By Professor Daniel Hodson
One curious feature of recent Brexit commentary is the extent to which it has ignored our most successful and dynamic industry: financial services. Arguably, this has been because the original threat to the City’s European dominance has receded thanks to its relatively quick response to the challenges posed by any likely outcome to the Brexit negotiations, including No Deal.
The City was the first to recognise on 24th June 2016 that Brexit was a done deal and it prepared accordingly. We read that City employment in its great banks has, if anything, increased since the referendum — a far cry from the Project Fear prophesy of mass job migration. Of course, repositioning has been necessary. Significant assets have been transferred into the EU27, but only a tiny fraction of those that remain under management in London.
But, financial markets are mercurial. They thrive on change and opportunity, nowhere more than in the City. They also resist and overcome restriction and prescription. The resources they can muster are well beyond the control of governments, however powerful. All these factors will be present in the post-Brexit City. One example demonstrates its huge potential: the opportunity to create, nurture and build a massive global market in a free, fungible, tradeable, highly liquid Euro, in contrast to the increasingly restricted currency now imprisoned within the Eurozone; let’s call it the euro-Euro.
First, though, we should learn the lessons of financial history. In the mid-1960s the US Federal Reserve Board imposed a punitive change to its so-called ‘Regulation Q’, drastically restricting the level of interest rates paid on US bank dollar deposits, thus driving dollar depositors to offshore banks, principally in London, and generating the massive and hugely successful EuroDollar market there.
My own employer, the Chase Manhattan Bank, then the biggest bank in the world after Bank of America, generated half its wholesale deposits through London at that time. It was the making of the modern City, catapulting it into global financial centre leadership, a position it has held, alongside New York, ever since.
And why? The EuroDollar market was a combination of a US onshore restriction, an effective but market-sensitive regulatory regime in London, a tsunami of international demand and the generation and maintenance of liquidity in a key market.
Now read across to recent developments in respect of one the world’s larger but weaker currencies, the Euro. Official interbank payments are limited to a specific EU-based system, TARGET2, as are security transfers. Euro clearing is being onshored to the eurozone and therefore effectively separating out the massive cost, capital savings and associated liquidity of the multi-currency and product clearing available outside (notably in London). There is an increasing understanding of, and reaction to, the undercapitalisation of EU27 banks because of the rigid, apparently riskless, treatment of their holdings of EU27 government debt; Germany is self-evidently a different risk from Greece or Italy. The continent’s financial markets are fragmented, lacking in liquidity in important products, and are retail rather than wholesale customer-orientated.
Contrast this to the post-Brexit City, opening its doors to all qualified comers through its Temporary Permission Regime, immediately attracting 1500 EEA-based firms to apply for City market access, a massive statement of support. No doubt part of the draw is the prospect of regulatory realignment of the over-prescriptive and disproportionate regime previously imposed by the EU, dismantling the anti-competitive and liquidity-sapping aspects of recent measures such as MiFID II on security markets and Solvency II on insurance.
What better way to greet their enterprise than the development of the euro-Euro based on open and unrestricted currency, derivative, and securities markets, and following the lines and rationale of its predecessor, the EuroDollar.
History is replete with innovative products that thrived under similar constraints and survive to this day. The blueprint for foreign exchange trading in euro-Euro is found in the vast international non-deliverable forward markets of Asia and Latin America that dwarf the size of the domestic currency markets, while the parallel for the trading and investing in euro-Euro equities market is to be found in the global depository receipts market which developed in parallel to domestic markets such as Russia, and that for derivatives illustrated by so-called Contracts for Difference.
At the euro-Euro’s root would be the City’s constant innovation, its global acclaimed fintech, its wealth of participants in its deep and liquid markets, its skilled and diverse workforce and supporting resources. Like the EuroDollar it would immediately command a global customer base, and similarly cement the City at the top of the global financial services industry.
And that’s only one example of the opportunities ahead, combining the multifarious assets of the City. It’s perhaps the final irony, though, that as the current structural imbalances of the Eurozone are increasingly exposed, and the measurable possibility of its facing a major financial crisis grows, the EU27 would necessarily look to the City’s deep and liquid markets, including a burgeoning euro-Euro to steer it through to safer shores.