Brexit & new policies of President Trump: what happens next?
In our complex, interlinked world with increasing political uncertainty, prediction models are required to answer the question “What happens next” and to allow for the definition of suitable strategies.
In the last 15 months we have seen two political “Black Swan” events that have neither been correctly predicted by politicians, strategists, economists, media, pollsters (etc.) regarding their likelihood and their real implications: Brexit and the election of President Donald Trump.
Significant change in policy leads to significant changes for business in general but especially for the globally interlinked financial services industry and its backbone the (systemically important) market infrastructure.
On background of the current Brexit timeline there are some important decision check-points coming up for the financial services industry and market infrastructure in Europe:
- Until end of 2017: Decision to move legal entities and /or regulatory required functions from the UK to either the EU27 to maintain passporting rights or Third Countries with an equivalence regime such as the US. This is required to be able to continue to serve clients in the EU27 in post-Brexit scenarios, were passporting rights from the UK to EU27 are lost. Moves would either we be reversed or minimised if it becomes clear that after Brexit passporting will continue.
- Until mid of 2018: Decision to move business areas or products from the UK to the EU27, thereby accepting dissynergies relative to today’s set-up. This could become necessary for the clearing of Euro-denominated products if European regulators and /or policy makers would mandate a location policy for such products.
- Until mid of 2018: Decision to optimise operational set-up and move operating units from the UK to the EU27 or US. This move could become mandatory if certain privacy and data exchange rights between the UK and EU27 are not maintained in a post-Brexit scenario. Else it could be an optional cost optimisation move also later to transfer jobs to lower cost countries. Operational units will not necessarily move to the same location as the regulatory functions under (1).
All these decision points relate to the timings, when more stable information from the Brexit process and about regulatory reforms in the EU27 and US are available. From a precise timing they are very much individual for each market participant or market infrastructure depending on their existing legal set-up and scope of business. Companies with existing, licensed EU27 entities will need shorter lead-time on (1) as companies starting on a green field. Participants dealing in none to little Euro-denominated products might not be required to take decision (2). Only companies with massive UK operational presence in high wages areas worth near- or off-shoring will consider (3).
The decision points (2) and (3) would move, if during Brexit negotiations a so-called transition period would be agreed.
In addition to the Brexit negotiations there are obviously other parameters and developments to be considered in the above decision, mainly:
- The Dodd-Frank wall street reform in the US, that is currently starting and probably will show first impacts 2018/2019
- The change of the regulatory landscape in the EU27 (e.g. REFIT – EMIR Amendments, MIFIR and CMU)
- The latest elections and developments in Europe and its impact on policies regarding the European Project in general, the Euro and the EU27 position vis-à-vis the UK on Brexit
To take the above key decisions market participants and market infrastructure are recommended to monitor the key drivers of change in the UK, US and EU27, some of which we try to list below in more detail.
Expected Drivers of Change
1. United States
Dodd–Frank Wall Street Reform
The Trump administration’s decision-making process on Dodd-Frank started in February 2017 with the president’s executive order that directed the Secretary of the Treasury to “consult with the heads of the member agencies of the Financial Stability Oversight Council (FSOC) and…report to the President within 120 days of the date of this order (and periodically thereafter) on the extent to which existing laws, treaties, regulations, guidance, reporting and recordkeeping requirements, and other Government policies promote the Core Principles and what actions have been taken, and are currently being taken, to promote and support the Core Principles.” . These Core Principles call to “empower Americans to make independent financial decisions,” “prevent taxpayer-funded bailouts,” “foster economic growth” through “regulatory impact analysis that addresses systemic risk,” and “restore public accountability within Federal financial regulatory agencies.
The House of Representatives approved on June 8th 2017 the financial CHOICE Act. It will inter alia allow banks to opt out of Dodd-Frank if they hold enough cash, and limit federal stress tests of major banks to every two years. It removes the power of the federal government to label a bank “too big to fail” and for bank recovery & resolution. The act would replace Dodd-Frank’s Orderly Liquidation Authority with a special bankruptcy process that aims to insulate the financial markets from a failing bank’s fallout.
