Ever since the results of the United Kingdom’s referendum on EU membership was finalised, much has been made (particularly in the City) of the impact on the UK’s financial sector. Indeed, I myself held a similar opinion: Regulatory Passporting: The killer argument against Brexit
Much of the UK’s success in the finance sector comes from trade within the EU (including the UK). As I (and others) wrote before, these passporting rights allows financial firms to access the entire Single Market with minimal regulatory checks. Outside of the EU and without passporting rights, financial firms wishing to trade within the single market would be subject to many more bureacratic hurdles. These would subject financial institutions to costs that would significantly impact their competitive edge.
On top of this, we have the upcoming enforcement deadline of the EU’s MiFID ii directive. This new directive enforces regulation on the finance industry on a vastly greater scope. Eventually, MiFID ii will be superseded by MiFID iii, legislation that is almost certainly guaranteed to be even greater in scope.
Some of the biggest financial institutions are already moving their base of operations from London to Frankfurt, Paris, or Brussels. This activity seems to provide evidence in support of the idea that Brexit would hit the UK’s finance sector.
However, I think a few questions that would greatly refute this theory have gone unanswered :
1) what is the nature of the City of London’s finance sector?
2) what is the cause and driver of MiFID, and how effective is it?
3) how will the City be affected by the upcoming iterations of MiFID?
London: Europe’s finance centre
The City of London is the home to the greatest financial sector in Europe. The London Stock Exchange itself is by far the largest stock exchange in all of Europe, with a market capitalisation of over £6 trillion. It is almost twice the size of the next largest stock exchange in Europe: Euronext, which itself has a significant base in London too. Another enormous exchange is the London Metal Exchange, the world’s largest market in options and futures contracts on metals, with over £10 trillion worth of contracts being exchanged every year. There are many other major financial marketplaces based in London include Lloyd’s of London insurance market, the Baltic Exchange, Tradeweb, and The Intercontinental Exchange (which owns the world’s largest stock exchange, NYSE).
What does this mean with regards to the loss of passporting rights? Yes, trade with Europe would be affected. But trade works both ways. The European finance sector who wish to trade on London marketplaces would also be hindered by this loss. An important factor is that exchanges cannot relocate – they are the market. Thus traders who wish to trade on a marketplace need to be where the exchange is. Just as London traders who wish to trade on European exchanges have to go to Europe, so do traders who wish to trade in London marketplaces need to come to London from all over Europe. Yes, some financial institutions in London will take action to set up branches in Europe to take advantage of passporting rights, but at the same time, financial institutions throughout all of Europe would move to set up offices in London to trade in London’s markets. This is simply an administrative exercise. The key difference is the sheer size of London’s finance sector. The gains in incoming businesses setting up branches will likely offset the losses in businesses moving branches into Europe.
MiFID, MiFID ii, MiFID iii – origins and efficacy
MiFID stands for Markets in Finance Instruments Directive. The first iteration (2004) superseded the Investment Services Directive (1993), itself the EU’s early attempts at regulating the finance sector. MiFID was supposed to ameliorate risks within the industry. MiFID was developed by a committee in consultation with industry players, who of course implicitly lobbied the system to favour their institutions, before passing through the legislative houses the participants of whom acted in their own political interests regardless of expertise. This government-led regulatory process is in contrast with industry standards and practices, which are jointly developed by experienced industry players independent of government interests, to benefit the industry without being encumbered by legislative processes.
The shortcomings of MiFID came to light in the wake of the 2008 financial crunch. In a rather phlegmatic knee-jerk response, the EU enacted MiFID ii in 2010, which for practical and politically expedient reasons would not apply until 2014, and then not be enforced until 2017. In comparison to its predecessor, MiFID ii vastly increased in legislative volume, scope, coverage, and detail. In the meantime, individual governments started cracking down on ‘bad’ players in the finance sector in their own knee-jerk political response to public reaction.
However, MiFID ii and all the government action in the same line was effectively scapegoating. MiFID ii sought to crack down on market abuse and enforce market harmonisation so that individual markets would not have an unfair competitive edge. But the 2008 crunch was not caused by market ‘disharmony’ or market abuse. It was a very clear case of overleveraging the mortgage market. Basically, in order to gain the competitive edge, banks lent out more and more mortgages to those less and less able to afford it, building up a financial bubble in property prices. The 2008 crash was a consequence of this bubble bursting, rebalancing the market to relative normalcy. No amount of market harmonisation or prevention of market abuse would have prevented such a crisis.
Seeing as players in the finance industry were the ones hardest hit by the 2008 crisis, it naturally followed that they would be the ones most vested in preventing such a crisis happening again. So the industry learnt its lessons, enacted their own checks, and the industry carried on evolving,
whilst government regulators were busy attempting to enforce the complicated details of the EU directive. After all, markets and technologies are not stagnant, and will develop quickly in any developed economy, especially in an industry so awash with money as the finance industry. Mechanisms within MiFID ii designed to reduce risk and fight market abuse were already rapidly becoming obsolete. Thus not only was MiFID ii outdated and ineffectual at its aims, it represented an ever-increasing bureaucratic burden on the finance industry that unnecessarily hindered growth without benefiting the industry.
To top it off, in an effort to chase its own tail and cover up the many problems created by MiFID ii, the EU is in the process of considering legislating for MiFID iii. In addition to increasing the bureaucratic burden, every iteration of legislative directive costs money for governments AND financial institutions to enact and enforce.
MiFID and the UK’s finance sector
In light of the doubtful benefits of MiFID (and its successive iterations), and given the great costs associated with enacting it, it is quickly becoming evident that not only does the finance industry not need MiFID; the EU’s involvement in regulating the industry is actually damaging the finance sector rather than protecting it. Outside the EU, the UK’s finance sector will no longer be subject to any further EU legislative meddling. The industry will be free to learn from its own mistakes and develop its processes and technologies to competitively flourish free from unnecessary bureaucratic burden. In contrast, financial industries within the EU will be further hindered by subsequent iterations of MiFID and its successors. This will actually make the EU less competitive in the finance sector, whilst the London carries on competing amongst the biggest international players the world over.