Within hours of the UK’s Brexit referendum result in 2016, Jason Waight and colleagues at electronic trading platform MarketAxess met in their London offices to discuss opening a new operation in continental Europe.
The decision was inevitable, he says, given the need to ensure EU27 clients do not suffer interrupted service as a result of the UK’s decision to quit the bloc. In 2018 the company, which traders use to buy and sell corporate bonds, opened a small office in a traditional townhouse overlooking a picturesque canal in Amsterdam.
Yet as the clock ticks down to the UK’s departure from the single market at the end of December, Mr Waight says the pull exerted by London remains undeniable — something that will keep the EU’s own ambitions to boost its domestic financial services sector in check.
“It would be an enormous undertaking to try to replicate the sheer scale and complexity of what happens in London,” says Mr Waight, the group’s head of regulatory affairs in Europe. “It is a question of scale or gravitational force . . . There is depth of experience and scale that could not be moved easily — even if one wanted to.”
That is not a claim that sits comfortably within EU capitals, which are engaged in an intensifying debate over the extent to which they can rely on the City of London as the continent’s key financial centre in the coming decades.
The European Commission will launch a new effort in the next few days to boost its own capital markets. It is a project which has become wrapped up in the EU’s push for greater “strategic autonomy” given the vulnerabilities exposed by the Covid-19 pandemic and the great power rivalry between the US and China.
The deteriorating state of relations with the UK in recent weeks has only strengthened the argument for the EU to stand on its own two feet, officials say. The UK’s decision to breach international law in its dealings with Brussels further erodes the EU’s willingness to offer financial market access — or “equivalence” as it is known — to the UK in a range of key sectors.
“We cannot afford to be the only large economic bloc in the world which has an under-developed financial sector,” says a senior European Commission official.
“Developments over the past few days and weeks have not reassured people that you can build a financial sector relationship with the UK based on trust,” the official says. “Nobody is talking about no longer doing business with the UK; London will remain a global financial centre. The question is on what terms.”
Fragmented financial centres
The EU has made repeated attempts spanning decades to bolster its financial centres — but it has struggled to make significant headway. Turning the EU’s hodgepodge of smaller financial capitals into a world-class system is easier said than done and it will require not only a clearer EU strategy but better cross-border co-ordination.
In the next few days, the European Commission will unveil its latest attempt to fuse the EU’s disparate markets and unclog the pipes that channel money from investors to business, with an action plan proposing reforms including boosting EU-level market supervision — something that has become more urgent given the regulatory failures in Germany surrounding the Wirecard scandal.
Valdis Dombrovskis, the European Commission executive vice-president who oversees financial regulation, says that at its essence, the EU’s goal is to be able to do everything that London can.
“That is our objective — to have deep capital markets which can help finance the European economy and European companies,” he says. “[The] Capital Markets Union [project] predates Brexit, but of course the fact that the EU’s largest capital market, financial centre, has left the EU and is about to leave the single market has implications.”
For now the City of London remains the continent’s dominant financial hub, accounting for just under a third of all capital markets activity, according to New Financial, a UK think-tank. It trades more foreign exchange, derivatives and shares, and handles more assets under management, than any other city in Europe.
Activity in Europe, by contrast, is fragmented, with financial centres lacking the volumes of trading, and plethora of associated legal and consulting services, that give the City its global heft. Frankfurt and Paris have their banking industries, Dublin and Luxembourg are centres for investment funds and Amsterdam is home to some of the world’s biggest market makers.
Michel Barnier, the EU’s chief Brexit negotiator, argues the EU cannot let things stay this way. He has stressed that the bloc would do itself a disservice if it allowed the City of London to retain the benefits of the single market, even though putting up barriers will mean extra costs for European companies.
“We need to look beyond the short-term adaptation costs, to our long-term economic interests,” Mr Barnier said in June. “We must ask ourselves whether it is really in the EU interest for the UK to retain such a prominent position.”
That strain of thinking has fed into Brussels’ approach to the Brexit talks, coupled with arguments that the EU cannot leave the stability of its financial system hostage to regulatory developments in a UK determined to break free from EU rules.
The EU has insisted since the start of negotiations that future market access should be determined by each side making independent decisions to grant permissions, based on the quality of the other side’s regulation and supervision.
In this way, Brussels can, for example, authorise EU companies to trade shares on venues in other countries, or to use their critical clearing infrastructure to manage risk. It is an approach that the EU already takes with other countries including the US and Singapore, and is based on a piecemeal set of provisions scattered across different European laws.
Known in EU jargon as “equivalence”, the UK financial industry complains that the system is inherently unstable — access can be withdrawn by the EU at 30 days’ notice and without recourse.
EU officials argue that any approach was always going to need to be based on equivalence given the UK’s decision to leave the single market and to prioritise its own regulatory autonomy over close economic ties.
In practice, the EU has moved steadily since 2016 to make equivalence harder to secure, notably by ramping up its demands for supervision over activities in other financial centres. EU officials say the changes were needed to prepare for Brexit. The bloc has also taken an increasingly hawkish view on what access rights should be given to the UK.
Earlier this year, as part of Brussels’ assessment work for UK equivalence, British officials filled in 2,500 pages of questionnaires about the country’s future regulatory plans, only for the commission to reveal — in a footnote of a Brexit policy paper in July — that access permissions close to the top of the UK wishlist were actually off the table for the time being.
The now-infamous “footnote 21” said Brussels would not grant pan-EU access rights for City-based investment firms “in the short or medium term”.
Mr Dombrovskis says the delay was logistical — the EU has new legislation in that area that is still bedding down. But EU officials privately acknowledge real reservations about giving Britain such a prize, given the bloc’s own ambitions to grow its financial sector.
