European capital markets - The regulatory considerations for banks as they move beyond Brexit - Deloitte
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European capital markets The regulatory considerations for banks as they move beyond Brexit
European capital markets | Section title goes here Contents Executive summary 1 Section 1: The impact of Brexit on European capital markets – the story so far 6 Section 2: Regulatory developments that will shape European capital markets in the future 18 Section 3: Banks’ European footprint 30 Conclusion 33 Endnotes 34 Contacts 36 B
European capital markets | The regulatory considerations for banks as they move beyond Brexit
Executive summary
Brexit became a reality when the banks with branches in the UK are having
Transition Period ended on 31 December to apply for authorisation as third country What was the impact of Brexit on
2020, four and a half years after the banks and are also rebalancing their OTC IRS markets?
UK Brexit referendum. The end of the activities between the UK and EU to satisfy IHS Markit compiled Q1 2021 data on
Transition Period came and went without the expectations of their home regulators. single currency OTC IRS across EUR,
any major disruption to financial or market GBP and USD using its MarkitWire
stability. Nevertheless, major changes have In terms of market structure, new trading platform.2 We set out below some
occurred in European capital markets, both venues and systematic internalisers (SIs) of the key conclusions from this data:
in the run up to the end of the Transition have been authorised in the EU to maintain
• Trading volumes on UK venues fell in
Period and following it. And these are by EU clients’ access to markets and liquidity.
Q1 2021 across all three currencies,
no means at an end. In some respects, While no single EU capital markets hub has
compared to the prior six months. The
we are only at the beginning. emerged, the Netherlands has been the
largest decline was for EUR IRS.
main destination for multilateral trading
This paper looks first at the impact facilities (MTFs), France for organised • Trading volumes on EU venues
of Brexit on European capital markets trading facilities (OTFs), and Germany for and swap execution facilities (SEFs)
so far. It then focuses on how future SIs. Despite this, the UK has maintained its increased in Q1 2021 across all three
regulatory considerations will influence dominant position in Europe in terms of the currencies, compared to the prior six
the development of European capital overall number of authorised MTFs, OTFs months. Overall, more trading went
markets and what this in turn means for and SIs. to US venues3 than EU venues. In
banks’ European footprints, in particular aggregate across the three currencies,
the balance of their activities between the In equity markets, the firms which operate SEF trades grew by approximately
UK and the EU. the largest MTFs and SIs in Europe now 15,000 trades (£2.4 tn aggregate
have MTFs or SIs in both the UK and EU. notional) and EU venue trades grew by
Striking the right balance of activities On the first trading day after the end of approximately 13,000 trades (£1.6 tn
between the UK and EU will set banks the transition period, European Economic aggregate notional).
on the right course for dealing with the Area (EEA) share trading migrated from
• Beyond what was strictly required by
trilemma they face in terms of meeting the UK to the EU. While there is no trading
regulation, EUR IRS trading volumes
the expectations of three key stakeholder obligation for bonds, EU supervisory
shifted from UK to EU and US venues.
groups: their customers (continuing expectations have led to the shift of
This could mean that the volume shift
high levels of service and innovation), traders and market risk of EU government
of some EUR IRS products has acted
their regulators (compliance) and their (and some corporate) bonds and repos
as a pull for further EUR IRS products
shareholders (returns). to the EU, with an associated migration
to be traded in the EU, or it could
of trading volumes.
reflect the difficulty in distinguishing
Deloitte is delighted to co-publish this
between DTO and non-DTO products,
paper with IHS Markit. In derivatives markets, about half of the
making it more straightforward for
firms which operate UK trading venues
The impact of Brexit on European many EU clients to transact all their
offering trading in derivatives subject to
capital markets – the story so far EUR IRS on an EU venue.
the derivatives trading obligation (DTO)
Brexit brought to an end the UK’s authorised new venues in either France or • Trading volumes in USD IRS on
membership of the EU and its unfettered the Netherlands between 2018 and 2020. SEFs also increased beyond what
access to the Single Market. This in turn Absent the required equivalence decision was strictly required by regulation,
required UK-based banks1 to set up new from the EU, significant trading volumes in potentially drawn by the concentration
EU entities and shift staff, assets, risk interest rate swaps (IRS) migrated from UK of the USD IRS market on SEFs. The
management capabilities, and investment to EU and US trading venues. market share of USD IRS on SEFs
services and activities from the UK to increased from 39% in July 2020 to
the EU. Germany has been the main 48% in March 2021.
destination for new bank authorisations,
with Ireland, France, the Netherlands and • There has been little or no change
Luxembourg also key jurisdictions. EU in where OTC IRS are cleared.
