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Impact of British Exit (Brexit) from the European Union on the UK structured products market

By Ross Trotman, Hartmoor Financial

David Cameron may not have the UK structured products market at the forefront of his mind when involved in late night negotiations with European leaders; however the impact of a Brexit will certainly have a ripple effect on the industry. There has been a huge amount of stories and features written on the outcomes of a Brexit on the UK economy, and it’s worth exploring the potential impact on our industry and on our customers.

Financial services re-location

London is seen as the not only the financial centre of Europe, but also the world. Worldwide financial institutions have large European headquarters in the UK as they are able to easily serve the European market. This is largely achieved via passporting, which is where an authorised firm in a European Economic Area (EEA) country is able to perform permitted activities in another EEA state by exercising the right of establishment of a branch or providing cross-border services. Global US banks, including JP Morgan have made threats about leaving London in the event of a Brexit, even though the expectation is that passporting will remain. The extent of financial services relocation will depend on what trade arrangements the UK could agree with Europe post Brexit. CityUK put figures out recently that highlighted 37% of financial services companies are very likely or fairly likely to relocate staff if the UK left the EU.

The movement of large financial institutions away from London may also mean a reduced focus of attention on direct/face to face servicing of UK based clients and industries. Financial services workers responsible for designing, marketing and trading of structured products may see their position moved to Paris, Frankfurt or Dublin where there may be less attention paid to the needs of the UK market and certainly a lack of direct involvement. Those tasked with covering the UK market not based in the UK find it difficult to have the same relationship with customers as those who are based there. Keeping abreast of local (and potentially differing) regulatory requirements in the UK may be much harder, with the potential impact of less products being offered to the market and created without the essential local knowledge. This is not to say that there won’t be any structured products providers left in the UK, but there may not be the current level of expertise across the spectrum of skills needed to service the market.

Regulation regulation regulation

The UK structured product market has been wrestling with regulation, guidance and thematic reviews for the past few years, all of which tends to be inextricably linked to what is happening in Brussels. Some pro Brexit camps have highlighted the benefit of not having to comply with consistent EU wide regulation if the UK were to leave the EU, as the UK would likely be able to decide on standards as it sees fit. There is some logic here, as the UK government would be able to legislate on a much more specific basis for the needs of the UK economy. However the huge downside is in order to continue to serve EU customers, British firms would need to comply with EU regulations as well. Exiting the EU may mean the UK can no longer influence or challenge regulations in Brussels, which could result in diverging regulatory environments and more implementation of standards for UK firms who have to follow both domestic and EU requirements.

In the structured product market, the impact of EU wide legislation in the form of MiFID and PRIIPS certainly raises issues around relevance and application into the UK market of a standardised EU wide approach. Being part of the EU now, allows UK based firms and industry bodies (UK Structured Product Association or TISA for instance) to help shape and influence what comes into legislation via Europe. The FCA listen to the financial services industry and are at the table when policies are decided and are able to represent UK interests and ultimately try to ensure relevant legislation is passed. If Britain were to leave the EU, there would be a loss of the seat at the table, yet still most likely the requirement for domestic firms to comply with the legislation.

This loss of influence is likely to see structured product providers having to manage two legislative powers, potentially leading to increased compliance and legal support. This could lead to high cost income ratios, a less efficient service proposition to customers and potentially higher cost product offerings. There is also the potential for diverging regulatory standards. This would create large headaches for domestic firms when trying to implement and meet best practice.

Liquidly and Funding Costs

In the first instance, parties most affected by a Brexit are likely to be financial institutions and in particular banks. UK banks now make great use of cross border liquidity solutions raising capital in different states all feeding into their liability management. One thing that is a certain outcome of a Brexit ironically is uncertainty. Capital markets hate uncertainty, and as a likely position of stability would not be achieved for some time, it is likely that capital raising would be more difficult and also it is likely that banks funding costs would increase. Currently UK banks make use of the ECB for liquidity; this would not be as accessible post Brexit meaning banks have to look elsewhere for liquidity. JP Morgan recently highlighted the risk of increased bank funding costs post Brexit as have UK banks such as Clydesdale. Higher costs for bank funding would have a knock on effect on asset creation, feeding through to higher cost lending activities.

For the structured product market, this may have a positive impact on terms available for customers. If there is an increase in bank funding costs, as the supply decreases from alternative sources, structured product terms typically will increase as the bank is willing to pay more for the money. This is also likely to feed into alternative funding sources such as fixed rate bonds. As customers typically sit on both sides of the funding angle (i.e. they lend to the bank via savings and borrow in the form of credit cards/mortgages) the net effect to household income is likely still to be negative of increased funding costs.

Overall if a Brexit were to happen, it could happen in a number of ways and hence the impact on the market is yet to be clear. One commonly touted likely model would be like the current one employed by Switzerland, where there are specific accords. This seems most logical but does also require constant renegotiation and has its flaws. We will wait and see what happens in the referendum in June, yet the true impact of a Brexit may not be known for many years after the event.

Unless otherwise indicated, opinions expressed in this article are those of the author and do not necessarily represent the corporate views of Hartmoor Financial or StructuredProductReview.com.