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On June 23, 2016, the United Kingdom voted to leave the European Union, unraveling more than 40 years of their combined history. While the UK has always had a chequered relationship with the EU, the fallout of the vote is expected to be equally long-drawn and far-reaching. UK is home to some 2.2 mn people in the financial and related sectors; around 700,000 of these reside in London. The financial services industry, contributing 11.8% of the economic output in 2014 / US$87 bn in taxes last year, is probably the most directly impacted by the result of the referendum.

Amongst the many uncertainties surrounding the exit vote is the status of London as the leading global financial capital. The sustainability of the banking sector in UK hangs on its access to the European single market. While Phillip Hammond, Chancellor of the Exchequer, aims to retain passporting rights for the independent UK, cracks are beginning to appear in London’s financial dominion. The city’s days at the helm appear to be numbered with multinational banks already scouting for alternate locations.

Drivers of Change: Regulatory considerations

In the aftermath of Brexit, the regulatory framework in the UK would require to be modified. The regulations currently draw from EU guidelines which the new British government may choose to modify to suit their needs better. Some areas where London’s dominion may be compromised:

  • Financial services and the Banking industry
    • Passporting access to the EU single market is the single most crucial aspect for Brexit negotiations that banks will focus on. Loss of this privilege might result in banks having to relocate or divert operations to another location in the EU.
  • Insurance
    • European activity in this sector has been historically concentrated in London and losing unfettered access to the EU market might divert business to Singapore or Tokyo.
  • Forex
    • London’s pole position as the world’s leading forex trading hub and principal euro trading center may come under threat. In the event, ECB attempts to mandate clearing houses handling euro-denominated currencies be located within the Eurozone again, London stands to lose a sizable portion of its forex business.
  • Trade
    • Over GBP200 bn of exports could be subject to tariffs; is likely to impact competitiveness. Key areas of financial services where legislative and regulatory changes will inevitably follow, assuming passporting ceases.
  • Authorizations and Passporting
    • In the absence of the present authorizations and passports, financial institutions in the UK will lose their abilities to provide cross-border services and establish branches in any other EU member state under the same passport. This could particularly affect the several Asian financial institutions that have set up in the UK as a gateway to Europe.
    • Much depends on the EU rules authorizing third-country or a non-EU country access. As per legal experts at Allen & Overy, the key issue is that even as the recast Markets in Financial Instruments Directive (MiFID) Directive and Regulation seeks to provide third country access for wholesale business, the current iteration of the EU bank regulatory framework, CRD IV (Capital Requirements Directive), does not.

MiFID II: Third Country Decision Tree post Brexit

 

Source: Ashurst

  • Trade regulations and Clearing requirements
    • EMIR currently regulates the derivative trading by banks comprehensively encompassing clearing, trade reporting and risk mitigation; under EMIR, central counterparties need to be authorized in any member state to be considered authorized throughout EU. With EMIR no longer applying, UK undertakings will become Third Country entities.
    • Consequently, the clearing houses in UK will become a third-country CCP; unable to provide clearing services to trading venues or clearing members domiciled in the EU where that CCP is recognized by ESMA. The UK government would require negotiating grandfathering provisions or seeking EMIR recognition to maintain a seamless flow of business.
    • Similarly, funds established as UCITS in UK will no longer fall under the UCITS directive and may possibly be categorized as an Alternative Investment Fund. Depository status for credit institutions providing custody services to AIFs and other funds may not continue either.
    • The European Securities and Markets Authority (ESMA) suggested a further deferral of the AIFMD Passport for Third countries as recently as 19 July, 2016. Considering, only 12 of the 22 jurisdictions initially identified have been assessed by ESMA and only 5 of these have received an unqualified assessment, the implementation of this legislation is going to be prolonged.
  • UK Law and EU Insolvency regulations
    • The EU Insolvency regulation has been designed to harmonize insolvency regimes across the EU, with the exception of Denmark; it facilitates cross-border insolvencies and requires all EU member states to recognize UK insolvency proceedings, choice of law clauses and UK judgments.
    • These regulations will cease to hold once Britain exits the EU and there is no certainty if comparable arrangements can be negotiated. UK’s interaction with the European Court of Justice may be impacted as well. UK law, which has long been the most popular choice for international contracts, might even be skipped for New York law.
  • Group restructurings and M&A clearances
    • Presently, multinational groups utilize the Cross Border Mergers directive to undertake internal restructuring and simplify their operations. Automatic transfer and assets and assumption of liabilities may no longer be possible between companies spread across UK and the remaining EU.
    • EU's "one stop shop" clearance process for mergers clearances will cease, requiring companies to seek clearance in multiple EU states; time involved and cost burden will increase.
  • Loan documentation
    • Market participants will need to thoroughly assess the loan documentation and evaluate costs, interest rate setting mechanisms, tax implications, covenants, confidentiality and data protection provisions, governing law and jurisdiction clauses for enforcement of contracts before any changes can be made.
  • Taxation
    • The EU has strongly influenced the UK tax regime, and UK might choose to remain aligned with certain directives, in order to minimize a negative impact of Brexit. The existing bilateral tax treaties with the other member states will also remain in place since they are not based on EU membership. On the positive side, the new UK government would have greater freedom to determine and legislate in the tax framework.
    • UK would not be required to adopt the EU Financial Transactions Tax (FTT), which it has been consistently resisting. However, since UK will no longer be a part of the EU, it will lose the significant influence it had on EU level tax matters. This will be adverse to UK business which could face the FTT.
    • Furthermore, tax directives such as the Parent/ Subsidiary and also the directives on Interest and Royalties would no longer apply. This could lead to imposition of withholding taxes on payments between EU and UK group members.

The contenders for London’s crown…

Attracting a global workforce, particularly the highly skilled and well paid professionals like in London requires a city to be well developed on a multitude of parameters. English-language facilities, good schools, restaurants, cultural offerings, and housing amenities are some of the essential parameters a city should exhibit. Additionally, corporate houses also assess the regulatory environment, availability of prime office space, transportation and communications infrastructure, tax rates among other parameters when deciding upon a potential location.

Paris, Dublin, Amsterdam and Frankfurt are already positioning themselves to woo financial firms, and Brussels and Luxembourg are also vying for a piece of the pie.

In our follow-up article, we will look at these cities in depth to find London’s successor.

 

Punit Khandelwal, AVP – Financial Research
Financial Research
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