For 41 years the UK has been a member of the European Union, having joined the (then) European Economic Community in 1973. On 23rd June 2016, the UK electorate will again have to decide whether the UK is to remain a part of this economic and political union. There have been a variety of contentious topics that have led to this referendum and which have driven debate on both sides since its announcement. The two main arguments employed by those championing the “Leave” campaign are immigration into the UK (arising from a 2004 EU directive mandating the free movement of people), and the cost of contributing to the EU budget (Britain paid £13bln into the EU budget in 2015 ). Proponents of the “Leave” campaign have promised a UK free of EU regulatory oversight, with better control of its borders (and therefore the ability to control associated infrastructure costs), leading to an additional £8bln to spend domestically.
While these benefits may debatably be true, much of it is far from certain. Trade renegotiations will be what define the “post-Brexit” landscape and these are likely to be lengthy, fractious, and at this point the final outcome is extremely hard to predict. Certainly, there are a number of strong incentives for the major EU powers not to offer the UK favourable trading terms as a means of discouraging other EU members from considering similar options. Within the world of financial services, while the benefits of leaving the EU remain hard to quantify and are often centred on long term outcomes, the short term effects of the referendum have been subject to in depth analysis and several key outcomes have been identified. Short term confidence shocks (and subsequent deprecation of asset values), restriction of access to EU markets and legal disputes over previously pan-EU trading agreements are outcomes of a split from the EU that have been predicted with a degree of confidence.
What follows is a run-down of the most likely effects, focusing on the immediate and most prominent hazards that the financial sector must remain aware of and prepare for.
Foreign Direct Investments and depreciating UK Equity values
In the short term, the UK leaving the EU would lead to a confidence shock within the financial markets as a result of the uncertainty around the outcome of the renegotiation of trade agreements. Uncertainty would cause investors to withdraw from the market, reducing liquidity and making borrowing conditions unfavourable. Indeed, withdrawal of assets has already begun before the vote. Strong evidence suggests an exit from the EU will have a negative impact on UK Equities in particular; Deutsche Bank predicts a 15% decrease in asset values and many other banks and financial institutions have produced similar predictions.
On a macro scale, this may lead to reduction in Sterling against other major currencies but could also lead to a reduction in capital inflows into the UK. In 2014, the UK’s total stock inward Foreign Direct Investment from the EU was £496 billion; nearly half of the global total of £1 trillion . The UK’s place in the single market significantly increases Britain’s trade with fellow EU member states, and as such a change in the UK’s regulatory relationship with the EU could mean companies have less incentive to invest or may even disinvest.
Regulatory and operational impact on Financial Institutions
Thousands of UK financial services firms make use of the ability provided by a shared regulatory environment to provide services in any of the other 27 Member States without having to get local approval to begin trading.
An exit from the EU would erode the ability of banks and asset managers to use the UK as a hub to provide financial services into Europe. Furthermore, benefits that came under common regulation, including MiFiD, could potentially be eroded. UK firms and other financial institutions could be required to either set up subsidiaries or relocate their headquarters within another EU country, leading to an increase in operational costs for these firms.
However, conversely, regulatory changes to the UK financial services framework as result of the leaving the EU could potentially benefit challenger banks such as Aldermore, who for the most part do not have a presence outside of the UK and as result will not incur extra operational costs as a result of the new trading conditions. An environment in which borrowing costs are rising and large international banks are encumbered by a rise in already large operational costs, may provide an opportunity for smaller and leaner banks.
Effects on the Derivatives Markets
Leaving the EU could lead to serious legal challenges for the derivatives market in the UK, which represents a large share of UK financial markets. Currently, derivatives contracts such as Interest Rate Swaps, Commodities Derivatives and Credit Default Swaps are traded under International Swaps and Derivatives Association (ISDA) agreements and normally come under British or American Law. If Britain were to leave the EU however, would the derivatives contracts between two Non-UK counterparties in the EU be accepted by local courts if there was a dispute over terms of the agreement? If amendments were required to these agreements to reflect an EU exit, the banks and their counterparties would incur large costs as hundreds of thousands of agreements will be affected.
Determining the full and lasting implications of “Brexit” on the UK financial services industry is extremely difficult given the uncertainty around the outcome of the numerous negotiations that would be required. It is possible that trade with non-EU nations such as China and other emerging market nations may make up for the loss of being part of a larger trading block, or an equivalency regime may be agreed allowing the UK to replace existing financial regulations without adversely affecting services in the long run. However, in the short term certain outcomes can be more confidently predicted. Depreciation in the sterling, a decrease in foreign direct investment and a potential need for legal and advisory services to renegotiate current ISDA agreements are all factors that financial institutions must be aware of, and ready for.