Professor Chris Martin on: Brexit and the City of London: A Clear and Present Danger

Professor Chris Martin, Professor of Economics, Department of Economics.

In September 2011, the UK government began legal action at the European Court of Justice (ECJ) against the European Central Bank (ECB). It claimed that an ECB policy proposal was outside its legal competence, as defined in European Union (EU) law[1]. The UK government took this action even though the Justice Secretary at the time, Chris Grayling, supports Brexit (as does the incumbent, Michael Gove), in part because of the requirement that EU law applies in the UK. Moreover, supporters of Brexit in the UK government have a strong aversion to the ECJ, with Grayling describing it as having “reached the point where it has lost democratic acceptability".

This episode is more than just one more example of the ironies of political life.  It illustrates the tensions at the heart of the EU between the single market and the single currency. The single market guarantees free movement of goods, services, labour and capital. The rules ensuring these “four freedoms” are enforced by the ECJ. The ECB is taking an increasingly prominent role in ensuring the stability of the financial system in the Eurozone. It has ultimate supervisory responsibility for all banks in the Eurozone and has direct supervision of the largest Eurozone banks. Clashes occur when access to the single market conflicts with the need for financial stability. There are nine members of the EU who do not use the Euro, but these tensions are especially severe in the case of the UK.

This is because of the dominance of the UK in European wholesale banking. There are two broad types of banking, retail (for example, bank lending to firms and households) and wholesale (for example, trading on foreign exchange markets or buying and selling financial securities and derivatives). Within Europe, the City of London dominates the latter.  Average daily turnover in the UK foreign exchange market exceeds US$2.5 trillion per day[2]. London is the largest global centre in Euro foreign exchange markets, with daily trade of over US$ 1 trillion. This is nearly 45% of global trades, a figure that far exceeds any country that belongs to the Eurozone[3]. The City is also dominant in markets for swaps, especially interest rate swaps.  Although these are obscure and complex financial products, they are central to the daily business of large financial institutions. London-based trades in these assets amount to over US$ 1.3 trillion per day[4].  A substantial proportion of these trades will involve banks that are ultimately regulated by the ECB.

The extraordinary size of these markets helps us understand why financial markets are so important for the performance of the UK economy. They account for 10% of GDP and 12% of UK tax receipts. Directly or indirectly, they employ over 330,000 people, many in high-skill, high wage jobs. Banking and Financial Services is one of the few areas where the UK has a large and consistent trade surplus, of nearly £47bn[5]. Not all of this is due to the City of London, but the City does make a major contribution.

There have been several examples of how the tension between the single market and the Eurozone affects the UK in recent years. The 2011 case brought before the ECJ by the UK Government concerned the proposed “Eurosystem Oversight Policy Framework” published by the ECB. This included a requirement that clearing houses for mainly Euro-related financial products should be located within the Eurozone. This would have required, for example, that LCH.Clearnet, which handles around 50% of the global interest rate swap market, relocate away from London. Other examples include the UK appealing to the ECJ against plans for a Financial Transactions Tax by eleven Eurozone countries and against the EU’s proposed cap on bankers’ bonuses[6].

In 2014, the ECJ found it in favour of the UK government, arguing that the ECB proposals exceeded its authority in EU law. In this case, access to the single market over-rode the ECB’s financial stability mandate. There will likely be similar cases in the future as regulation of European financial markets increasingly moves into the ECB and as the dominance of the Eurozone within the overall EU grows. The tensions are a threat to the dominance of the City of London while the UK is a member of the EU. How would things change if the UK were to leave the EU?