1European capital markets | The regulatory considerations for banks as they move beyond Brexit
the capital impact of splitting the portfolio In many cases the immediate consequence
• The same shift in trading can be illustrates the sensitivity of capital to the of Brexit is to leave the UK entities
seen in the dealer-to-dealer (D2D) specific ways in which these portfolios are with reduced profitability and the new
markets across all currencies and in constituted, and the challenges of splitting or expanded EU entities struggling to
the dealer-to-client (D2C) market for those portfolios as a result of Brexit. While develop viable business models and
EUR IRS, although the shift for D2C it is very difficult to generalise, given that achieve sustainable profitability. These
markets is less pronounced than the impact will be very sensitive to the pressures come at a time when both the
that in D2D markets. specific portfolios under consideration, the Prudential Regulation Authority (PRA)
• Due to the absence of equivalence RWA and hence capital increases arising and the European Central Bank (ECB) are
in relation to the DTO, some EU and from disrupting hedging sets may cause scrutinising business model viability and
UK banks and EU and UK clients have more trades to be done in EU entities if the profitability very closely.
reduced market access. result of this is to create new – or preserve
existing – hedging sets. In our view, the situation in which banks
• Despite a shift in volumes to different find themselves today across their
venues, the location of traders, Brexit has also given rise to corporate tax combined European operations is not a
salespeople and introducing brokers considerations, including whether potential stable equilibrium, particularly when we
has not necessarily changed. exit taxes can arise on moving activity from take into account the future regulatory
• The trading volume shifts have the UK to the EU, along with questions developments which are set out in the
created a more geographically around the appropriate transfer pricing following section. Banks face some difficult
fragmented market in EUR and and profit split between the UK and EU for decisions about how to reconcile regulatory
GBP IRS and a more geographically the new model. Banks have also had to and supervisory requirements with
concentrated market in USD IRS on consider VAT, employment tax and other commercial realities.
SEFs. Anecdotally, the geographical mobility implications of moving staff.
fragmentation does not appear to The more important question is therefore
have had a direct impact on liquidity. At this stage, four months after the end of not so much what has happened so far,
the Transition Period, while some capital but what happens next.
markets activity has migrated from the UK
The execution of Brexit plans has to the EU, there is no doubt that the UK Regulatory developments that will
introduced and increased a number remains the largest capital markets hub shape European capital markets in
of inefficiencies in UK, EU and Rest of in Europe. The movement of business, the future
World (RoW) 4 banks’ capital, operating, capital and people from the UK to the EU Banks must consider a number of key
and business models, raising their cost so far has been to enable the banks to regulatory developments as they move
base. Balance sheets and supporting continue to service their EU customers and beyond Brexit, in relation to which many
infrastructure have in most cases been meet initial regulatory requirements and unanswered questions remain:
fragmented between UK and EU entities, supervisory expectations. In short, they
reducing the potential for banks to have been driven more by regulatory than • How will the ECB approach
benefit from economies of scale and purely commercial considerations. supervision for the UK and RoW banks
netting of exposures. To understand the that are required to establish an EU
mechanics of how portfolio fragmentation But the inefficiencies highlighted above Intermediate Parent Undertaking (IPU)
feeds through to capital, we modelled clearly have commercial consequences. by December 2023?
risk-weighted assets (RWAs) using the The aggregate costs across banks’
• How will the EU treat branches of third
standardised approach for counterparty European operations have risen
country banks?
credit risk (SA-CCR) for a stylised significantly as a result of fragmentation,
hypothetical portfolio of cleared euro- without so far a corresponding increase • How will supervisory expectations
denominated IRS trades. Where the in revenues to offset this rise. In addition, around booking models and substance
portfolio was split between two entities, the challenging European macroeconomic evolve, for instance in relation to
but the hedging sets were kept together, environment will continue to make it the location of senior staff and risk
SA-CCR capital requirements increased by difficult for some banks to achieve returns management functions?
