Effect of Brexit on the Financial Markets

What are financial markets?

Financial markets are an open and regulated system where companies can raise large amounts of capital through bonds and stock markets, or offset their risk by investing in commodities, foreign exchange futures contracts or other derivatives. Due to the size of financial markets, they are highly liquid, meaning businesses can easily and quickly generate cash by selling their assets.

Since financial markets are public and work under a lot of regulations, there is a lot of information transparency and prices of everything traded reflects this. (Source: “Six Basic Functions of Financial Markets”, Iowa State University, March 5, 2012.) 

What is the European Union and what is Brexit?

The European Union, like the name
suggests is a political and economic union of 28 countries within Europe.

The creation of the European union was to firstly bring countries together after the 2^nd world war had left many economically and politically disabled or struggling. This economic cooperation would become the world’s biggest single market and it still is today. (European Union – European Commission, 2017)

Even though the UK has benefited a lot from being in a single market, there were many who thought that Britain would be better off on its own; and for this reason the government decided to have a referendum after which on the 23 of June 2016, Britain exited the Single market, giving back it’s seat in the European Parliament and all the benefits that came with it.

How can financial markets affect economic performance?

Demirgüç-Kunt and Levine in their 2001 book, ‘Financial Structure and Economic Growth’ said there is a strong connection between financial markets development and economic growth.

The way in which this
happens is that a well-functioning financial market will efficiently direct the
flow of savings and investments in an economy as such to enable businesses to
accumulate capital and goods and services to be produced. A well-established
financial market alongside a wide range of financial products will benefit
borrowers and lenders and therefore the economy as a whole.

Another benefit of an efficient financial market is that by
providing a range of financial options at varying risk levels and pricing
structures, borrowers and lenders can be closely matched for their individual
needs. This allows investors to determine and calculate their cost of financing
by looking at their returns on their investments and then choosing the best
financing and investment choice for their requirements.

The European Union created a single banking market with a single
currency and therefore created Europe-wide financial markets which made
investing and borrowing euro-denominated stocks, bonds and derivatives easy for
all EU countries that are part of the Euro by eliminating exchange rate risks.
By doing so, products and services that were previously only available on a
country by country basis were now available to a wider market, creating better
competition which in turn makes markets more efficient and prices lower for
individuals.  This is called the
‘Single-Passport’ system, whereby any business set up in one-member state may
provide its services to the rest without further authorisation requirements (European Commission 2016)

Not only does euro-based financial markets
benefit the Eurozone, it also attracts international investors to invest here
and benefit from the competitive market, (Mishkin, 2012)
and by being part of the ‘single-passport, Non-European companies can set up
their head office in London, and have access to all the benefits of the Single
Market.

UK financial market relationship with the EU

Professor Nick Bloom of Stanford University said:

“The single European market increased competition and forced British firms to increase the level of innovation.”

London is one of the biggest financial hubs of
the world and hosts the largest number of banks and commercial insurance
companies. According to (Belke A. et
all) around 6 trillion euros, which is equivalent to 37% of Europe’s
financial assets are managed in London, which is twice the amount of the
nearest rival Paris. London also dominates Europe’s 5.2 trillion-euro
investment banking industry.

What this means is that major investments
happing in some of Europe’s biggest cities are financed by companies operating
within London.

This
is why, (Mark Carney, Governor of the Bank of England), said:

“Europe relies heavily on London’s debt and equity markets.”

When it comes to foreign exchange markets, the
UK is way ahead of its European counterparts with an impressive almost 40% share
of the worlds foreign exchange and derivatives handling.

According to the (City of London Corporation) each year, $869 trillion worth of
Euro, Yen and Dollars are traded from London. This is higher than all the
Euro-Zone countries combined.

