Did Brexit Wreck the City of London? - Anonymous Banker (Volume IV)

I have a friend whose economic and financial analysis is always interesting because it is apolitical. He is a former City economist with decades of experience. Unfortunately, like many people who have something genuinely valuable to add to the conversation, he prefers to protect his privacy in our turbulent political and cultural landscape. But I’ve always found his explanations and insights useful and I think you will as well. That’s why he’ll be contributing to my Substack from time to time as the Anonymous Banker.

This piece is part of a series of articles which attempt to provide an objective, data-based look at the economic impact of Brexit on the UK and debunk the myths peddled by both sides of the debate.

Read Volume I here, Volume II here and Volume III here.

---

In the months after the Brexit vote, time and again friends of mine who do not work in finance frequently commiserated with me: “You guys must be appalled by Brexit, all your jobs are off to Frankfurt, Zurich and Paris!”. “Are you worried we won’t have access to Frankfurt after Brexit?” they’d ask.  Financial media talked up the possibility of the world’s major global banks abandoning London, leaving the City and Canary Wharf dusty ghost towns.

Let’s look at the headlines around Brexit’s impact on the City and then compare them dispassionately to what the data actually shows. In this article and the next, we’ll examine key sectors of finance the City operates in and what they mean in the context of Brexit.

1.       Stock Markets

Recently, in a blow to Brexiteers and Global Britain, it was reported that London has been overtaken by Paris and Amsterdam:

Is this true?

The headline claiming Paris has overtaken London as the largest equity market relies on comparing the value of shares listed in Paris to a narrow definition of the ‘London market’. In order to reach the conclusion that Paris is ‘larger’ one has to exclude international secondary listings in London and also the value of the UK’s AIM market, by comparing the UK Main Market to Paris’ Euronext. If I add up the value of all stocks listed in London according to Bloomberg, and those listed in Paris, at the time of writing, the true comparison is $3.925 trillion versus $3.164 trillion – or 24% larger in London’s favour.

London is very much an international market with many global companies choosing to list on the London Stock Exchange whereas the French exchange is essentially a domestic exchange comprised of French companies. Therefore, the comparison used in the headlines is less apples to apples and more apples to onions.

What is without question is that the UK market has been a terrible performer since 2016. This is due to the derating of Sterling against the US dollar and the ‘Brexit Discount’ placed on the market. This amounts to international investors valuing shares listed in London at a lower rating than they do on the world’s other major exchanges.[1] This can be seen clearly in the chart below, though it’s important to point out the decline began in 2014, not 2016. What is behind the spirit of the headlines is that London has always been by far and away the largest market in Europe, but this statement is not as clear cut as it once was.

The financial media has also highlighted the fact that London has been losing company listings to New York (see the front page of today’s FT for example). Many companies are choosing New York as their preferred venue to list their shares rather than London, but we are also seeing some companies actually elect to de-list from London to re-list in New York. A key driver of this is the higher valuations available to certain companies in New York compared to London, especially in sectors like technology. This partially reflects the Brexit discount highlighted above but also factors specific to the US – for many companies the biggest market for their products is the US, and the US capital markets provide greater visibility for a company than European ones. For a European technology company, it can be attractive to list in a market that ‘gets’ and champions your sector, alongside prestigious names in tech such as Apple, Amazon, Google etc. One can see this with Spotify choosing to list in the US rather than its home market of Stockholm, which indicates this phenomenon is not solely a UK/Brexit issue.

What about Amsterdam overtaking London as Europe’s leading share trading venue in terms of volume? What the article is actually referring to is trading in EU shares. In the immediate aftermath of the UK leaving the EU without a deal on financial services, Amsterdam was indeed the beneficiary of these trades in EU shares being ‘booked’ there. In fact, London resumed its position as the largest trading venue in June 2021, as this article from Bloomberg illustrates.

If we look at the total volume of shares traded by country in Europe (rather than restricting ourselves to EU shares and excluding UK shares) it is clear which country dominates share dealing in Europe:

Source: Bloomberg Intelligence.

66% of shares traded in Europe were booked in the UK in December 2022. This amounts to some 1.2 trillion euros, compared to 200bn euros for the Netherlands. On this measure, the total of all EU trading combined represents less than half the market share of that of the UK.

2.       Foreign Exchange

Curiously, the dominance of the UK as a venue in certain financial markets is not widely known even among City types, to say nothing of the general public. It’s worth sharing some of these statistics below in the interests of spreading knowledge, rather than tub thumping for UK plc.

London dominates the huge international foreign exchange (or FX) markets. Each day, $7.5 Trillion (!) are traded in the foreign exchange markets[2] and as of April 2022, the UK accounted for 38% of this turnover – twice the size of the US market. The big 4 EU economies (Germany, France, Italy and Spain) accounted for just 4.7% combined, making the UK an 8x larger market.

Source: Triennial Central Bank Survey April 2022, Bank for International Settlements. Table 6, Page 14.

More euros are traded in London than the entire EU financial centres combined, despite the UK never having been a part of the monetary union.

Surely the UK’s dominance of this market must have been battered by Brexit? The UK’s market share of FX in 2016 was 36.9% compared to 2022’s 38.1%. In between, the UK’s share reached 43.2% (this data is only prepared on a triennial basis). London’s high share of the global FX market is not a recent phenomenon – it has long been the case.