8%, whereas in the more severe scenario, on equity (RoEs) in Europe which meet their
• Will the EU restrict portfolio delegation
where the portfolio and hedging sets targets or in some cases even exceed their
to third countries?
were split, SA-CCR capital requirements cost of equity, creating further pressure to
increased by 51%. This extreme variation in reduce costs.
2European capital markets | The regulatory considerations for banks as they move beyond Brexit
• Will the EU seek further changes to the
MiFID II/MiFIR third country regime?
• Will key equivalence decisions be
made and how will the EU seek to What will Scenario 2:
Scenario 1: the
reduce the EU’s exposure to UK central the future the open approach
closed approach
counterparties (CCPs)? look like?
• How will EU and UK regulation evolve
and how will regulatory divergence affect
equivalence decisions?
• What progress will the UK make on Trade • In this scenario, some UK and RoW • The open approach is closer to the
Deals with key non-EU jurisdictions, and banks bring more substance into the post-Brexit status quo than the
to what extent will these Trade Deals EU and manage more market risk in closed approach.
incorporate financial services? the EU. Their EU entities become more
• EU entities continue to rely on non-EU
standalone, and less reliant on non-EU
expertise across a number of products.
How these developments play out in expertise. However, fragmentation of
EEA share trading largely remains in
the short term will be crucial in shaping booking models means that some UK
the EU, but derivative trading subject
European capital markets in the medium and RoW banks determine that certain
to the DTO moves to the venue which
term. A key question is the extent to which business activities are not profitable
provides best execution, which may be
EU policymakers and regulators, and to a and reduce EU presence.
in the EU, UK or US.
lesser extent their UK counterparts, take
• There is a growth in portfolio
a closed or an open approach to third • The UK has a regime more tailored
management in the EU, but also a
country firm services and activities in to its capital markets and successful
growth in assets under management
their respective markets. We set out two Trade Deals which incorporate financial
(AUM) in UK funds and asset
theoretical scenarios, based on whether services enhance the UK’s reputation
service providers.
the approach is closed or open. Overall, as a global capital markets hub.
we assume that the EU’s approach will • Largely due to an absence of key
• Ultimately, there is limited pull for
be more closed than that of the UK’s. equivalence decisions, EU clients and
further trading activity and liquidity
Therefore, it is predominantly the EU’s counterparties face reduced choice,
to migrate to the EU, except for some
position that drives the outcomes in each reduced (or more expensive) access
specific products or sectors, where the
scenario as the UK’s relatively more open to non-EU expertise, increased costs
EU builds expertise, for example, short-
approach is closer to the status quo. and increased risk.
dated IRS.
• The UK has a regime more tailored
• However, building a global market in
to its capital markets, but protracted
specific products or sectors through
negotiations and uncertainty with
regulatory openness rather than
respect to UK Trade Deals mean that
regulatory fiat may lead to deeper,
there is limited growth in business
globally integrated, EU capital markets.
with other jurisdictions to offset the
business that has left the UK as a • Meanwhile, some global banks may
result of Brexit. also look to do more in non-EU/UK
jurisdictions, for instance certain
• Ultimately, the closed approach leads
booking activities or expertise, as they
to a growth of capital markets activity
assess their businesses in a more open
in the EU. This acts as a pull for further
global environment.
liquidity to migrate to the EU.
• In short, the open scenario provides
• However, the growth is confined to
more flexibility for banks to achieve
EU products and EU clients. The EU’s
a better balance between regulatory
restrictive approach to market access
and commercial considerations and to
means it is much less likely to become
provide a broader range of services at
a location of choice for banks’ global
lower cost to their customers.
activities. The reduced choice and
access, and increased cost and risk
for clients and counterparties, stymie
the EU’s efforts to build a global
capital market.
3European capital markets | The regulatory considerations for banks as they move beyond Brexit
Banks’ European footprint about their strategic ambitions, alongside Given the degree of uncertainty in
Inefficiencies which have resulted issues relating to the viability of business how regulatory developments will play
from Brexit and the post-COVID-19 and operating models. How each bank out, it may be premature for banks to
macroeconomic environment set the determines its optimal European footprint execute significant restructuring plans.
context within which banks will consider will vary considerably depending upon Nevertheless, we highlight below three
their European footprint. This time change whether it is a RoW, EU, or UK bank, as main areas on which banks should focus
will be driven by business needs, as well as on its existing legal entity structure, in the near and medium term.
much as by regulation. Banks will have distribution of capital markets activities,
to address a wide range of questions and strategic and business priorities.