In addition on June 12 2017 the Treasury Department released its report to reform the US financial system: “A Financial System That Creates Economic Opportunities: Banks and Credit Unions”. It includes dozens of recommendations to reform “laws, treaties, regulations, guidance, reporting and record keeping requirements, and other Government policies” that inhibit federal regulation of the US financial system in a manner consistent with the set of core principles enunciated by President Trump in Executive Order 13772, issued on February 3 2017. End of July U.S. Treasury Secretary Steven Mnuchin proposed to raise the Dodd-Frank $50 billion asset threshold used to subject a bank to enhanced supervision to $250 - 300 billion and that regulators should be able to exempt from the regime, banks that are big but not overly complex. That would significantly cut down on the number of banks that are subjected to the Federal Reserve’s heightened capital, leverage, liquidity and supervisory requirements . In August 2017 President Trump has nominated Joseph Otting, former chief executive of OneWest Bank, as a permanent head of the Office of the Comptroller of the Currency, which oversees national banks. The OCC will initiate the process of amending the Volcker rule by formally seeking public comment from banks and others on how it is working. A first step towards loosening the Volcker rule banning banks from trading for their own books.
2. United Kingdom
On May 18th 2017 Prime Minister Theresa May and Conservative Party presented their election manifesto calling on voters to give the government freedom to — worst case — walk away from Brexit negotiations without a deal.
While signalling to the EU27 negotiation partners, that the UK is willing to risk a “Hard Brexit” with no post-Brexit or transitional agreements, the UK government plans to be much more interventionist to increase productivity, reinvigorate production and stimulate investment in technology and research and development. It plans to support certain parts of the economy and in return will demand closer collaboration within key industries. This is to compensate losses from the financial services sector, that might be impacted hardest in a Hard Brexit scenario.
However this manifesto and negotiation strategy did not get the voters approval leading to a situation where the conservative party lost its majority in the June 8, 2017, election making a “soft” Brexit as well as amendments by the parliament to any deal negotiated by the UK government much more likely. This is also reinforced by the support of Labour for a transition period between 2019 and the final Brexit date.
One of the main challenges for the EU27 will be that the US revision of Dodd-Frank will likely coincide with the exit of the UK from the EU, creating a situation were two countries with the most important global financial centres, New York /Chicago /Atlanta and London, could start a regulatory competition with the EU in order to attract businesses for their financial centres.
While having to redefine their relationship with on one hand the US and on the other hand the post-Brexit UK, the EU27 is struggling with substantial internal challenges that is impacting financial markets.
Overall the EU27 has started to prepare for the new challenges by amending EMIR as part of the Commission’s Regulatory Fitness and Performance programme (REFIT) and proposing in the context of the Capital Market Union (CMU) an enhanced, more integrated supervision of financial market infrastructures and market participants by the supervisors and the central bank issuing each relevant currency (central bank of issue).
Brexit as driver of change for EU27
The view on Brexit is somewhere between hostile and opportunistic, where the EU27 seeks to minimize the damage of the UK leaving the EU and further national interests by gaining additional business. In addition it is paramount for the EU27 to not create a precedent for an exit process others would want to follow light heartedly.
Several financial centres within the EU27 are pitching for banks and asset managers, requiring a European passport, to move all or part of their operations from London — including Paris, Amsteram, Frankfurt, Dublin, and Luxembourg. They are supported by respective national regulators as well as the ECB, which has reiterated on several occasions, that it will not allow banks from Britain to have a Euro zone licence if they wanted an unlimited ability to outsource operations back to London. Regarding asset managers in July 2017 European Securities and Markets Authority (ESMA) issued a guidance for fund managers aiming at preventing investment firms setting up “empty shell” subsidiaries in an EU27 country, to allow them to continue serving European clients, but leaving the bulk of their management staff and operations in London.
