expect the greatest impact to be on the bond and derivatives markets. Forex is an international market, in which London has a prime position. Settlement of FX transactions happens through CLS (originally Continous Linked Settlement), the largest multicurrency cash settlement system to mitigate settlement risk for the FX transactions of its member banks, and is thus not dependent on London’s access to TARGET2. That would therefore not need to change should access to TARGET2 be stopped. Next, the settlement of equity trades is closely linked to the respective stock exchanges, on which the equity trades are executed. Finally, commodities (eg crude oil and metals) trading is largely a dollar-denominated business.
The BIS Triennial Central Bank Survey of foreign exchange and derivatives market activity is the largest survey in its field (BIS, 2015). Table 4 provides figures for the OTC single currency interest rate derivatives, which counts for the majority (79 percent) of the global OTC derivatives market. It shows that London accounts for about 70 percent of euro-denominated trades and New York for 70 percent of the US dollar trades. These large shares are no surprise, because these two markets are the most liquid interest rate derivatives markets in euros and dollars, respectively, and thus attract the majority of trading in the respective currencies. Next, 50 percent of the global OTC interest rate derivatives market relates to euro-denominated derivatives, which is clearly the largest market.
What do these statistics tell us? First, the City of London is currently home to the main market in euro-denominated interest rate derivatives (with 70 percent of euro-denominated trading). Second, the London share in euro-denominated trading is one-third of the total global interest rate derivatives market. Third, the potential impact for the City of London is that up to 69 percent (= $927.8 billion/$1,347.7 billion) of its interest rate derivatives market could move to continental Europe after Brexit.
Moving to government bond trading, Figure 1 shows the monthly amount of cleared government bond trades (both cash bond and repo trades) executed by LCH.Clearnet. The UK entity clears trades for the following markets: Austrian, Belgian, Dutch, German, Irish, Finnish, Portuguese, Slovakian, Slovenian and UK government bonds. The French entity processes the cash trades and repos for Italian, French and Spanish government securities. LCH.Clearnet thus serves the major markets for euro-area government bonds. It is interesting to see that French entity has recently overtaken the UK entity, partly because of the increased trade in euro government bonds from the south of Europe.
The trading and clearing of the bonds of the nine euro-area governments, which now done in the UK, could be easily transferred to the French entity, if the UK entity can no longer clear euro-denominated trades. Figure 1 shows that monthly government bond trading amounts to €6 trillion, both in the UK and France.
It should be noted that LCH.Clearnet shows only a partial picture of euro government bond clearing. Euroclear in Brussels and Clearstream in Frankfurt also clear a large amount of euro-area government bonds.