1. Review and optimise legal entity Do RoW banks need a UK subsidiary, given the loss of passporting? While substantial UK
subsidiaries may remain a core part of some global banks’ operating model, others are likely
structures
to re-evaluate their utility in order to release capital.
Banks should review and optimise their
legal entity structures to ensure that they
Should RoW banks increase the proportion of activity undertaken through their UK branches?
have the right legal entities, permissions,
As third country branches have access to the parent entity capital base, some groups will consider
risk model approvals and infrastructure
growing their third country branches relative to UK subsidiaries. The UK remains open to hosting
needed to support their clients, deliver
significant capital markets activities through third country branches (subject to conditions). However,
their strategic ambitions, and meet
the PRA’s risk appetite for certain activities being conducted through third country branches may be
other regulatory requirements (e.g.
limited. In addition, some clients will prefer to face a UK subsidiary.
on resolvability).
In turn, what role should UK and RoW banks give to third country branches in the EU? It is not
currently possible to passport from third country branches in the EU, limiting their geographical
scope. But some banks maintain branch presences for operational purposes (including to access ECB
standing facilities). Moreover, differing regulatory regimes across Member States (MS) may mean that
branches fulfil a useful role within a bank’s broader European operating model. The EU may however
seek to harmonise its approach to third country branches and/or bring large third country branches
under Single Supervisory Mechanism (SSM) supervision.
How should in-scope RoW and UK banks respond to the legal entity implications of the IPU
requirements? Banks are working through significant strategic questions, including the balance of
assets between subsidiaries and third country branches, and between EU and non-EU entities. Banks
may also look to rationalise their EU footprint to eliminate superfluous subsidiaries.
2. Optimise the distribution of What are the consequences of various possible distributions of activity for regulatory capital?
Banks should conduct a capital consumption analysis of their European booking model to identify
activities across jurisdictions and
potential areas for optimisation, in conjunction with market access rules.
legal entities
For any given legal entity structure, banks What preferences do clients have in terms of types and locations of entities with which they
should look to optimise their balance are willing to transact? While regulators may set requirements for where and how certain types of
sheets, including within IPU sub-groups business can take place, banks must remain responsive to client needs and preferences (within the
(where relevant), and between UK and constraints imposed through regulation and supervision).
EU entities.
Are there “tipping points“, such that once a certain portion of business, staff or operational
infrastructure has moved, it becomes more efficient to move more substantial portions or
even entire functions and businesses? Banks should look to determine such tipping points and
track progress as the economic, commercial and regulatory environment evolves. These analyses
may trigger deeper consideration of banks’ European operating models and the sustainability of their
UK and EU business models. There may also be tipping points from a tax perspective.
At what point does there become a case for RoW banks to consider relocating their European
headquarters? While the UK has typically been the destination of choice for many RoW banks’
European headquarters, in the medium to long term, some banks may begin to consider whether the
“centre of gravity“ of their European business has shifted.
4European capital markets | The regulatory considerations for banks as they move beyond Brexit
3. Identify growth opportunities Where should banks locate new business? Banks will consider the distribution of this business
within Europe, but also between Europe and other jurisdictions. Banks will also likely assess whether
and align European footprint with
the EU is on track to develop truly global – as opposed to regionally-focused – financial markets.
global strategy
Banks should look beyond near-term To what extent will the commercial and regulatory environment drive broader shifts in global
regulatory and supervisory pressures footprints? Global banks may look beyond the question of their EU/UK footprints and consider the
resulting from Brexit and consider the viability of moving certain booking activities or expertise to their home jurisdictions.
evolving macroeconomic, commercial,
and political landscape in order to identify
strategic growth opportunities in Europe
and beyond.