London
currently accounts for 70% of the Euro Sovereign debt trades, meaning that the
EU countries cannot shut outlondons capital markets as this would be suicide. (Rueters)

According
to Reuters (Kai Pfaffenbach) Frankfurt
is desperately trying win over businesses to relocate to their city from
London. To help in this, the European Central Bank started the “Capital Markets
Union” project in 2015, where they want Euro-zone financial markets to provide
improved fund raising for companies by replicating Britain’s financial services
and become more efficient in the stocks, bonds and other securities markets.

How Brexit is affecting Financial Markets:

https://www.ft.com/content/0260242c-370b-11e6-9a05-82a9b15a8ee7
The question of how Brexit will affect the UK economy is very uncertain. The sterling fell to a 31 year low, stock markets fell and foreign direct investment has frozen. All these things point towards the short-term impact of Brexit to be very serious. The real question is, what will the long term effects be, and how will markets react to cope with such uncertainty about the future.

The
institutional framework of the EU and the euro has created dependencies amongst
countries. For this reason, Brexit will have affects in not just UK financial
markets, but financial markets across the globe.

According
to (Gordon and Shapiro 1956) the
dividend discount model, expectations about future effects on financial markets
will have an effect on stocks and other financial variables now.

From
the graph above, we can see that when the news of Brexit was announced and the
UK markets became uncertain about the UK’s future in the single market, the
pound fell to its lowest price in 31 years.

Because
of Brexit and Policy uncertainty, markets adopt a ‘wait-and-see’ attitude
towards investment decisions. 

If London is no
longer part of the single market, it loses its attractiveness as a foreign
direct investment hub and a gateway to the European financial markets.

According to the
financial times, almost half of the FDI coming to the UK comes from the EU and
after Brexit, this investment will significantly decrease due to increased
trade costs and tariffs. The Office of National Statistics (ONS) tells us that
FDI has been about 5% of UK GDP between 1999 and 2015. The analysis from the
financial times estimates the decrease in FDI would be 22%.

The impact of Brexit
on the UK financial sector can be broken down in to 3 things:

1. What agreement can the UK make with the EU in its post-Brexit
   negotiations.
2. The extent to which financial sector businesses move their
   operations from the UK to a Eurozone country before any negotiation agreements
   are made.
3. How well the UK financial sector can survive based on its global
   position and relationship.

Until a deal is made
with the EU, we cannot predict how the market will end up like, but we can
hypothesise certain outcomes like the following:

Currently, the UK is
still part of the EU, and hence has passporting rights. Once these rights are
gone, UK firms will have to have state level authorisations from EU countries
to perform activities. This will depend upon whether the regulators in those
countries will allow UK financial markets to sill operate within their borders.
The best outcome would be if the UK retains their passporting rights through
either a negotiation or remaining a part of the EEA.

Johnathon ford
writes in the financial times that another option that UK based companies may
have is to open up subsidiaries in different EU countries, that way giving them
access to customers within those markets. This is however costly and
inefficient.

Alternatively, UK firms could take advantage of Third Country Regime (TCR) access provisions. What this means is that companies that were incorporated outside the EU can still do business on a cross-border basis if they wish to do so without having an establishment within that EU country, however EU law will require that the regulations and legal structure they follow complies with EU.

Reuters business news
tells us that Standard Chartered (Stan.L) and JPMorgan (JPM.N) were the latest
global banks that have outlined plans for European operations after Brexit.

Goldman Sachs Lloyd
Blankfein said that “London’s growth as a financial centre could stall as a
result of upheaval caused by Brexit.”

So,
because of Brexit and the uncertainty of what the future holds for UK’s
financial markets; UK based financial firms especially those in London are
looking to move their operations into the EU market to benefit from the single
market.

Another financial market area that will be affected by Brexit is
that of selling of derivatives for companies to buy protection or lower their
risk portfolio against changes the US dollar and or spikes in the price of oil.

As a result of tighter financial regulations on banks, some will
opt out of providing this service and those who do will offer a smaller variety
of products at a higher price. Ultimately, this is bad for markets as they are
not getting the best deal they can.

