Liquidnet: Brexit Deal Rejected - What Is The Impact ?

By Rebecca Healey, Head of Market Structure, Liquidnet EMEA.

After May’s defeat with 432 MPs voting against her Brexit Deal, the House of Commons vote last tonight on a motion of no confidence in her government.

https://twitter.com/_RebeccaHealey/status/1085582282008788993

While she won, the rejection of the current Withdrawal Agreement (WA) proposal was not a clear indication of any alternative Brexit plan. May now has three days to let MPs know what her Plan B is - by January 21st either:

Revisiting the original deal with the EU deal despite the initial rejection; Britain pays off a £39 billion slate and keeps trade benefits of EU membership until the end of 2020;

Proceed with No Deal - no transition period, no £39 billion payment and World Trade Organization (WTO) terms for trade.
Remaining in the EU - the country has the right to revoke its decision to leave the EU provided this occurs before March 29th.

A revised deal which will require buy-in from Brussels and an extension to Article 50;

Or a second referendum which would also likely require an extension to Article 50.

Before we discuss what this might mean for the financial services industry, let us quickly recap what could happen next.

Potential Outcomes

Chances of revising the original deal are minimal given the higher than anticipated margin of 230 votes, including 118 conservatives, voting against the deal.  A revised deal or second referendum requiring an extension of Article 50 are more likely outcomes. May has already announced cross-party talks to find parliamentary consensus. There are a number of challenges to a successful conclusion:

1. Any substantial revision to the WA risks unravelling the process altogether given member states individual requirements – Gibraltar for Spain, and fishing rights for France. Europe is continuing to ratify the current WA and have made clear that their position cannot change despite the rejection of the deal.
2. Any potential revised deal will now require a proven majority in the UK parliament before Europe is likely to revisit.  This could require not just the terms of the WA but what the future relationship will entail under the Political Declaration (PD), which may need to become legally binding.
3. To achieve UK consensus and EU approval any revision is likely to lead to a softer Brexit – either membership of the EEA (Customs Union and Single Market) or Norway-style agreement, either of which will galvanize Brexiteers to push harder for a no-deal.
4. Questions over how an extension of Article 50 would work in practice given that the EU Parliament is effectively in shutdown from April 2019 for elections on 23-26th of May and there is currently no representation of the UK in those elections. There are also changes due at the European Commission (EC) with the replacement of Jean Claude Juncker and a new Commission as well as a new president of the European Council and the European Central Bank requiring the extension to be extended due to the changes within European Trialogue.
5. Second Referendum options will need to be carefully constructed over Deal, no-deal or remain to avoid a repeat of the first Referendum result with Leavers resolve hardening.
6. May’s ability to survive despite winning the Leadership Confidence vote last year.  Her cabinet may force her to resign, although this is unlikely given the negative implications this could have on future negotiations with Europe.

What Does This Mean for Financial Services?

While there is a parliamentary majority for avoiding a no deal Brexit, there is zero consensus on how this should be achieved meaning the political uncertainty is set to continue as both parties – Conservative and Labour - now seem irreconcilably split. Any chance of a no-deal occurring at all means firms will have to continue with contingency plans, reinforcing a UK withdrawal into Europe.

1. Trading will continue in a similar manner as it does today but we are likely to see activity gradually shift towards Europe given the level of investment by firms thus far in building European businesses.
2. Prolonged political uncertainty is likely to lead to a reduction in balance sheet liquidity.  This may result in more electronic flow and trading in smaller clips which could counter the recent propensity for trading blocks and the proportion of large in scale trading maintained at ~36% of dark volumes during 2018 compared to 10% in 2016.
3. Systematic Internaliser (SI) activity is in decline; decreasing to an average of €6.5bn in November and December, with a fall in the average fill size from ~58.9k EUR in April to ~21.7k EUR in December.  In the second half of 2018, the executed notional is down by 31% for interactable SI activity and 46% for non-interactable liquidity*2. This may be due to improvements in classification of true SI activity reducing noise in the SINT tape, as well as brokers realigning the level of capital available within SIs as the success of individual business models become apparent.
4. Regulatory intervention on trading protocols is likely to continue, leading to uncertainty over future European Market Structure. The European Commission’s recent amendment to subject SIs to the tick size regime for standard trade sizes and restrict their ability to price improve is likely to lead to further changes in liquidity formation within SIs and an announcement from ESMA is imminent on amendments to the periodic auction regime which, given the shift to trading in smaller clips, could have increased significance.
5. Data Accuracy – continued confusion over readiness of UK FIRDS and how data will be shared between UK and EU which will impact transparency calibrations and obligations as well as liquidity calculations and reporting obligations until further clarity on UK withdrawal has been agreed.

In the event May gets the WA through before March 29th

The WA transfers and converts existing EU law into UK law, including EU binding technical standards (detailed EU rules) as per HMT’s Statutory Instrument (SI) which onshores MiFID II/MiFIR.
An implementation period will run from 29 March 2019 until the end of December 2020 – where EU law remains applicable in the UK – and is likely to be extended, which means that firms, funds, and trading venues would continue to benefit from passporting between the UK and EEA as they do today.

Future Arrangements

1. Trading – although there is currently no equivalence regime in place between the UK and the EU, the recent extension with Switzerland to June 30th 2019 is likely to viewed as a possible solution.
2. Any deal based on equivalence could potentially be impacted by the re-categorization of “investment firms” under the Investment Firm Review (IFR) and European Supervisory Authorities (ESA).  Organisations outside the EU could fall under greater supervisory oversight by the EU.
3. Share Trading Obligation - If an instrument is listed in Europe, this may now only be traded by MiFID II Investment Firm on a European venue or its equivalent. There are concerns that the EU will not offer equivalency to certain venues such as US SEFs which could be detrimental to European investors in terms of being able to access liquidity.
4. Transfer of Data - Current rules allow the EC to recognise a third country’s data protection standards as adequate.  The EC is to start an assessment of the UK as soon as possible after withdrawal, endeavouring to adopt decisions by the end of 2020 if standards are met.
5. Clearing - The EC has already stated that it will act where necessary to address any financial stability risks in the EU arising from a hard Brexit, this includes adopting a temporary and conditional equivalence decision in order to ensure that there will be no disruption to central clearing. ESMA has already started engaging with UK CCPs to ensure there is continued access to UK CCPs for EU clearing members and trading venues as of 30 March 2019.
6. Legal Dispute Arbitration -  The UK have already proposed for either the EU or UK to be able to refer a dispute to the independent arbitration panel at any time, and if the dispute raises a question of interpretation of EU law, the European Court of Justice (ECJ) will be the sole arbiter of EU law, for a binding ruling. If either the UK or the EU fails to take measures necessary to comply with the binding resolution of a dispute within a reasonable period of time, “the other Party would be entitled to request financial compensation or take proportionate and temporary measures.”

Brexit negotiations are a long way from finished and we can anticipate further political and regulatory upheaval throughout 2019.  We will continue to publish updates and our thoughts as further information becomes available.

Source: Liquidnet