Much discussion has been made on the Brexit impact for market participants. However, the threat of a “Hard Brexit,” together with the extreme but not impossible scenario of EU-UK relations breaking down into a “no deal” scenario, also poses risks to London’s trading venues.
The Brexit effects on British trading venues in this scenario can be categorised into either operator impacts or client impacts.
On the day of Brexit, the United Kingdom’s status will revert to that of a “Third Country.” This status poses the palpable risk of regulatory impediments being raised on UK trading venues. As a Third Country, UK venues will lose their “EU recognised status.”
The challenges from this are twofold:
The primary risk of such an outcome would be that European products with trading obligations would cease to be tradeable on UK venues. The associated reduction in client liquidity may catalyse wider falls in client participation on UK venues, as counterparties refocus on European venues in pursuit of tradable liquidity
Without a recognition agreement from the EU, predicated on a successful EU-UK deal, UK trading venues will be unable to trade EU client interest in products subject to the MiFID II trading obligation. By 2018 it is anticipated that these products will include:
- Equity and equity-like instruments
- Interest rate derivatives
- Credit derivatives
- Equity derivatives.
Unable to trade core financial instruments, the attractiveness of London venues will likely be undermined and client activity refocused towards alternate EU venues.
An associated risk would be the loss of advantageous reporting waivers, deferrals and exemptions for certain physically settled energy and commodity products.
The existence of exemptions and deferrals for certain physically settled energy and commodity products offer advantages to market operators and participants if these products are traded on an EU-recognised venue; an Organised Trading Facility (OTF) or a Multilateral Trading Facility (MTF). For example, the REMIT carve out allows physically-settled power and gas products to have a permanent carve out from MiFID II’s definition of ‘Financial Instruments.”
This has two notable benefits:
Firstly, it may help some non-financial firms qualify for exemption from MiFID II authorisation. Those firms dealing exclusively in the trading and delivery of physically settled wholesale products will be able to escape the demands of needing authorisation as a MIFID II firm.
Secondly, the exemptions reduce transparency and transaction reporting requirements in such instruments for MiFID II trading venues. The loss of these exemptions are likely to make UK venues unattractive to client interest and thus uncompetitive relative to EU venues, unless the UK seeks amendments to the MiFID II regime.
In addition to direct challenges, venue operators will also face the ramifications Brexit may cause to their clients; market participants.
The current size of UK venues’ domestic market in London could shrink as financial firms reposition EU facing roles to the continent due to the loss of passporting rights. Unable to access EU clients on a cross-border basis, market participants are likely to conglomerate around new EU hubs. The result is that the depth of client interest in London is likely to fall as counterparties refocus on other EU based venues in search of deeper tradeable liquidity; thus reducing revenues for UK venue operators.
The prospect of the fragmentation of client liquidity and regulatory barriers being imposed on UK trading venues should highlight the need to establish contingency plans in the face of a “Hard Brexit.”