London also dominates the euro derivatives market. EU
policymakers have not liked this for a while and want to shift this to a
Eurozone country after Brexit. This will in turn increase the price of trading
for corporations that deal in multiple currencies as they will have to go through
several clearing houses.

Bankers are unsure how much extra it will cost a European
company to borrow without direct access to London, however, the association for
financial markets said customers are being overly optimistic if they think that
lending agents will bear the burden or grunt of this. They will push the
increased cost of borrowing onto the consumer, which will ultimately make them
less competitive in the market.

Ernst and Young say in their research paper that they surveyed major corporates including Airbus and Volkswagen and found that these companies were really worried about rising costs of funding as a result of Brexit.

London has dominated the financial centre for decades and has
built its reputation on the service it provides. It would be very difficult to
replicate this market. This has been due to its vast talent pool, widespread
use of the English language and the UK legal system and the vast amount of
money going through the UK through these financial markets.

Another
great strength of the UK is its over-the-counter derivatives market.
Corporations often use swaps to protect themselves against adverse interest
rates and currency moves. Over-the-counter derivatives have to go through
clearing houses who are sort of the middle man who make sure neither party
defaults on their payments. Even though the UK is not part of the Euro single
currency, it still manages ¾ of all euro-denominated swaps.

As
the UK decides to leave the EU, this creates a problem, because now most of
these swaps won’t be clearing through the bloc. Germany and France have already
said that they want the euro-denominated derivatives to be cleat=red through
the EU; however LSE has argued that doing so would cost London thousands of
jobs. According to a private report by EY, this estimate loss of jobs could be
around 83,000 by 2024.

The
EU needs London’s money, says Mark Carney, governor of the Bank of England. He
calls Britain “Europe’s investment banker” and says half of all the debt and
equity issued by the EU involves financial institutions in Britain.

What impact would Brexit have on the way in which banks are regulated in the UK?

There are
three pillars in the UK banking regulations:

1. The capital
   requirements directive IV and the capital requirements regulation.
2. The banking act of
   2009
3. Bank Resolution and
   Recovery Directive (BRRD)

Since the
BRRD and CRD IV were EU legislations, the UK has to decide after Brexit how
much they want to keep. CRD IV implements the requirements of Basel III, which
the UK would still be committed to after Brexit. Brexit will likely have an
effect on the legislation application of the EEA branches and subsidiaries.

What  impact would Brexit have on the UK insurance industry?

The London market currently has access to over 500 million customers
through the EU and a substantial amount of insurance and reinsurance is
distributed into and out of the UK. For the UK to continue to have access to
these customers, they have to negotiate bilateral treaties to ensure member
states allow them passport into the EU.

The prudential regulation authority (PRA) has been very involved in
negotiating the solvency II directive which was based on the risk-based regime
of the UK.

What  impact would Brexit have on the UK funds industry?

Currently
most UK based fund managers already use Irish or Luxembourg UCITS and
alternative investment funds (AIF) platforms for Pan-European distribution of
funds therefore Brexit will likely not have much effect on this sector of the
financial market.

The
problem the UK asset management industry will face is the risk of changes to
rules enabling MIFID investment firms, AIFMS and UCITS management firms to
choose UK based investment managers. Currently, the administration is deemed
sufficient for EU firms to contract asset management jobs to the UK managers.
Another drawback may be that EU member states may put obstacles in front in the
form of tax regimes that make it less attractive for EU firms to hire UK
investment managers.

Corporate tax:

The
EU previously set the legal requirements for corporate tax in the UK. Since we
will no longer be a part of the EU, these regulations will be revised by HMRC
and new draft regulations will be put in place. Currently businesses that have
offices within and outside the UK enjoy a 0% rate of withholding tax. This may
no longer be the case and companies will look for ways to save themselves from
varying taxations in different countries, or changing their place of business
to protect themselves from higher or double taxation.

