The European Union cannot set up an internal capital market on a global scale without embracing the City of London, according to a new report.
The report ‘The capital markets union: Should the EU shut out the City of London?’ written by Jonathan Faull and Simon Gleeson from the pro-EU thinktank the Centre for European Reform warns that the creation of an ‘onshore’ market without the City of London could see European corporates seeking financing outside of the EU 27.
The paper notes the EU’s increasing ambition to create an ‘onshore’ capital market since the UK’s vote to leave in 2016.
“The ambition is laudable: deeper integration of capital markets could make the European economy more stable, more effectively channel funding to the best investments, and give investors and firms more options,” the report states.
However, the paper argues that the UK’s imminent departure from the EU ends the prospect of the development of a global-scale capital market.
It states that out of the billions of euros investment in the bloc every year, as much as half passes through the City of London. In the fund industry, the UK manages more than a third of European assets under management.
“Post-Brexit, assuming that it will be difficult to build mechanisms to replace the City immediately, the obstruction of flows of FDI into the EU-27 economy could pose a significant problem.”
Faull is chair of European Public Affairs at Brunswick Group and worked for the European Commission from 1978 to 2016. Gleeson is a partner and specialist in financial markets law and regulation at Clifford Chance.
Seeking finance outside the EU
The authors argue that if the European market remains relatively small, then European corporations may continue to seek finance outside the Union.
“Companies will increasingly be forced to look for financing elsewhere. With the UK leaving, Europe’s major hub of non-bank capital will soon be outside the EU’s regulatory purview. The EU will need to decide whether to keep London at arm’s length while pursuing an inward-looking strategy, or instead open up its market to London and the rest of the world.
“This dilemma poses a fundamental policy challenge for the EU. Deeper integration with the UK and the rest of the world would increase European businesses’ access to international capital and could boost European growth. However, deeper integration might also result in a loss of EU regulatory control, given the relatively small size of EU markets compared to New York and London.”
The UK will face a concomitant policy challenge over how far it diverges from EU rules and mechanisms, since some form of ‘equivalence’ is likely to be the price of frictionless admission to EU markets.
The report argues that with London within the EU, the focus was on preventing market abuse and improving business conduct, but with the UK outside, these measures now amount to what the authors call a ‘soft closing’ of the EU market.
“The ‘soft closing’ which was designed to protect EU markets now runs the risk of isolating them from the largest financial centre in Europe.”
It said this problem is enhanced by the understandable tendency in Brussels to look holistically at EU-UK arrangements and attempt to eke out negotiating levers in every aspect of regulation.
“In particular, [the EU] believes that, since access to EU customers is a priority for UK firms, the denial of such access is a potential negotiating tool for the EU.”
The report suggested that the European Commission’s recent attempt to use the threat of derecognition of the Swiss stock market as a bargaining tool in the EU-Swiss treaty negotiation is an example of this happening on a smaller scale.
However, it said that even the EU’s own equivalence rules make it extremely difficult to apply actively discriminatory rules to the UK without applying equivalent measures to US, Asian and other firms.
Any ‘raising of the drawbridge’ against the UK would mean raising the drawbridge to international finance in general, it said.
The report also observed that in the aftermath of the UK’s Brexit referendum European policymakers believed that there would be significant relocation to Europe, but it suggests this is not happening and certainly not in the short term.
“Firms are establishing subsidiaries in the EU and will book transactions with EU counterparts with those subsidiaries, but their guiding minds will remain in London.”
Gleeson concluded that the EU needs to accept this reality.
He said: “If the EU seeks to retreat from the global capital markets in pursuit of regulatory sovereignty, the outcome will – paradoxically – be increased reliance by EU industry and savings institutions on markets over which they will have no control at all. In order to preserve a degree of regulatory control, the EU must adopt and champion multilateralism in global financial regulation – and that cannot be done from behind locked doors.”