Why does the UK dominate this market? There are many reasons, but the key ones relate to time zone – the ability to trade with Asia in the AM and the US in the afternoon in one trading session (the FX market is a truly 24 hour market, unlike stock markets for example). History plays a part – the importance of the UK to the global financial system in times of empire, prior to the US dominance post World War 2, with the Bank of England playing the role now occupied by the US Federal Reserve as the world’s most important central bank. In addition, the openness of the City to global capital flows over time (many countries restricted the FX market, including the US for a long time, which played into London’s hands), low regulation and culture of financial innovation, coupled with a respected legal system. English being the business world’s lingua franca also plays a role. The world has been happy to do its business in London.

Allied to this long-term experience and deep global relationships, the infrastructure that has grown up around and supports London’s financial markets in terms of accounting, law, regulation, clearing (the processing of vast numbers of trades without error) and technology should not be underestimated. The amount of financial plumbing[3] between London and other financial centres (especially New York) is huge given the decades of investment that has gone in to create it. The idea that this could be supplanted overnight to Paris or Frankfurt, together with know-how and relationships is for the birds.   

What is important to stress though is that the Pound is not a major currency, despite what many on the Brexit side might argue. These markets are dominated by the US Dollar, the world’s true global reserve currency, and to a lesser extent, the euro. This is reflected in the chart below which shows the importance of different currencies in daily FX turnover. As you might expect, the currencies of the world’s largest economies are the key players in the market – US, EU, Japan (JPY) and China (RMB). In fairness to the Brexiteers, the Pound (GBP) punches well above its weight as the 4^th most important currency in the market, ahead of China. This is a function of London and the Pound’s legacy, rather than the scale of UK Plc. It is a curious anomaly given the size of the UK in the modern world.

Source: Bank for International Settlements, BIS Quarterly Review, December 2022.

This point ties back to my prior pieces on Trussonomics – the world does not need to own Pounds or have a view on their value the way it does for the Dollar or Euro given their importance to world trade. The market reaction to Truss’ plans reflected an element of indifference from global investors who don’t need to own Pounds when our government is not seen as credible.

In the context of the currency markets, it is also worth highlighting the role of London in the global market for the world’s oldest form of currency, gold. London is the centre of world gold trade and is referred to as the ‘terminal market’. Trading of the commodity in London sets the global reference price for gold, twice daily, known as the LBMA Gold Price. Some 50% of global gold trading is transacted through London as the chart below illustrates (NB: the World Gold Council has estimated this percentage to be as high as 70%[4])

Source: World Gold Council, Bloomberg, COMEX, Dubai Gold & Commodities Exchange, ICE Benchmark Administration, London Metal Exchange, Multi Commodity Exchange of India, NASDAQ, Shanghai Gold Exchange, Shanghai Futures Exchange, Tokyo Commodities Exchange.

The international nature of the City is highlighted further in the chart below, which shows the cross-border assets and liabilities of banks operating in the UK. Rival financial centres are much more dependent on their own domestic markets (French banks servicing French companies) compared to the more open UK market.

Source: BIS/FT.

Famously, there are more Japanese banks in London than Tokyo, and more US banks in London than Manhattan.

3.       Interest Rate Derivatives

A related area to FX that the UK holds a major position in is that of interest rate derivatives, or swaps. What on earth is this? These products allow customers to borrow or lend money on a fixed or floating basis, in different currencies, over different time periods, whilst a counterparty takes the other side of the trade. Huh?

Say I have borrowed US Dollars on a floating basis (my interest cost varies as interest rates change) and I want to remove the risk of changing interest rates, I can convert my loan into a fixed cost one by entering into a swap with someone who wants to receive fixed payments but pay on a floating basis. Confused? You should be.

These markets are huge. In Q3 2022, some $43.8Tr of swaps were traded in Europe. The UK accounted for 71.4% of this volume, compared to the EU’s 28.6%.

Source: ISDA, Interest Rate Derivatives Trading Activity Reported in EU, UK and US Markets: Third Quarter of 2022.

Globally, the UK accounts for 45.5% of turnover in interest rates derivatives, some 50% larger than the share of the US:

Location of OTC Interest Rate Derivatives daily average turnover (% share, April 2022)

Source: ISDA, TheCityUK calculations.

A further illustration of the UK’s dominance of this market is its role in clearing – the efficient processing of these trades in complicated financial products. The chart below shows the market share of interest rate swaps cleared through London.

Source: Clarus, January 2023.

Yes, you are reading this correctly. Almost 100% of swaps in US Dollars and Euros are cleared in London, not New York or Frankfurt. Such is the UK’s dominance of this activity that the EU opted to allow this activity to remain in London post Brexit as they (currently) lack the infrastructure and ability to handle the volumes involved in this complex activity. This is a bone of contention for the EU – as we will see below, the EU has repatriated many elements of finance out of London and back under its control, as no equivalence arrangement is currently in place between the UK and the EU for financial services post Brexit. However, such is the critical importance of clearing, the EU has decided (or more accurately accepted the commercial reality) to allow clearing of Euro dominated swaps to remain in London until 2025.

---

Part 2 of Brexit & the City, which covers Fund Management, Venture Capital and Insurance, will be released on Monday.

---

[1] Let’s try to avoid being overly technical but what this amounts to is global investors placing a higher price-earnings ratio on say US Inc versus UK Plc. In short, they’re prepared to pay a higher price for the earnings of companies listed on other exchanges than they are for those listed in the UK.

[2] Source: Triennial Central Bank Survey April 2022, Bank for International Settlements. Table 6, Page 14.

[3] The foreign exchange rate between the Pound and the Dollar is still called Cable to this day in the market, and refers to the first undersea cables between London and New York for trading currency.

[4] https://www.gold.org/gold-market-structure/global-gold-market