VAT

VAT was a European Union Concept and now that the UK
government is responsible for this, they may decide to change the rates at
which this is charged or what products VAT will be charged on.

Accounting law

At the moment, there is a significant EU accounting and company law legislations that may come under review after Brexit. These include, directive 2013/34/EU about annual financial statements, consolidated financial statements and reports. Directive 2009/101/EC about the disclosure of company documents and company obligations. Directive 2012/30/EU on the formation of public limited companies. Directive 89/666/EEC on disclosure requirements for foreign branches of companies.

Global Impact of Brexit

There
is no roadmap to follow or analogy to invoke as a guide or pattern for how the
Brexit vote will reverberate in the months and years to come. However, a few
immediate consequences seem highly likely:

• The
flight to safety away from the epicenter of this British-EU divorce will push
capital away from the region and toward key safe-haven markets including the
U.S.—especially Treasuries—and to Japan. This will further lower market
interest rates and raise relative currency values.

• A
higher U.S. dollar and Japanese yen are negative to both economies’ export
sectors. In the case of Japan, this is particularly unhelpful to its efforts to
reinflate and reinvigorate the economy after decades of deflation.

• The
higher U.S. dollar also triggers additional pressure on China to float the yuan
lower, as it is caught in the divergence between its two largest export
markets—the EU and the U.S..

• For
the U.S., the negative impact on exports is relatively small compared with
trends in domestic demand, but the deflationary pressure on tradable goods will
widen the divergence between reasonably strong inflation in the services sector
vs. reasonably strong deflation in the goods sector.

• The
European Central Bank will be compelled to raise its level of intervention yet
again, as risk premiums across the region rise. Among the larger Eurozone
members, Italy is in a particularly vulnerable position—now made more
vulnerable. Each blow to members of the Eurozone periphery also further make
Germany’s outperformance in the Eurozone even more unsustainable.

The nature of the UK’s eventual exit agreement with the EU is crucial, and hangs over a multitude of markets.

CEP BREXIT ANALYSIS

Life
after Brexit: What are the UK’s options outside the European Union?

• It is highly uncertain what the UK’s future would look like outside the European Union (EU), which makes ‘Brexit’ a leap into the unknown. This report reviews the advantages and drawbacks of the most likely options.
• After Brexit, the EU would continue to be the world’s largest market and the UK’s biggest trading partner. A key question is what would happen to the three million EU citizens living in the UK and the two million UK citizens living in the EU?
• There are economic benefits from European integration, but obtaining these benefits comes at the political cost of giving up some sovereignty. Inside or outside the EU, this trade-off is inescapable.
• One option is ‘doing a Norway’ and joining the European Economic Area. This would minimise the trade costs of Brexit, but it would mean paying about 83% as much into the EU budget as the UK currently does. It would also require keeping current EU regulations (without having a seat at the table when the rules are decided).
• Another option is ‘doing a Switzerland’ and negotiating bilateral deals with the EU. Switzerland still faces regulation without representation and pays about 40% as much as the UK to be part of the single market in goods. But the Swiss have no agreement with the EU on free trade in services, an area where the UK is a major exporter.
• A further option is going it alone as a member of the World Trade Organization. This would give the UK more sovereignty at the price of less trade and a bigger fall in income, even if the UK were to abolish tariffs completely.
• Brexit would allow the UK to negotiate its own trade deals with non-EU countries. But as a small country, the UK would have less bargaining power than the EU. Canada’s trade deals with the United States show that losing this bargaining power could be costly for the UK.
• To make an informed decision on the merits of leaving the EU, voters need to know more about what the UK government would do following Brexit.
• This is the first in a series of briefings analysing the economic costs and benefits of Brexit for the UK.

