Making sense of Brexit: what are the market structure implications of the UK leaving the EU

The only certain thing we know about Brexit is that there is no certainty on what the UK’s exit from the EU will look like! And even one month on after the referendum result, the situation is still very fluid. In the immediate aftermath of the referendum it seemed as if the UK government would opt for a ‘hard Brexit’ and now under the leadership of the new British prime minister, a softer option might be on the cards.

So as the political debate and fallout continues after the referendum, what can we say now about the potential impact of Brexit on post trade regulatory initiatives and market infrastructure in the future? To date, most of the media focus from a post trade perspective has been on the impact of Brexit on Euro-denominated clearing and trade reporting – topics we will get back to shortly.

The other subject which has been raised post-UK referendum is MiFID II. Market participants in the UK have spent the last few years lobbying hard against some of the MiFID II rules, and now the regulation has been highlighted by some lawyers as a potential way for financial firms outside of the EU to continue to provide services to customers inside it.

It is the equivalence rule of MiFID II which has been mooted by lawyers as the possible means by which UK-based banks and brokerages could continue to do business with financial services firms inside the EU. But the issue here is that the MiFID II equivalence rule is not yet tried and tested hence cannot be relied upon.

Going back to the post trade consequences, as far as euro-denominated clearing is concerned, the ECB has made previous attempts at insisting that this type of clearing should be conducted in the Eurozone. Brexit re-opens the case and while there is a preference for UK law to govern derivatives contracts, it would appear that the subject of euro-denominated clearing and whether it can take place in a country which is outside the Eurozone will likely become a hot political potato. Notably, in the immediate aftermath of the EU referendum, Francois Hollande said that euro-denominated clearing should not be conducted in London.

The other area of market structure which some have claimed will be impacted by Brexit, is trade reporting. This has been highlighted on the basis that it is directly regulated by ESMA; however, this actually means that there will be less disruption. As ESMA (rather than national regulators) already regulates all trade repositories, it means that the impact on trade repositories should be minimal, other than perhaps to require their HQs/administrative staff be based in the Eurozone. Given that most trade repositories already have a presence in the Eurozone due to the location of their data centres there, it seems it would impact a minimal number of staff.

Moreover, we believe that in spite of Brexit due to the wealth of expertise in London and the challenges of setting up in the Eurozone – language, resource skills and legal requirements – most financial services businesses will continue to have their primary operations in London.  Furthermore, we believe that by leveraging  modern and flexible technology, UK-based IT services firms can move with ease to where there may be additional need for resources or where systems are physically located, for example in the Eurozone, and to continue to support clients with the same service level agreements.

In addition, if we take a step back and look at the actual impact of Brexit, for some financial market participants the referendum result has had a more positive short term effect. The market volatility which struck after the referendum has meant increased volumes for many brokers which has had a positive impact on performance – whether this continues will depend on whether volatility returns.

So, all in all, the truth of the matter is that no one knows what the impact of Brexit will be on market structure. For now, we believe that most market participants in the short to medium term are working on the basis of business as usual, while in the long term they will wait to see how Brexit negotiations pan out before they act. That said many are presently considering how they would position themselves in a worst case scenario.

What we can say for sure is that in a fast changing global political landscape with huge opportunities in new markets, as potential trade deals are signed (with a new Department for International Trade), flexible technology becomes even more important to enable new revenues from new markets. Firms which stand to benefit most from the UK’s departure from the EU will be those that are able to leverage technology that is nimble and can be hosted in the EU and that deals with local regulations.