Conclusion to the EU, or outside Europe altogether. regulatory relationships. When considering
Brexit has already led to a number of However, what is clear in our view is that their European footprint, banks should
significant changes in how banks provide the more closed the approach, the higher review and optimise both their legal entity
capital markets services and activities are clients’, counterparties’ and banks’ structures and the distribution of activities
into the EU. However, there are further costs and risks, and the lower are clients’ across jurisdictions and legal entities. They
changes to come, driven both by regulation and counterparties’ choice and access should also identify growth opportunities
and the commercial pressures that banks to markets. In particular, if the EU takes and align their European footprint with
face, especially in the current, very difficult a restrictive approach to market access, their global strategy. This will set them
economic environment. In many ways, we it is much less likely to become a location on the right course for dealing with the
are still only on the first chapter of changes of choice for banks’ global activities. trilemma they face in terms of meeting
driven by Brexit. the expectations of three key stakeholder
Banks will need to monitor the impact of groups: their customers, their regulators
It is not yet clear how much more capital regulatory developments on their business and their shareholders.
markets activity will migrate from the UK models and strategy and invest in EU
5European capital markets | The regulatory considerations for banks as they move beyond Brexit
Section 1: The impact of Brexit on European
capital markets – the story so far
Banks’ legal entity structure • While it is very difficult to generalise,
• Beyond what was strictly required
and booking models: given that the impact will be very
by regulation, EUR IRS trading
• UK-based banks have set up new sensitive to the specific portfolios under
volumes shifted from UK to EU and
EU entities and shifted staff, assets, consideration, the RWA and hence
US venues. Trading volumes in USD
risk management capabilities, and capital increases arising from disrupting
IRS on SEFs also increased.
investment services and activities from hedging sets may cause more trades
the UK to the EU. • There has been little or no change to be done in EU entities if the result
in where OTC IRS are cleared. of this is to create new – or preserve
• Germany has been the main destination
existing – hedging sets.
for new bank authorisations, with • Some EU and UK banks and EU and
Ireland, France, the Netherlands and UK clients have reduced market
Interim assessment:
Luxembourg also key jurisdictions. access.
• While some capital markets activity has
• The trading volume shifts have migrated from the UK to the EU, there
Markets:
created a more geographically is no doubt that the UK remains the
• New trading venues and SIs have been
fragmented market in EUR and largest capital markets hub in Europe.
authorised in the EU to maintain EU
GBP IRS and a more geographically
clients’ access to markets and liquidity. • The movement of business, capital and
concentrated market in USD IRS
people from the UK to the EU has been
• The Netherlands has been the main on SEFs.
driven more by regulatory than purely
destination for MTFs, France for OTFs,
commercial considerations.
and Germany, where most new banks
Capital and operating model
have established themselves, for SIs. • The aggregate costs across
efficiency:
banks’ European operations have
• Despite this, the UK has maintained its • The execution of Brexit plans has
risen considerably as a result of
dominant position in Europe in terms of introduced and increased a number of
fragmentation, without so far a
the overall number of authorised MTFs, inefficiencies in UK, EU and RoW banks’
corresponding increase in revenues
OTFs and SIs. capital, operating, and business models.
to offset this rise. In addition, the
• EEA share trading migrated from the • To understand the mechanics of how challenging European macroeconomic
UK to the EU, while in bond markets, portfolio fragmentation feeds through environment will continue to make it
EU supervisory expectations have to capital, we modelled RWAs using difficult for some banks to achieve RoEs
led to the shift of traders and market SA-CCR for a stylised hypothetical in Europe which meet their targets, or in
risk of EU government (and some portfolio of cleared EUR-denominated some cases exceed their cost of equity.
corporate) bonds and repos to the IRS trades. Where the portfolio was split
• In many cases, UK entities have
EU, with an associated migration of between two entities, but the hedging
been left with reduced profitability
trading volumes. sets were kept together, SA-CCR capital
and the new or expanded EU
requirements increased by 8%, whereas
entities are struggling to develop
• IHS Markit compiled Q1 2021 in the more severe scenario, where the
viable business models and
data on single currency OTC IRS portfolio and hedging sets were split,
achieve sustainable profitability.
across EUR, GBP and USD using SA-CCR capital requirements increased
its MarkitWire platform. by 51%. • In short, the open scenario provides
more flexibility for banks to achieve
• Trading volumes on UK venues • This extreme variation in the capital
a better balance between regulatory
fell in Q1 2021 across all three impact of splitting the portfolio
and commercial considerations and to
currencies, compared to the prior illustrates the sensitivity of capital to the
provide a broader range of services at
six months, while trading volumes specific ways in which these portfolios
lower cost to their customers.
on EU venues and SEFs increased. are constituted, and the challenges of
Overall, more trading went to US splitting those portfolios as a result
venues than EU venues. of Brexit.
