Brexit: Don't Cry For The City... Yet

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Includes: KBE, VIXY, XLF
by: Macro Bruin

Summary

London is one of two cornerstones of the international financial system (New York being the other).

Fears about a reclusive UK are partially justified; the worst-case scenario is indeed terrifying.

But the absolute worst-case scenario is all but guaranteed NOT to occur.

Only time will tell what The City's fate will be – but London doesn't appear to be going anywhere... for now.

While the news is populated with quotes from wistful international financiers lamenting the passing of London as a great financial center, the reality is, as usual, more nuanced.

With other European cities already competing to take London's coveted spot, the possibility still remains that The City (the affectionate nickname for London financial services) is being written off prematurely. Indeed, the only actual casualty thus far is business confidence and investor certainty, as measured by the VIX uncertainty index (NYSEARCA:VIXY) - and even that isn't too badly hit!

(Sorry about the French wording. Periodically changing my BBG language is the only way I keep up my fluency)

If you did not already know it, here (extremely briefly) is why London is so important in international capital markets:

  1. Global center for Eurodollar transactions
  2. Access point for Continental Europe
  3. 'Banker Heaven' (restaurants, clubs, museums, elite schools... the list goes on)[*] Yes, this is a reason, albeit a very trivial one.

While the Eurodollar market is by definition an international market (a Eurodollar is just a dollar deposited outside of the United States[**]), the global center of the market is London. For decades, London has enjoyed primacy as the clearing place for Eurodollar transactions. This (somewhat dated) BIS paper provides a good description of London's Eurodollar dynamics.

This chart, from the FT, ought to make clear the (ever expanding) importance of the Eurodollar market (in fact, the Fed's below estimate likely understates the magnitude of the Eurodollar market... because it is truly international, no single agency has all the information):

The following table from The Economist also gives a good overview of London's financial firepower more broadly:

I would be remiss if I did not explicitly point out some of the more remarkable numbers:

  • 40% of the market for foreign equities - This speaks to London's status as the access point to Europe. The London Stock Exchange lists many non-British companies.
  • 20% of cross-border bank lending - This ties back to London's importance in the Eurodollar market. There is no better place to go for international credit.
  • 43% of OTC Derivatives turnover - This bears repeating: FORTY THREE PERCENT. (Imagine how problematic it would be for that to disappear!)

Perhaps now you have a better understanding of why financial stocks (NYSEARCA:XLF) (NYSEARCA:KBE) have gotten hammered and why other European cities presently vie for the crown: there's lots of money to be lost in London - potentially - and lots to potentially be made in emerging European capitals.

If you were to take Brexit concerns to their most extreme conclusion, the scenario would spell genuine disaster for international financial markets:

  1. Asset pricing would get out of whack. Without the active trading provided by London finance houses, there would be significant illiquidity and resultant price volatility - markets would be less efficient.
  2. Market dislocations would have a deleterious impact on business confidence and investor outlooks, thus reducing desired capital formation and raising effective financing costs, possibly catapulting the global economy into recession.
  3. Large deadweight losses would further be incurred because London's extensive financial infrastructure and institutional networks would have to be rebuilt in new locations and with new policy frameworks.

I now have good news and bad news. First, the bad news: I have not been able to find estimates on the costs of this outcome, but the magnitudes would certainly be crippling given that the present infrastructure has developed over the course of more than a century of international finance.

Now, the good news: Such estimates are not needed because the 'doomsday' outcome carries close to a 0% probability.

Once Article 50 is invoked by the UK (assuming that even happens...), there will be two opposing parties in the ensuing negotiations: the UK and the EU. Importantly, neither side has an incentive to completely do away with London's status as the preeminent international financial hub:

  • UK negotiators will be aware of the huge economic gains reaped from financial services exports and their best-case will be full maintenance of British passporting rights.
  • EU negotiators (careful - the game theoretic dynamics get tricky here) will have a delicate balancing act to play. On the one hand, they must be pragmatic: EU member states still rely heavily on London as a financial center (for Eurodollar placements/purchases, securities underwritings, derivatives clearing, etc.) and there is thus a significant disincentive to knee-capping The City. On the other hand, an overly favorable settlement for the UK may serve to encourage referendums in other nations ('Hey, they did just fine!'), thus precipitating the dissolution of the EU. You can imagine such an outcome is antithetical to the negotiators.

source: gettyimages.com

My tentative 'gut feeling': The EU will seek significant real trade sanctions on the UK (because EU trade with the UK is not strategically critical - they can live with much less of it without feeling significant pain) as a means of deterring Frexit, Spexit, etc., but will not seek to confiscate London's financial dominance - they rely on it too much. But that's just my completely non-rigorous, untested hypothesis. Feel free to develop your own.

But as usual, the bottom line is this: Take a deep breath. Yes, the prospect of London financial services collapse is scary. No, it's not likely to happen (any time soon). To encourage contemplation, I recommend a cursory survey of the following:

Footnotes:

*If you question that London is the preferred capital for IB executives, ask them how they would feel about moving to Frankfurt.

**For an in-depth treatment of Eurodollar banking, I recommend Stigum's 'Money Markets' Ch. 7

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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