What happens now? A week after the United Kingdom's historic
referendum on June 23 resulted in a narrow vote to leave the
European Union, market and currency instability continue while
political leaders become less and less clear as to when (and even
if) Brexit will actually occur, and what such a historic uncoupling
might entail.
For U.S. alternative funds and fund managers, the only real
certainty is that Britain's exit from the EU, commonly known as
"Brexit," will drastically reshape the financial
landscape in London, Europe and around the world.
Although George Osborne, the U.K.'s Chancellor of the
Exchequer, has sought to assure markets and investors that the
government was prepared to respond to Brexit's financial
impact, significant doubts remain. The value of the pound dropped
to levels it hasn't seen in decades and global markets plunged,
wiping out trillions of dollars' worth of assets. Standard
& Poor's stripped the U.K. of its triple-A credit rating,
reflecting the significant uncertainty that exists until the path
forward becomes clearer.
As a result, in the short term, market volatility and the drop in
the value of the pound will likely lead to a rash of technical
defaults under financial covenants where the value of GBP makes a
difference. Similarly, counterparties to derivative contracts
involving sterling could be affected due to margin calls or
substantial mark-to-market payment obligations in the event of a
closeout following material shifts in currency markets, and company
values can be affected if they have major sterling exposure without
appropriate hedging in place. The cost of hedging non-sterling debt
for companies operating in sterling will also likely rise.
Other areas of immediate concern for British companies due to the
sterling's drop will be commercial contracts (which may become
uneconomical to continue performing), regulatory capital
obligations, decreased liquidity and downgrading.
Companies that foresee a material effect on their activity or
ability to perform contracts may need to disclose this change in
position to their investors, regulators or counterparties,
depending on their particular regulatory and contractual
obligations.
That said, apart from an initial period of instability, very little
is likely to change in the near future. Part of the reason for this
is that many firms had already reduced the number of deals they
were completing in the U.K. and in Europe ahead of the vote due to
concerns about how the economy would be affected. However, the main
factors are the sheer level of uncertainty about what an
independent-again U.K. will look like and how it will interact with
the common market.
Ultimately, the outcome of the vote to leave will depend heavily on
whether EU membership will be replaced with a sort of
"quasi-membership" (either by becoming a member of the
EFTA (European Free Trade Association) and adhering to the EEA
(European Economic Area) agreement or entering into some other form
of free trade agreement with the EU), or whether the U.K. will have
no formal link with the EU going forward.
In the EFTA/EEA scenario the U.K. could enjoy continued access to
EU markets but without the ability to vote on financial services
legislation. Membership would not be automatic — the four
other EFTA member states (Switzerland, Iceland, Liechtenstein and
Norway) would have to agree to the U.K.'s request for
membership, and that could take some time.
But EFTA/EEA membership could mean that a number of EU regulations
would continue to apply. These include directives on collateral
arrangements (FCAD) and regulations on insolvency (EUIR), choice of
law governing contractual and noncontractual obligations (Rome 1
and Rome 2), and reciprocal recognition of commercial judgments
(Brussels 1), all of which simplify dealings by U.S. funds with
entities in EEA states. Of course, negotiations will need to be
carried out, and the U.K. might try to cherry-pick the rules and
regulations that will apply to its membership in the EEA.
In any event, apart from the EEA, none of the potential structural
models would give the U.K. financial services sector the same
rights to do business across the EU as it currently has. Its best
bet — continued access to EU markets but without the ability
to vote on financial services legislation — would be EEA/EFTA
membership. Otherwise, British firms will likely be faced with
restricted EU market access and "third country" status
following an exit, which can be more or less burdensome, depending
on the legislation at issue.
Under MIFID II (the Markets in Financial Instruments Directive II),
for example, U.K. firms wishing to provide services to retail and
certain professional clients in the EU may be required to set up
branches in particular member states. Where access to EU markets
will be possible without a branch (e.g., access to EU-eligible
counterparties and certain professional clients), such access will
nevertheless be subject to the delay and uncertainty involved in
seeking an EU Commission decision on equivalence.
Other financial services regulations — UCITS, AIFMD, CRD IV,
EMIR — will have different rules regarding "third
country" status, and again, the only certainty will be a
certain level of uncertainty while necessary third-country
agreements between the EU and U.K. are put into place, subsidiaries
or branches are set up, and contracts replaced or amended. In the
midterm, firms will likely look to establish a base on the
continent to ensure a ready-to-go presence once Brexit is complete,
and this process can take some time.
From a U.K. perspective, it seems unlikely that Brexit will trigger
a mass overhaul or repeal of EU-based financial services
legislation, especially given the cost that would be associated
with the resulting systems and operational changes. That said, a
vote in favor of Brexit seemed unlikely last week, so anything is
possible.
In the months and years ahead, issues of regulation, currency and
employment, among others, will need to be resolved, the outcomes of
which will shape the new reality of investing in the U.K. However,
none of this can occur until the British government triggers
Article 50 under the EU treaty to commence the two-year window for
exit negotiations.
The timeline for Britain's exit has yet to be determined. Prime
Minister David Cameron, who announced plans to resign as a result
of the referendum outcome, indicated he would delay Brexit
negotiations until his successor had taken over in the fall,
despite EU officials urging the U.K. to accelerate the process in
order to reduce the uncertainty. As a result, the market volatility
is expected to continue for the foreseeable future, and the
U.K.'s official departure from the EU — along with its
myriad effects — remains years away.
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