6European capital markets | The regulatory considerations for banks as they move beyond Brexit
Banks’ legal entity structure and
Figure 1: Location of EU hub Figure 2: Planned target operating
booking models
model assets (EUR bn)
Legal entity structure
To maintain services to EU clients given
the loss in passporting, UK-based
banks expanded their EU footprint by
setting up new or expanding existing
EU subsidiaries. This enabled banks
to passport across the EU and was
considered more practical than licensing
a number of existing EEA branches as
third country branches. UK-based banks
also revised their EU branch networks,
for example, by transferring existing
branches of their UK entities to their
(new) EU entities.
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banks are also leveraging cross-border For EU-based banks passporting into Booking models
licences and exemptions in individual EU the UK, the UK established a Temporary A bank’s booking model sets out the
MS to continue serving clients for certain Permissions Regime (TPR). The TPR began product mix, client base, risk management
products from the UK, thereby reducing at the start of 2021 and banks within the and operating practices across its legal
the immediate impact of Brexit. TPR can continue the activities permitted entity structure. Banks were required to
under their previous passport within the set out both “Day 1“ and “Day 2“ plans
Germany has been the main destination UK for a limited period, while they apply for with the ECB and EU National Competent
for new bank authorisations, with Ireland, any necessary authorisations. EU banks Authorities (NCAs) as part of the licensing
France, the Netherlands and Luxembourg with wholesale branches in London have process for new banking and investment
also being key jurisdictions where new been required to re-authorise with the firm entities. “Day 1“ plans focused on
authorisations and assets have been Prudential Regulation Authority (PRA) and the changes required so that banks could
located. According to ECB data as at the Financial Conduct Authority (FCA). In continue their services on Brexit “Day 1“.
March 2020, UK-based banks planned to line with its stated policy for international “Day 2“ plans set out the timeline within
move EUR 1.2 tn of assets to euro area banks, the PRA has required a small which banks agreed to transfer risk
entities on completion of their target number of EU banks whose branches management of specific products to the
operating models, 70% (EUR 837 bn) of take significant retail deposits in the UK EU, with associated first and second line
which comprised capital market assets.5 to establish a UK subsidiary to undertake capability. While these were based on ECB
this activity. This course of action was not supervisory expectations, each bank has
available to the UK in relation to EU banks a bilateral agreement with its supervisor,
while it was a member of the EU. and banks are continuing to build out the
substance agreed as part of these plans.
7European capital markets | The regulatory considerations for banks as they move beyond Brexit
The ECB has been clear in its expectation To evidence that the booking model Clients
that there should be no “empty shells“ of the EU entity leaves the entity with UK-based banks have transferred
in the EU and that “EU products and significant market risk, supervisors have EU clients to EU entities. Banks have
transactions with EU clients involving looked at the projected entity RWAs as a also sought to rely on cross-border
non-EU products“ should be booked in the percentage of the RWAs in the UK entity national exemptions in the EU which
EU and that “risk management capabilities that could be allocated to EU27 activity. would permit clients to remain with the
related to EU products“ should be located EU supervisors typically expect nearly half UK entity. However, for some countries,
in the EU.6 However, there is no uniform of market risk generated within the EU these exemptions have proved complex
definition and agreement of the term “EU entity to be managed in the EU, as opposed to obtain.
product“. In practice, the approach varies to being transferred to the UK entity or
depending on the business and operating elsewhere via back-to-back trades. Over-the-counter (OTC) back-book
model of the bank, as well as the overall migration
level of market risk it manages in the Staff Some banks have opted to run off their
EU. From a corporation tax perspective, While the COVID-19 pandemic has in some OTC back-books with EU clients in their
transfer pricing rules should be applied cases slowed progress, the majority of entirety in the UK, whilst others have
to the new booking model, to provide an banks have moved and/or expect to move planned novations only when demanded
arm’s length remuneration to such risk a number of senior managers, risk and by the client. Consequently, the build-up of
management functions performed in compliance managers, and sales staff to assets and capital in EU entities has proven
the EU (in line with OECD transfer pricing the EU. Most banks are looking to maintain slower than supervisors expected.
guidelines applied in the relevant EU MS). traders in London where possible and for
sales staff to report back to a product head
Most UK-based banks agreed to onshore in the UK or elsewhere. This may involve
into the EU management of market adjusting existing lines of responsibility,
risk of at least EU government bonds mandates and governance. The majority
(including repos) and EUR-denominated of banks also make use of outsourcing
IRS where market making to EU27 clients. arrangements to other jurisdictions.
