London's financial future at stake over Brexit

Brexit trade negotiations are down to the wire this week. Even if the U.K. and European Union strike an accord, it won’t cover Britain’s most valuable industry, and one coveted by the EU: finance.

That has set off a land grab between the 27-nation bloc and the U.K. for lucrative financial transactions and the jobs and clout that come with them. The financial services sector has the biggest trade surplus of any industry in the U.K., with exports in 2019 of £79 billion, equivalent to $106 billion.

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European regulators have demanded banks base certain operations currently conducted in London in the EU post-Brexit. Banks such as Goldman Sachs Group Inc. and exchange operators such as the London Stock Exchange Group PLC have set up trading operations on the continent in recent weeks.

The EU last week committed to rules governing derivatives that will prevent London-based traders at EU banks from continuing business seamlessly after Brexit is completed on New Year’s Eve.

“This is part of a wider strategy of moving finance into the EU,” said Tim Cant, a London-based lawyer at Ashurst Group, which specializes in financial regulation. “It’s part of that wider movement of euro-denominated business into the eurozone.”

Assets worth £1.2 trillion are already heading to continental Europe from the U.K. following the country’s 2016 Brexit vote, according to accounting firm Ernst & Young, and hundreds of employees at JPMorgan Chase & Co., Goldman Sachs, Morgan Stanley and other banks are moving to Frankfurt, Paris and other European cities.

The U.K.’s departure from the European single market means that London-based banks, exchanges and financial firms will lose automatic access to EU markets from Jan. 1. To serve customers in the EU next year, U.K.-based institutions will have to be granted equivalence rights, under which the EU allows them to conduct certain financial activities. These rights can be withdrawn at short notice.

One key battleground is derivatives trading, which is dominated by London. The Nov. 25 decision by the EU’s European Securities and Markets Authority effectively prevents the London-based units of EU banks from trading with U.K.-regulated firms unless they transact on venues in another jurisdiction which both sides recognize: the swap execution facilities, or SEFs, of New York.

“This is a very political issue, but I think what we need to realize is, not saying anything [about the financial sector] on either side is not going to result in either the U.K. or the EU winning,” said Emma Tan, vice president of regulatory affairs at JPMorgan. “It’s really going to be the case that, ironically, U.S. SEFs will be the main beneficiaries of the absence of action.”

Based on French bank data, about 70% of trade volumes executed by EU banks in the U.K. are at risk, Robert Ophèle, chairman of France’s financial markets regulator, said.

“It will either be lost or carried out on U.S. SEFs,” he added.

ESMA said it recognized its derivatives decision makes life difficult for London traders at EU banks.

“This is a political decision beyond ESMA’s remit,” Fabrizio Planta, the body’s head of markets and data reporting, said. “ESMA have been calling the industry to adjust their business model in anticipation of Brexit.”

While the EU hasn’t granted equivalence rights to U.K. derivatives trading venues, it has granted them to British clearinghouses, which operate between buyers and sellers in trades and pledge to complete the deal even if one side reneges. London has much of this financial plumbing, which manages trillions of dollars of derivatives contracts every day.

However, the time frame for equivalence on clearing is limited to June 2022 and some companies are feeling pressure to move it to the EU. German and French government officials have asked one global bank with significant operations in London to explain how it will transfer clearing into the EU after the deadline, according to a person familiar with the situation.

London will remain Europe’s dominant financial hub for now, say financial professionals. Financiers in the city see two regulatory paths ahead, one that tries to stay closely aligned with EU rules, and another that strikes out on its own, changing regulations in a bid to attract business.

“Fragmentation only breaks what we have built together,” William Russell, the lord mayor of the City of London Corporation, which manages the U.K. capital’s finance district, said. “It is bad for business and bad for consumers.”

Some Brexit supporters favor divergence, with the U.K. setting cheaper, less onerous rules. Daniel Hodson, the former chief executive of London’s LIFFE futures exchange, which is now part of Intercontinental Exchange Inc., said EU law was too prescriptive.

“Here you can do it unless we say you can’t,” Mr. Hodson said in a recent debate organized by the Bruges Group, which campaigned for Brexit. “There you can’t do it unless we say you can.”

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Finance firms aren’t waiting around. On Nov. 24, Goldman Sachs said it was starting Sigma X Europe, a Paris-based platform to trade European shares, in addition to its U.K. Sigma platform. And the London Stock Exchange is adding Turquoise Europe, an Amsterdam-based platform for trading, to its London platform.

“We want to ensure that our clients continue to have access to all of our key liquidity sources post-Brexit,” Liz Martin, global co-head of futures and equities electronic trading at Goldman Sachs, said.