The Commercial Realities of Brexit


Based on the number of articles we have published on the subject, Asia Research might seem a bit obsessed with Brexit, particularly not being in either the UK or Europe.  But from a trade, financial, and political point of view, Brexit has implications far beyond Europe and hence well worth reporting here in Asia.

From a more ‘System 1’ basis of thinking, we dealt with ‘The Psychology of Brexit’ in the Q3 2016 edition. In this article, the author takes a more ‘System 2’ view in examining the ‘The Commercial Realities of Brexit’, by looking at the facts.

“So, I believe the framework I have outlined today is in Britain’s interests. It is in Europe’s interests, and it is in the interests of the wider world.

But I must be clear. Britain wants to remain a good friend and neighbour to Europe. Yet I know there are some voices calling for a punitive deal that punishes Britain and discourages other countries from taking the same path.

That would be an act of calamitous self-harm for the countries of Europe, and it would not be the act of a friend.

Britain would not—indeed we could not—accept such an approach.

I am equally clear that no deal for Britain is better than a bad deal for Britain.

Because we would still be able to trade with Europe. We would be free to strike trade deals across the world, and we would have the freedom to set the competitive tax rates and embrace the policies that would attract the world’s best companies and biggest investors to Britain. If we were excluded from accessing the Single Market, we would be free to change the basis of Britain’s economic model.”

UK Prime Minister Theresa May, 17th January 2017

The Brexit referendum, was a majority decision and the UK Prime Minister, Theresa May, stated she will abide by it, despite prior to the vote campaigning to remain in the EU.

Her speech at Lancaster House on 17th January 2017 surprised many with its clarity.  In essence, having been rebuffed in numerous ways by EU members since she was raised to the office of Prime Minister, she took the bold step of declaring that Britain would not seek to remain in the EU or to retain Single Market access within the current arrangements.

Instead she expressed the intention for the UK to remove itself from all existing ties consequent upon membership of the EU and will instead seek to enter into a new trading relationship with the EU.

This was the most extreme form of Brexit that the broadsheets had discussed, and it had been largely discounted by the UK industry and banking industry who sought or had even assumed a ‘soft Brexit’ over an extended time.

There are plenty of opinions offered in the media about Brexit and there has been near ubiquity in the tone of the coverage.

Let us take a different tack and examine the underpinnings. Rather than offer further opinion, it might be useful to examine the facts that underlie the three broad issues that Theresa May discussed in her speech at Lancaster House.


In terms of the balance of trade, in the six months from June to November 2016 (the most recent monthly data set available), the overall nett exports from the EU27 to the UK was +£49 billion. This therefore represents a significant amount of demand which the EU is not in a position to ignore, bearing in mind its current state of near economic stagnation. This will provide significant leverage for the UK in its negotiations with the EU27.

Whilst the parameters around the negotiations of terms of trade between the UK and the EU for manufacturing will be bound by World Trade Organization rules (which will involve tariffs of 3-6% on most goods), a key concern has been the status of the UK’s large service sector and within that the particular relationship that UK banking will have with the EU in terms of access and tariffs.

Most commentators have focussed on ‘passporting’ (this allows financial institutions, to locate themselves in an EU state and do business in other European Economic Area states, without additional financial or administrative impediments). In practice, this potential loss of passporting might be less significant than the question of ‘clearing’.

Most banks already having EU subsidiaries based in France, Ireland, or Germany—thus the decision about whether the customer relationship managers in these banks will need to be based in the EU, or whether the middle or back offices will also need to be located in the EU, is more divisible.

Clearing is the process whereby different sides of a financial transaction settle the trade. European leaders appear to think that they have spotted a prize: a large number of high-skilled, high-wage jobs which could be mandated to be located within the EU27’s borders.

One leader of an EU nation has publicly stated that he wants Euros to be cleared within the Eurozone.  This is interesting and pertinent because this is not a statement about regulation, but rather a clear commercial desire, as currently the European Central Bank does not have the power to regulate clearing houses; this is instead left to national central banks.

Interest rate swaps are the largest financial asset class globally. 90% of that market is currently cleared through London—a total of USD 655 trillion. In addition, London is the largest clearing house for foreign exchange in the world. Thus, it has significant scale and is central to financial transactions worldwide.  This activity required USD 130 billion to be held in order to protect against default by the parties to these transactions, in the central margin default fund.

Whilst the revenues that the London Clearing House derives from the clearing business are measured only in the hundreds of millions of US dollars, it is easy to overlook the central importance of the business. That is because after 2008 it was agreed and mandated by the G20 to bring bilateral contracts onto a central exchange platform, in order to make them more visible and to reduce the financial risks within the financial system.

The central importance of the clearing house is that it is a risk buffer in the financial system, rather than a risk-taking enterprise (e.g. banks and asset managers). By centralising the various exposures, they are able to nett off a significant amount of the exposures and can therefore compress the regulatory capital required to be held against these various transactions. In 2015, USD 25 billion of regulatory capital was freed up by this netting and compression. The more transactions that are cleared in a central location, the more netting and compression can take place, increasing the efficiency and lowering the costs of doing further business.