8European capital markets | The regulatory considerations for banks as they move beyond Brexit
Figure 3: EU MTF authorisations Markets
Market structure
To maintain EU clients’ access to markets
and liquidity, UK-based banks, brokers
and other operators have established
new authorised MTFs, OTFs and SIs in the
EU. UK-based banks also put in place EU
financial market infrastructure membership
and connectivity, where required. While
no single EU capital markets hub has
emerged, the Netherlands has been
1HWKHUODQGV *HUPDQ\ )UDQFH ΖWDO\ ΖUHODQG 6ZHGHQ %HOJLXP 6SDLQ 2WKHU the main destination for MTFs (seeing
a seven-fold increase in authorisations
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between end-2018 and end-2020 and
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narrowly overtaking Germany). France
Source: ESMA register has been the main destination for OTFs
(although total authorisation numbers
Figure 4: EU OTF authorisations are smaller), and Germany has been the
main destination for SIs (nearly doubling
authorisation numbers between end-2018
and end-2020).7 SIs are where banks deal
on their own account on a bilateral basis
with clients (subject to meeting specific
criteria in MiFID II). The fact that Germany
has been the main destination for SIs is
unsurprising as Germany has also been the
main destination for banks.
)UDQFH 1HWKHUODQGV 6SDLQ *HUPDQ\ 2WKHU Despite this increase in authorisations in
the EU, the UK has maintained its dominant
7RWDODXWKRULVDWLRQVHQG position in Europe in terms of the number
$XWKRULVDWLRQVHQGȂHQG of MTFs, OTFs and SIs authorised. As at
1 December 2020, the UK had authorised
Source: ESMA register
84 MTFs, 48 OTFs, and 69 SIs.8
Figure 5: EU SI authorisations
The number of authorised venues does
not tell us about trading volumes or
liquidity. This data is not as readily available.
Nevertheless, we set out below some initial
information for equity and bond markets
and have partnered with IHS Markit to
provide a case study in relation to the OTC
IRS market.
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9European capital markets | The regulatory considerations for banks as they move beyond Brexit
Equity markets Bond markets relation to transactions subject to the DTO,
Under both the EU and UK MiFIR, only Many of the largest MTFs, OTFs and SIs in UK firms cannot access EU venues (except
trading venues from equivalent third Europe for bond trading were authorised in in certain cases where temporary relief
countries may be used for the purposes the UK in 2019. Of those authorised in the is available) and EU firms cannot access
of fulfilling the share trading obligation UK, all the firms operating the largest MTFs UK venues. About half of the UK firms
(STO).9 The EU has made STO equivalence and SIs and the majority of firms operating operating trading venues offering trading
decisions for Australia, Hong Kong and the the largest OTFs authorised new entities in in derivatives subject to the DTO also
US.10 The UK has also made equivalence the EU between end-2018 and end-2020.15 authorised new venues in either France or
decisions for these three countries and, Due to the characteristics of the bond the Netherlands between 2018 and 2020.19
more recently, also added Switzerland.11 market, for example, that the majority of Significant trading volumes in certain IRS
trading is off-exchange, there is no MiFIR migrated from the UK to the EU and US
Neither the UK nor the EU granted each trading obligation for bonds. Nevertheless, (see Box A).
other such an equivalence, although the ECB has placed expectations on banks
the FCA confirmed in a November 2020 as part of “Day 2“ plans that trading staff The EU also did not grant the UK
statement that UK market participants for EU government bonds (including repos) equivalence with respect to regulated
could continue trading all shares on should be located in the EU and that markets (EMIR Art.2a), meaning that EU
EU trading venues and SIs under the market risk in relation to these products firms may no longer treat derivatives
Temporary Transitional Power (TTP)12 should be managed in the EU. In 2019, traded on UK Regulated Markets as
(subject to certain conditions). Rishi Sunak, the vast majority of clearing in euro- exchange-traded derivatives and they
UK Chancellor, has also announced that the denominated repos migrated from the carry higher capital requirements.
