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.