State of Play
Ensuring business readiness for the original Brexit date of 29th March 2019 was a significant achievement for financial service firms. Notwithstanding the extension of Brexit to October 2019, the business community have rolled out most of their Day 1 solutions, in some cases servicing clients out of EEA entities in advance of the original March deadline.
Whilst the final version of Brexit still remains unclear, firms are committed to fully executing their Day 1 ‘hard Brexit’ planning to this timeline. But as we have discussed before here, that will not be the end of Brexit implementation. Day 1 planning provided business continuity in the case of a ‘hard Brexit’, however decisions made were guided very much by time constraints.
Most firms now additionally have an EEA entity facing clients and various other institutions. This has added an additional layer of cost, complexity and inefficiency for little additional benefit – remember that most firms put these plans in place to retain clients, rather than gaining extra revenue or market share. Whatever the firms long term strategy or objectives may be, what they do all have in common, is that their Day 1 post-Brexit state is unlikely to be the optimal and sustainable ‘end state’.
Focus on Day 2
For Day 2, we believe that firms must target areas that give them relief from increased costs and that allow them to rapidly fulfil the promises they made to regulators for the newly formed EEA entities to be independent from an operational and risk perspective.The first adopters will also position themselves favourably to capitalise on opportunities that arise from the market settling back into equilibrium state.
We have identified three distinct areas of focus to help to prepare for Day 2. In turn, we believe each area should be considered through a separate lens - from a regulatory stand point, from a cost-saving / efficiency perspective and from an opportunity to increase revenue and provide a competitive advantage.
1. Booking model
Back-to-back booking models, whereby the risk of business transacted out of the firm’s EEA entity is transferred back to the UK or other non-EEA entity, was the preferred model for Day 1 Brexit readiness. Whilst the firm’s risk management strategy, in part influenced by client preference, is a factor here, it is important to consider both the local regulator and ECB stance on risk booking models.
Significantly, the ECB want to avoid EEA entities operating as ‘empty shell’ companies with a heavy reliance on third country risk hubs (as detailed in the ECB Banking Supervision August 2018 Supervisory expectations on booking models) – the concern being that the local entity cannot manage their counterparty and market risk independently. In our experience, a firm’s application for local regulatory approval has required a detailed plan to meet this requirement.
Aside from the regulatory focus, the back-to-back booking model is expensive, both from an operational and capital usage perspective. Now is a good opportunity for firms to review their booking models in their entirety, not just the additional EEA entities, aligning models in operation to current and future regulatory standards, whilst considering industry best practice.
2. Financial market Infrastructure
Time constraints in the run-up to Brexit meant that financial service firms generally replicated the myriad of market access from their UK entity into the EEA entity – across trading venues, CCP, custodians, brokers, agents and dealers. Whilst this guaranteed the continuation of existing services to their clients in preparation for Brexit, it created duplication and inefficiency.
The result is a direct impact to the firm’s balance sheet in the form of additional capital requirements, as well as increased staffing costs and the associated operational complexity of managing business from multiple locations. As firms start to utilise their duplicated market access, this is becoming clear and will focus the minds of front and back office alike.
3. Collateral optimization
Brexit has the potential to impact firms’ collateral management in two aspects – one results from likely Day 1 choices and the other will impact more widely from any fragmentation in the OTC derivatives market.
Lets address the first one, which will impact firms immediately. Duplicate entities will result in distinct and separate pools of collateral that do not benefit from netting opportunities and cross margining benefits - collateral used for initial margin particularly will be impacted.
Additionally, any relocation of the OTC derivatives market away from London to EEA centres would fragment what is presently a single market, the EU denominated swaps market being a perfect example. As with the duplicate entities this will reduce a firm’s collateral efficiency, with the associated funding implications. Over the last few years, we have seen firms invest in optimising their collateral management so adding another entity into the mix will feel like a step in the wrong direction.
Although firms are clearly experiencing Brexit fatigue, there is the opportunity to quickly address the cost and operational consequences of the ‘hard Brexit’ / Day 1 readiness model and perhaps explore new opportunities.
Over a series of articles, we will focus on each of these themes in more detail, looking in turn through the three distinct lenses we identified - regulatory, efficiency and from a business opportunity perspective. In the meantime, feel free to contact Rehaan Anjum to discuss the implications of Brexit on your business.