The uncertainty of Brexit accompanied by the phasing out of LIBOR has turned the financial services industry in Europe on its head. As organizations take precautions amidst the uncertainty, it has become evident that the number one financial hub in the world has begun to fall from its pedestal.
Until concrete decisions are finalized, the true fate of UK banking remains unclear. However, one thing is certain: A massive amount of money is flowing out of London in response to the UK’s imminent departure from the European Union.
Before we analyze the possible downward spiral of the UK’s financial position, let’s trace the history of its success.
London: The #1 Financial Center in the World
Though the roots of London as a financial center date back to the 1500s, the turning point was the “Big Bang” of London’s stock market. On October 27, 1986, the London Stock Exchange (LSE) was deregulated – an overhaul that the UK government desperately needed to make. This included removing fixed rate commissions, allowing foreign companies to trade and switching to electronic trading.
The revitalization of the LSE trickled through the entire financial system and spurred a revolution. The daily asset turnover in the LSE drastically increased, international firms were enticed to buy UK businesses and the derivatives market boomed.
Since then, London has enjoyed its place at the top in Europe.
In 2014, the UK was the leading exporter of financial services across the world, with a trade surplus of $95 billion. This amount was more than the combined trade surpluses of the next three leading countries (US, Switzerland and Luxembourg).
In 2015 – a year before the Brexit referendum rattled markets – this surplus reached a record high of $97 billion. At that time, the UK was the largest center for cross-border banking, and around half of European investment banking activity was conducted in London.
These factors alone – among many others – demonstrate just how influential the London financial market is to Europe and the rest of the world.
But now, businesses and banks are shifting their resources elsewhere to avoid the risks that the current financial landscape of the UK presents.
The Mass Exodus of Financial Assets
Part I: Brexit
The Brexit referendum in 2016 has loomed over the UK for the past three years. At the time of the vote, the 2019 deadline seemed so far away. But as the end of March snuck around the corner, the country scrambled to agree on an exit plan – so much so that the deadline has since been extended to the end of October.
This means that the UK is still lingering in uncertainty. The lack of a clear path has created turmoil for UK businesses. No matter what outcome plays out in the coming weeks and months, the havoc wreaked to date may not be reversible in the near future.
Here’s what businesses have been doing to protect themselves – and how the UK’s financial authority has suffered as a result.
To avoid the uncertainty altogether, many UK businesses have decided to leave London and shift their assets to the EU. They are also moving employees and setting up new offices in non-UK cities. This way, they’re guaranteed to be able to still do business in the EU after Brexit, regardless of the final exit strategy employed.
Goldman Sachs, Morgan Stanley and UBS are among 25 other financial institutions that are moving assets to Frankfurt, Germany, Barclays is moving over $280 billion worth of assets to Dublin, Ireland and Bank of America is moving assets and staff to Paris, France. Over 500 employees from French firms are slated to be repatriated back from London to Paris.
All in all, $1.3 billion and 7,000 finance jobs have already left the UK as a result of the uncertain landscape … and these numbers are expected to continue to increase.
From interest rates and currencies to securities and derivatives, many financial markets in the UK have experienced increased volatility as a result of the uncertainty and the exodus of funds out of the UK.
Many European companies that hold currency swaps and other derivatives through banks in the UK, for example, have opted to repaper those agreements through EU-based entities instead. This is because many contracts have maturities out well beyond the expected withdrawal date. While these contracts will remain valid, derivative traders still have to rush to coordinate how they will be serviced. To do so, banks are switching their contracts to new EU entities in a process called repapering. Not only is this a cumbersome process, but it can also be expensive.
This is another case of uncertainty that has made conducting business in the UK more trouble than it’s worth for some entities. Also, these additional costs are hampering business investment even more and, thus, are contributing to the hampering of the UK economy as a whole.
The Bank of England itself is also holding its breath for the Brexit fallout. In a recent Monetary Policy Committee meeting, the bank held interest rates steady, quoting that “the economic outlook will continue to depend significantly on the nature and timing of EU withdrawal.”
This news – among other political headlines – has continued to signal uncertainty to the currency market, which has led to increased volatility in GBP rates. The GBP/EUR rate in particular has experienced massive swings, creating more headaches for European companies with GBP exposures, UK companies with EUR exposures and multinational companies with cross operations in Europe and the United Kingdom.
Many corporations are using operational strategies to regulate their exposure to this volatility by limiting their exposure in GPBs and, in some cases, shifting operations out of the UK. Others are turning to derivatives to help them fix (at least in the short term) the value of their exposure.
It’s no doubt that the uncertainty around Brexit has disrupted UK finance. The combination of shifting jobs and monetary assets out of the previously booming industry has already threatened London’s position as the World’s financial center.
Many organizations are unwilling to wait around and see if a Brexit deal will be made at all – and the London Financial Center is paying the price.
Part II: LIBOR
Another situation that’s only compounding the negative implications from Brexit is the phasing out of LIBOR: the London Interbank Offered Rate. LIBOR is an average value calculated from a panel of banks that submit estimates of their own borrowing costs.
This rate has traditionally served as the first step to calculating interest rates on various loans worldwide and is available as a benchmark in several different currencies – including the USD and the Euro.
The end of LIBOR can be traced back to 2008, when it fell under scrutiny after many financial institutions were accused of fixing the rate for profit. Since then, and despite policy changes and fines, the credibility of LIBOR has continued to be questioned, culminating in regulators’ decision to phase out the rate by 2021.
Though LIBOR is calculated based on the input of several global banks, it does have a significant impact and focus on the London banking system itself. So, the scandal and resulting phase out of LIBOR has seriously damaged the Bank of London’s authority – especially once it was revealed that the central bank knew more about the interest rate manipulation than was previously known.
The basis of trillions of dollars of contracts, LIBOR’s demise has caused massive headaches for many organizations. Like Brexit, the key problem this situation presents an increase in uncertainty, fueling volatility in the marketplace.
What rate should they move to as a replacement benchmark? This question has been a hot topic of debate around the world and some countries are farther along in settling on a replacement rate than others.
In the US, the Secured Overnight Financing Rate (SOFR) will replace USD LIBOR. Trading – mainly between large financial institutions – began in May of 2018, and liquidity has been increasing ever since. However, corporate players on the whole have not yet entered into the SOFR marketplace and, instead, continue to trade LIBOR derivatives with termination dates well past the anticipated end of LIBOR in 2021.
Though the phasing out of LIBOR has more of an indirect impact on the London Banking scene compared to Brexit, this is a lot of uncertainty, volatility and tarnished credibility for a financial center to experience at once.
Is this the end of UK banking?
Only time will truly tell. But UK banking certainly won’t ever be the same.