With the political storm around Brexit continuing to rage in the UK, the prospect of a ‘no deal’ exit from the EU is now, in the words of Mark Carney, ‘uncomfortably close’. That sense of the worse-case scenario becoming reality now pervades much of the financial services landscape, not least because following the European Central Bank’s (ECB) release of its booking model principles last week, the precise nature of a ‘hard’ Brexit has been brought starkly into focus.
The concepts underpinning the ‘Supervisory expectations on booking models’ are certainly not new – the idea of ‘no empty shells’ has been part of the ECB narrative for a good while. But the prospect of now having to perform, under the instruction of local EU regulators, a detailed gap analysis against those expectations forces firms to address the most intricate and challenging questions around booking, hedging and risk management. Ultimately, firms must now define the shape and structure of their EU-facing business at the most granular level – a necessary task of course but one that firms had largely deferred whilst the chance of a negotiated deal between the UK and the EU on financial services remained a possibility.
For those third country firms operating through a London branch today, detailed considerations of market risk hedging strategies, counterparty risk mitigation and funding requirements are particularly pronounced given the existing reliance on the power of the Head Office balance sheet and infrastructure. The ECB expectations very clearly point to the need to avoid undue complexity in intragroup arrangements, pushing Single Supervisory Mechanism (SSM) entities to full control of the local balance sheet and associated decision-making, as well as independent access to financial market infrastructure and a wide range of EU27 counterparties to support traded risk management or hedging.
So what does all of this mean in the coming weeks? Undoubtedly in the short-run firms will be required to focus effort on where there are gaps in their current proposals against the ECB’s booking model principles, and understanding what this means for the business. But more importantly, now is the time for Front Office resources to fully engage in the process and lock down what the EU27 business will look like from April 2019.
Amongst the critical questions to answer are:
- What is the true profitability of current EU27 business, what growth assumptions can be reasonably made to ensure that the scale of the EU Front Office hub is reflective of the scale of the future business?
- If a back-to-back, internal hedging strategy is unworkable for the ECB, what is the most economically viable and capital efficient means of hedging exposure held in the new SSM entity?
- What does independent access to financial markets infrastructure mean in relation to group ‘insourcing’ arrangements and post-trade operations headcount?
- What contractual updates are required to support the increased use of financial markets infrastructure by the SSM entity and how quickly can these updates be made?
The capital markets industry finds itself squarely in the middle of the most challenging aspects of Brexit. The fact that there is so much uncertainty as to the nature of the future relationship between the UK and the EU only magnifies that challenge. Unfortunately though, these problems and questions can no longer be passed down the road – they require urgent focus now because 29th March 2019, is fast looming into view… it is, without doubt, ‘uncomfortably close’.