The EU’s resistance to business-as-usual is at its strongest in the highly sensitive area of clearing houses: systemically important institutions that prevent the effects of a default from cascading through the financial system.
London dominates derivatives clearing, and handles the bulk of the €735tn market in Europe. London Stock Exchange Group’s LCH clears about 90 per cent of all euro-denominated interest rate swap transactions.
The eurozone offers few alternative venues that can cope with the volume of business, and both the European Central Bank and the Bank of England have warned of a threat to financial stability if access to London is suddenly lost. But that strategic reliance has made Brussels, backed strongly by France, ever more determined to build up the EU’s own clearing capacity.
The proposed solution, adopted by the European Commission on Monday, is to allow European banks continued access to UK clearing houses until mid-2022, while ramping up the pressure for the activities to be transferred within the EU.
The EU has been busy in recent years equipping itself with the regulatory tools to do this. It adopted legislation in 2019 empowering Brussels to deem that a clearing house is so systemic that it should only be allowed to service European customers if it relocates activities to the EU — a measure that is widely understood as being targeted at LCH.
There have been hints of a more restrictive approach in other areas too. The European Securities and Markets Authority, a Paris-based EU agency, called in August for the bloc to set clearer limits on the extent to which investment funds can be domiciled within the EU but managed from outside.
The pattern has left the UK worried that Brussels views equivalence decisions as an industrial policy tool rather than a financial stability one. “The EU sees it as a bit of a zero-sum game where they can increase activity in the EU by forcing them to move from the UK,” says one British official.
Within the EU, there is a debate on how far to go down this road. France has championed a restrictive stance on UK access as it seeks to bolster Paris, for example, while Luxembourg has called for “a footbridge” to be preserved between the City and EU financial centres.
These internal debates form the backdrop to key access decisions that the EU must take in the coming months, including reforms to laws and regulations on share and derivatives trading and hedge-fund management.
EU officials underline that, in any case, ties with London will remain very important in an interconnected financial world where European companies source services from across the globe. What is at stake is ease of access, and the areas in which the EU wants to make a concerted effort to compete.
Stéphane Boujnah, chief executive of Euronext, which runs the main stock exchanges of Paris, Amsterdam, Dublin, Brussels, Lisbon and Oslo, insists the EU wants to retain its links with other financial centres — as long as they play by the rules. “Everyone wants to have an open capital market. No one is suggesting [the EU should] build a European fortress,” he says.
Banks also want to keep fragmentation to a minimum. For Pablo Portugal, managing director for advocacy at the Association for Financial Markets in Europe, “overlapping and conflicting trading obligations in the EU and UK would have a negative impact on European investors, with a risk of compliance uncertainty, higher costs of execution and an inability to access optimal prices and volumes.”
‘Capital markets union’
In parallel to its deliberations on how to treat the UK, the EU needs to nurture its homegrown capital markets capacity. The idea of fostering EU financial centres by stimulating cross-border activity and fusing disparate markets has been the goal of successive administrations in Brussels for 20 years. Progress has been uneven, to put it politely.
The bloc succeeded in liberalising financial trading at the start of the century, using regulation to break the monopolies of national exchanges. But it has failed to achieve the goal of building the kinds of deep, international-scale pools of capital seen in the UK and the US.
Corporate bond issuance and the value of investment funds in the EU27 grew faster than in the UK between 2015 and 2019, according to New Financial. But London dominates most other markets. It has 43 per cent of the global $6.6tn-a-day market for foreign exchange trading, and half of the $6.5tn a day swaps market, while the rest is typically traded in New York and Asia.
In recent years, Brussels has been seeking to make progress under the banner of building a “capital markets union”, but financial services professionals complain that initiatives have so far avoided politically difficult but logistically necessary changes that are needed, such as harmonising insolvency and securities law.
Thomas Wieser, a former senior EU economics official who led an audit of the capital markets union project earlier this year, argues the EU needs to be more ambitious.
“Up to now there have only been three EU countries with deep and stable capital markets — the UK, Sweden and Netherlands. And the biggest has left the EU,” he says. “The way to make CMU happen is to make Europe an ever more attractive place to put capital to work — it can’t be done through whatever discriminatory policies are introduced against the UK.”
A centrepiece of the proposals due from the commission in the coming days will be a fresh attempt to standardise how supervisors enforce the EU’s rule book for financial trading, and to open a debate on whether to shift more responsibility for that to the European level. Officials argue that this is all the more important given the multipolar nature of the post-Brexit EU financial system, with multiple midsized centres.
Nicolas Véron of the Peterson Institute for International Economics in Washington says the EU needs to go further, prioritising its plans for a so-called banking union, which aims to strengthen and integrate the continent’s banking sector.
He argues the EU’s recent decision to embark on massive, centralised debt issuance by the commission as part of its post-Covid-19 recovery plans amounts to a leap towards cross-border “financial risk-sharing”, further aiding the cause of financial integration.
“The bottom line is we still have a fragmented financial system,” says Mr Veron. “A capital markets union implies a seamless financial space, which you cannot have without banking union.”
This presupposes that the EU will coalesce around a bold agenda, setting aside local imperatives. Some of the firms that have recently arrived in financial centres such as Amsterdam are sceptical.
“It would be very difficult to create a financial market which functions properly if five or six different jurisdictions fight for each one of the bits and pieces,” says Enrico Bruni, head of Europe and Asia Business at Tradeweb, which set up an operation in the Dutch city after the Brexit vote.
“It needs a very clear, co-ordinated effort that starts from the highest political level in Europe.”