08 Jun 08.06.2016 Brexit Blues: What Happens Next?
08.06.2016 Brexit Blues: What Happens Next?
It’s now official: UK voters decided to leave the European Union. A week or so later, we have been inundated by questions of what happens next? Whist we are shocked by these results, we now must look at what happens next and what our clients do in the next few months or indeed years.
Brexit was a seismic and unexpected result, which caught global investors off guard. The big question: What happens next? As noted in Brexit Q&A, the “Leave” win means that the UK government must decide when to invoke Article 50 of the Treaty of Lisbon, which outlines the legal process by which a state can withdraw from the EU. This can take up to 2 years and there are a number of options, which is open to the UK.
Prime Minister David Cameron announced that he would step down in October and suggested that the next Prime Minister should initiate the Article 50 process. Once it does, the withdrawal negotiations would begin. At a minimum, it would take two years, but that time frame could be extended by unanimous agreement among the remaining 27 member nations. During the process, the UK would obey EU treaties and laws, but not take part in any decision-making.
The biggest issue is how trade would be handled between the EU and the rest of the world. According to Svetlova LLP, there are three basic options for the UK’s exit, based on existing models. However, it is still unclear which model they will follow.
Total exit: the UK leaves the EU and does not continue to benefit from any part of the single market. The UK either relies solely on the rules of the World Trade Organization (which include rules governing the imposition of tariffs on goods and services) as the basis for trading with the EU or negotiates a new bilateral trade deal with the EU.
The Norwegian model: the UK leaves the EU but joins the European Economic Area (EEA). The EEA is made up of 28 EU member states and three countries, which are not EU member states (Norway, Iceland and Liechtenstein), and extends the free movement of goods, services, capital and persons beyond the EU to those three countries. Under this arrangement, the UK would not benefit from or be bound by the EU’s external trade agreements. It would have to make significant financial contributions to the EU and continue to allow the free movement of persons, two of the Leave camp’s main criticisms of EU membership.
The Swiss model: the UK leaves the EU and does not join the EEA, but enters various bilateral agreements with the EU to obtain access to the internal market in specific sectors, rather than the market as a whole. Switzerland has negotiated a large number of sector-specific bilateral agreements with the EU and has access to some parts of the single market, but is excluded from the single market in some major sectors (for example, the financial services sector).
BREXIT impact on US companies: The choice of model will impact US companies that have a large presence in the UK. One sector in particular that is left hanging is financial services, because under the “Total Exit” or “Swiss” models, there would be no right for UK-authorized firms or individuals to provide financial services in the EU on a “passported” basis. This is critical because most US financial institutions currently use a UK-authorized person and/or entity to provide financial services elsewhere in the EU. Without passporting, the companies would need to obtain authorization from a EU member state by either establishing an authorized branch or subsidiary in that state.
Loss of passporting would create legal, compliance and infrastructure headaches, not to mention steep costs to US firms. Additionally, many US banks make London their hub across the pond because of the access to talent, support services and the use of English as the global language for financial services. So while many Wall Street operations and legal departments are scouting locations in Dublin and Frankfurt, they are hoping that they will not have to move the majority of their people and offices.
MARKET REACTION: At 1:00am, when the referendum results were becoming clear, the first thing I did was to look up when US stock market circuit breakers are triggered. At that time, the British pound sterling tumbled to its lowest level since 1985, US stock futures were getting crushed and the mad dash to safe assets like US treasuries, German bunds and gold was under way. The news from trading desks across the globe was that unlike in 2008, there was no liquidity crisis and markets were functioning fairly well.
CENTRAL BANK TOOLBOX: Over the past eight years, amid the financial crisis, worries about Greece and a generally sluggish economic recovery, global central banks have been able to soothe markets with interest rates cuts (sometimes going negative) and unconventional tools like bond buying (“Quantitative Easing”). This time around, though, the central bank toolbox may come under pressure. Global interest rates are already close to zero and bond buying may not do the trick if the BREXIT shock causes individuals and businesses to shut down and do nothing for a while.
That said; the next Federal Reserve occurs July 26-27 and if the cloud of EU uncertainty has prompted a further sell off in stocks, a rise in the US dollar and general mayhem around the globe, don’t be surprised if Janet Yellen and company reverse course and explicitly say that the central bank is not going to keep raising rates and would consider undoing last December’s hike and launching QE IV, if conditions worsen.
Frexit, Italeave, Czexit: Some economists and traders are concerned that because the world was not prepared for BREXIT, there could be a domino effect, whereby other nations will choose to leave the EU. Even a coordinated central bank intervention could not fight off the power that a fraying EU might create throughout the world.
And now, the weather: After talking to a number of traders, economists, bankers and analysts, it is clear to me that very few of them thought that BREXIT would occur; as a result, they are still in a bit of shock. While Friday was not terrible, the short, intermediate and long-term implications of BREXIT are simply unknowable. Like the weather in London, it looks we will be forced to live with lots of clouds, occasional storms and hopefully, a ray of sunshine.