The effect of Brexit on financial markets and the City of London is unknowable; it depends on a large number of factors that are difficult to foresee and difficult to control. Optimists argue that Brexit would allow the City to flourish in a low regulatory environment as the UK frees itself from the burdensome regulations of Brussels.  But this is highly subjective. What seems like a meddlesome imposition to some looks to others like a prudent response to the toxic risks of financial instability, so clearly exposed by the 2008 financial crisis. As the Centre for European Reform argued in a 2014 report[7], a nation state cannot have financial stability, internationalised finance and national sovereignty. A country can only have two of these three. Given the post-crisis focus on financial stability, it seems clear that in order to continue as one of the few dominant centres in global finance, the UK will have to conform with international regulations on financial markets.

Although the long-term impact of Brexit is deeply uncertain, it is clear that the UK would have to do very well in the negotiations that would follow a vote for Brexit in June. Just to keep things as they are, three things would have to happen. First, the UK would need continued access to the single market, with recourse to the ECJ for adjudication and enforcement of the rules of the single market. That would require access on terms similar to those negotiated with Switzerland or Norway, something that comes with a substantial price and with reduced influence on the rules of the single market. But that would not be sufficient. Second, the UK would need continued access to the TARGET system for clearing payments in the Eurozone. Although not a member of the Eurozone, the UK used the rules of the single market to gain access to TARGET. Access to this allows UK-based financial institutions to more easily participate in inter-bank and other short-term money markets in the Eurozone. Access was granted on the basis that non-Eurozone EU members should have the same ability to transact in the common currency as Eurozone members. This principle would not apply if the UK were to leave the EU and so continued access to TARGET would be problematic in the event of Brexit.

Thirdly, the UK would have to negotiate arrangements similar to the current passport system of financial regulation. Currently, the UK benefits greatly from the “passport” system whereby financial institutions based in the UK can provide financial services in all EU countries without further financial regulatory requirements. In effect financial institutions can use their compliance with UK financial regulations as a “passport” to operate anywhere in the EU. The financial services passport is a major reason why many foreign banks, especially American and Swiss ones, have large UK-based subsidiary operations. The presence of these large banks then encourages Eurozone-based banks like BNP-Paribas and Deutsche Bank to also base a large part of their operations in the UK. It is hard to overstate the importance of this. According to CityUK, 37% of financial services companies say they are very likely or fairly likely to relocate staff if the UK left the EU[8] and lost the passport system. Goldman Sachs and JPMorgan have indicated the passport system is a primary reason for their presence in London and stressed the importance to them of the UK remaining in the EU[9] because of this. It is at best highly uncertain whether the UK would be able to secure a passport-like arrangement following a Brexit.

In summary, the dominant position of the City of London in highly lucrative wholesale banking is already under threat as the UK struggles with being a major centre for large-scale markets in Euro-denominated assets while not being a member of the Eurozone.  Even if the UK remains within the EU, the unresolved tensions between the requirements of the single market and the need for financial stability on financial institutions based in the Eurozone will continue to create difficulties. But the outlook for the City of London would become much bleaker were the UK to vote to leave the Eurozone in June. Financial markets are very keen for the UK to reject Brexit.

This blog post is part of a new IPR Series – all related to the BREXIT debate and the EU Referendum. This collection of commissioned blog posts  will be published as an IPR Policy Brief in May 2016. Sign up to the IPR blog to get the latest blog posts, or to our mailing list to receive invitations to our events and copies of our Policy Briefs.

[1] Case T-496/11
[2] Bank of England data for 2013: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/qb130410
[3] ibid
[4] Again, Bank of England data for 2013. This figure is for daily transactions in OTC interest rate derivatives; these are “mostly in interest rate swaps”.
[5] Illustrative figures are in https://www.cityoflondon.gov.uk/business/economic-research-and-information/statistics/Documents/an-indispensable-idustry.pdf
[6] https://www.cer.org.uk/sites/default/files/smc_final_report_june2014.pdf
[7] https://www.cer.org.uk/sites/default/files/smc_final_report_june2014.pdf
[8] https://www.dlapiper.com/en/uk/insights/publications/2015/10/banking-disputes-quarterly/brexit/
[9] In evidence to the Parliamentary Commission on Banking Standards.