Thus the idea of moving only Euro clearing to inside the EU—which would therefore have the effect of requiring tens of billions of Euros of additional regulatory capital to be put aside against these trades, funded by the banks and the corporations who are engaged in these trades, would be unattractive. It would increase costs and reduce available credit within the Eurozone for banks to lend to customers.

For Italy, Portugal, Greece and a number of other countries this would be unwelcome as they are struggling to find smaller sums to effectively recapitalise their domestic banks. As a by-product, it would increase the cost of doing business for banks and companies in Africa, Asia, and South America.

It would therefore make sense to try to co-locate the vast bulk of all clearing services within the EU27.

Let us look at the prize. It has been estimated in an Ernst & Young report that 232,000 jobs are at risk in the UK if clearing were to leave. This would therefore require these 232,000 people with a range of specialist skills to be found within the EU, and promptly. The idea that a significant function could go from London to another EU state to continue that function, with the people going to the new location, seems questionable. When JP Morgan, a US investment bank, looked at the situation, they cited a range of significant impediments to moving to Paris, including France’s protectionist labour laws, let alone the 28 years that they reported it would take to find schools for the children of 800 staff!

There is also the associated issue of supervision. Germany has struggled with supervision of what, in June 2016, the International Monetary Fund described as “the world’s most systemically important bank”, Deutsche Bank. The bank’s conduct has led to numerous investigations into a variety of its business lines. Some of the internecine machinations of the EU banking system can be seen from Deutsche Bank’s relationship with the deeply troubled Monte dei Paschi bank in Italy. /

Bearing in mind the inability of German regulators to control Deutsche Bank, and the numerous transgressions and accruing fines, it is questionable as to whether the German banking regulator together with the German Central Bank would be looking for a very large complex additional area to supervise, in the form of Euro clearing.

This highly specialised, deeply integrated business requires a variety of highly skilled people and technology. It seems impractical and risky to move it within Europe for a number of issues; nevertheless, this could become a decision based on politics alone, and politicians can and do make capricious decisions. Seeing a prize of this size in terms of high paying jobs and tax revenues, they may overlook the details of capacity (e.g. Xavier Rolet’s evidence to parliament select committee, January 2017).

It is even possible that, as an unintended consequence of trying to make Euro clearing more cumbersome in the UK, Euro and perhaps other clearing services are squeezed out of the EU to New York.


The other significant area that Theresa May mentioned was a desire to maintain security ties.

The current EU Commissioner for Security is British and was appointed in August 2016. Despite the UK’s lead in this field by EU standards, he was described by the chairman of the EU Parliament’s foreign affairs committee as “a type of junior commissioner”. As if that was not clear enough, Gianni Pittella, leader of the European Parliament centre-left socialists and democrats, said, “it is a little, technical portfolio”, adding that there should be “no prize, no award” for voting to leave the EU.

Britain is the EU’s largest military power, and for a number of years Britain alone has been reaching its target in terms of defence spending (Britain is estimated to have spent about 2.1% of its GDP in 2016 against a target of 2.0%). However most of the countries in the EU, especially the large ones, are falling well short of the target. For Germany in 2016, the expected expenditure is only 1.2% (ironically, perhaps, Greece’s is 2.6%, but given that they are largely funded by German money,  perhaps Germany is a little closer to their benchmark than they are given credit for!).

Thus, in dollar terms, Germany would need to spend an additional USD 27.7 billion in 2016 alone to reach their defence spending target. This has been a source of significant irritation to the US, and mentioned by all of the candidates in the recent US elections, but Donald Trump appears more likely to make waves over this matter, despite his view of the obsolescence of NATO. Thus the UK leaving the EU will draw further unwelcome attention to this deficit.

Whilst much comment has been directed at the UK–EU relationship, little comment has been directed at the EU27’s internal relationships post-Brexit.

The matter of the UK’s nett contribution to the EU budget, which was €8.5 billion in 2015, will highlight this area, as the deficit will need to be made up by the rest of the cash-strapped EU27 or there will be the prospect of services needing to be cut.

Like any relationship that breaks down, the discussion of the future relationship can degenerate into bickering and irrational behaviour as the parties struggle to focus on the best outcome for the new reality. Helpfully, Theresa May has taken a powerful overview of the requirements and levers that both sides have.

Britain, as the second largest importer of EU goods in the world, will have significant leverage over the setting of tariffs for manufactured goods and will be able to use this in settling the overall trade agreement, but it is always possible that an emotionally blinded EU—especially where Juncker, Head of the European Parliament holds some sway—could make an emotional decision rather than one guided by getting the best solution for all concerned.

Theresa May hinted that, if an acceptable deal is not reached, she could turn the UK into a regional tax haven in order to retain business in the UK: a sort of ‘supersized Singapore’ in Europe.

You will be able to hear pronouncements about progress from various sources. Elections in France, the Netherlands, and Germany this year may change the way talks evolve, but we believe that the issues discussed above represent the key underpinnings.

How will we know in which way the above arguments are playing out?

In the Sterling / Euro exchange rate, the last two years have seen a broad and steady decline in the purchasing power of Sterling. Watch the consistency of the price movement carefully. The 1.20 level is a litmus test.

If the rate breaks above 1.20, you will know which side the market participants are backing. Expect further appreciation thereafter.

We will be watching closely.