Economists for Brexit: A Critique

• Professor Patrick Minford, one of the ‘Economists for Brexit’, argues that leaving the European Union (EU) will raise the UK’s welfare by 4% as a result of increased trade. His policy recommendation is that following a vote for Brexit, the UK should strike no new trade deals but instead unilaterally abolish all its import tariffs.
• Under this policy (‘Britain Alone’), he describes his model as predicting the ‘elimination’ of UK manufacturing and a big increase in wage inequality. These outcomes may be hard to sell to UK citizens as a desirable political option.
• Our analysis of the ‘Britain Alone’ policy predicts a 2.3% loss of welfare compared with staying in the EU. This is only 0.3 percentage points better than Brexit without unilaterally abolishing tariffs which would result in a 2.6% welfare loss.
• Minford’s results stem from assuming that small changes in trade costs have tremendously large effects on trade volumes: according to his model, the falls in tariffs become enormously magnified because each country purchases only from the lowest cost supplier.
• In reality, everyone does not simply buy from the cheapest supplier. Products are different when made by different countries and trade is affected by the distance between countries, their size, history and wealth (the ‘gravity relationship’). Trade costs are not just government-created trade barriers. Product differentiation and gravity is incorporated into modern trade models – these predict that after Brexit the UK will continue to trade more with the EU than other countries as it remains our geographically closest neighbour. Consequently, we will be worse off because we will face higher trade costs with the EU.
• Minford’s assumption that goods prices would fall by 10% comes from attributing all producer price differences between the EU and low-cost countries to EU trade barriers, ignoring differences in quality.
• Single Market rules (for example, over product safety) facilitate trade between EU members as it creates a level playing field. Minford’s assumption that the Single Market merely diverts trade from non-EU countries is contradicted by the empirical evidence.
• Minford also overlooks the loss in services trade that would result from leaving the Single Market, such as ‘passporting’ privileges in financial services.
• Minford’s approach of ignoring empirical analysis of trade data seems predicated on the view that because statistical analysis is imperfect, it should all be completely ignored. But such statistical biases may reinforce rather than weaken the case for remaining in the EU. Theories need grounding in facts, not ideology.

Bibliography

• https://fullfact.org/europe/our-eu-membership-fee-55-million/
• https://www.reuters.com/investigates/special-report/britain-europe-cost/
• https://www.ft.com/content/0260242c-370b-11e6-9a05-82a9b15a8ee7
• https://www.ft.com/content/61221dd4-d8c4-11e6-944b-e7eb37a6aa8e?mhq5j=e5
• http://www.nortonrosefulbright.com/knowledge/publications/115128/mifid-ii-mifir-series
• http://uk.reuters.com/article/uk-britain-eu-banks/banks-planning-to-move-9000-jobs-from-britain-because-of-brexit-idUKKBN184132
• http://www.ey.com/Publication/vwLUAssets/ey-uk-eu-planning-for-uncertainty/$File/ey-uk-eu-planning-for-uncertainty.pdf
• https://www.reuters.com/investigates/special-report/britain-europe-cost/
• https://www.accountingweb.com/community/blogs/geoff-collings/the-effect-of-brexit-on-uk-accounting
• https://www.accountancyage.com/2016/07/21/what-brexit-means-for-accounting-employment-and-taxation-law/ http://www.europarl.europa.eu/RegData/etudes/BRIE/2016/587384/IPOL_BRI(2016)587384_EN.pdf
• https://www.ceps.eu/system/files/WD%20429%20AB%20et%20al%20Brexit%20Applied%20Economics.pdf
• http://www.frbsf.org/education/publications/doctor-econ/2005/january/financial-markets-economic-performance/
• https://www.ft.com/content/74708d46-c6ca-11e6-8f29-9445cac8966f

Mishkin,
F. (2012). Introduction to Financial Markets. [online]
Www2.econ.iastate.edu. Available at: http://www2.econ.iastate.edu/tesfatsi/finintro.htm#FMI
[Accessed 10 Sep. 2017].