There is also an ongoing pitch to attract the clearing of Euro denominated products to the Eurozone post Brexit. Mario Draghi in January 2017 stated, that the European Central Bank should maintain oversight of UK’s vital clearing business even after Britain leaves the European Union. The former French finance minister Michel Sapin took a more radical position by stating in April 2017, that it would be unacceptable for London to remain the main Euro-clearing centre once it leaves the European Union. In June 2017 European Central Bank’s Governing Council has recommended an amendment to Article 22 of the Statute of the European System of Central Banks and of the European Central Bank to provide the ECB with a clear legal competence in the area of central clearing. In addition the European Securities and Markets Authority (ESMA) proposed that the authorisation of CCPs and their ongoing supervision should be with the central bank of issue.
These approaches by the EU27 would force market participants to change current, efficient set-ups in the UK.
What happens Next?
For the next 12 – 24 months:
- The US will focus on rolling back some of the Dodd-Frank reform, establishing a new tax regime and renegotiate trade agreements with a protectionist tendency under its “America First” doctrine. Quantitative Tensioning is short term most likely until there would be slow down in the economy. Ongoing skirmishes in international trade relationships might lead to an on going trade war between the US and the EU27 as well as China respectively. A trade agreement with the UK, that will be favourable especially for the US, is most likely. The main disruptive factor could be a potential impeachment of President Trump over either the alleged Russian connections of his campaign team and his firing of former FBI Director James Comey, or his business conflicts of interests with the presidency and due to his foreign business relations being a potential direct violation of the foreign-emoluments clause of the U.S. Constitution.
- The UK will focus on the Brexit negotiations with the EU, while simultaneously working on implementing a standalone economic strategy, that will most likely include a favourable tax environment, targeted investment in UK development regions, deregulation post Brexit and the (pre-)negotiation of international trade agreements – especially with the US. There will be “UK First” tendencies, especially with regard to the labour force. Potentially there will be a 2 – 3 year transition period to smoothen impacts from Brexit both for the UK and the EU27.
- The EU27 will focus on resolving internal challenges and hold their breath for the German and especially Italian election. A stronger alignment of France and Germany seems very likely. Thereafter one of the main focuses will be the Brexit negotiation on one hand and preparing to compete with a changing UK. Economic reform and deregulation, especially in the capital markets, will be the focus, mirroring the Dodd-Frank review in the US and any UK approaches. There is a very high likelihood that EU27 will pass legislation to force certain business, such as the clearing of Euro denominated products, banking and asset management into the Eurozone /EU27. The single largest risk for the EU27 and Euro as well as a potential distraction will be Italy due to its election and on-going banking crisis. The Greek debt crisis will continue to go on and ultimately will lead to reduction of the countries debt mid-term. The EU27 will try to focus away from the US and UK and forge stronger ties with Asia, Canada etc. to fill the gap created by new emerging US policies and the post-Brexit UK. In case a trade war with the US would escalate — especially between Germany and US — there is a high incentive for the EU27 to become more protective vis-à-vis banks, brokers and market infrastructure, probably raising the bar on the third county equivalence and oversight on third country entities not only vis-à-vis the UK but also the US.
For the next 24 – 48 months:
- Overall the next 2 – 4 years will most likely be dominated by a regulatory fragmentation as all three parties try to create an attractive regulatory and tax environment for corporations and to ensure the financing of their respective real economies through financial markets. The lead-time to pass regulation will be 6 – 18 months and the implementation time thereafter 12 - 24 months. Markets will become more fragmented and slightly less efficient. For both market infrastructure and market participants it becomes more important to have a foot hold in all three markets to benefit from regulatory, tax and product arbitrage, that will open new revenue opportunities at likely less regulatory cost and with lower taxes. However investments into a more decentralized strategy need to be taken very soon. In addition market infrastructure might focus on Asia, if through different arrangements services can be provided from there to the US, EU27 and UK.
This article was first published in edition 10 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
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