UK will consult in the summer on deleting UK to France.16 According to the Financial Intercontinental Exchange (ICE) announced
the UK’s STO. Times, trading volumes in EUR-sovereign in February 2021 that it will move its
debt have shifted from the UK to the EU.17 trading of European carbon futures and
In 2019, all the largest MTFs and SIs for options from the UK to its Netherlands-
share trading in Europe were authorised Derivative markets based exchange in Q2 2021.20
in the UK. Anticipating an absence of Under the EU and UK MiFIR, only trading
equivalence in relation to the STO, the venues from equivalent third countries may
firms operating these venues and SIs all be used for the purposes of fulfilling the
authorised new venues or SIs in the EU.13 DTO. The EU and UK have both made DTO
On 4 January 2021, around EUR 6.3 bn of equivalence decisions for Singapore and
daily EEA share trading shifted from UK the US but have not found their respective
to EU trading venues,14 representing the venues equivalent.18 This means that, in
majority of the market.
10European capital markets | The regulatory considerations for banks as they move beyond Brexit
Figure 6: EUR All IRS – Market share by volume Box A: What was the impact of
Brexit on OTC IRS markets?
60% IHS Markit compiled Q1 2021 data on
50% single currency OTC IRS across EUR,
GBP and USD using its MarkitWire
40% platform. We discuss below some
30% of the key conclusions from this data.
For a more detailed overview of the
20% data and the regulatory drivers, see
10% IHS Markit’s briefing.21
0% Trading volumes on UK venues
Jul-20 Aug-20 Sep-20 Oct-20 Nov-20 Dec-20 Jan-21 Feb-21 Mar-21
declined (Figures 6 – 8)
Trading volumes on UK venues22 fell
SEF MTF/OTF EU MTF/OTF UK Off-facility
in Q1 2021 across all three currencies,
Source: IHS Markit
compared to the prior six months. The
largest decline was for EUR IRS, where the
market share of UK venues fell by 29%
Figure 7: GBP All IRS – Market share by volume
between July 2020 and March 2021. The
market share of UK venues fell by 7% for
GBP IRS and by 3% for USD IRS, although
in absolute terms the fall for USD IRS
was slightly larger. In aggregate across
the three currencies, trading volumes on
UK venues fell by approximately 19,300
trades, representing a fall in aggregate
notional of £2.3 tn.23
Overall, more trading went to US
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU venues than EU venues (Figures 6 – 8)
The market share of EU venues24 grew
6() 07)27)(8 07)27)8. 2IDFLOLW\ by 19% for EUR IRS, 4% for GBP IRS and
3% for USD IRS between July 2020 and
Source: IHS Markit
March 2021. The market share of SEFs25
grew by 11% for EUR IRS, 8% for GBP IRS
Figure 8: USD All IRS – Market share by volume and 9% for USD IRS between July 2020
and March 2021. In aggregate across the
three currencies, more trading went to
US venues than EU venues, as SEF trades
grew by approximately 15,000 trades
(£2.4 tn aggregate notional) and EU venue
trades grew by approximately 13,000
trades (£1.6 tn aggregate notional).
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
6() 07)27)(8 07)27)8. 2IDFLOLW\
Source: IHS Markit
11European capital markets | The regulatory considerations for banks as they move beyond Brexit
Beyond what was required by Figure 9: EUR non-DTO/MAT – Market share by volume
regulation, some EUR IRS trading
volumes shifted from UK to EU and
US venues (Figures 9 – 11)
The EU, UK and US regimes all contain
requirements for in-scope firms to trade
specified products on specified venues.26
Stripping out the transactions in products
subject to these requirements, there
was still some shift in trading from UK to
EU and US venues, mainly for EUR IRS.27
This means that some trading volumes in
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
EUR IRS left UK venues, beyond what was
strictly required by regulation. 6() 07)27)(8 07)27)8. 2IDFLOLW\
Between July 2020 and March 2021, the Source: IHS Markit
market share of EUR IRS fell by 15% on UK
venues, but grew by 10% on EU venues Figure 10: GBP non-DTO/MAT – Market share by volume
and 9% on SEFs. This could mean that the
volume shift of some EUR IRS products has
acted as a pull for further EUR IRS products
to be traded in the EU, or it could reflect
the difficulty in distinguishing between DTO
and non-DTO products, making it more
straightforward for many EU clients to
transact all their EUR IRS on an EU venue.
The market share of USD IRS for non-DTO
IRS on SEFs also grew by 14%. This was
potentially drawn by the concentration of
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
the USD IRS market on SEFs; looking at all
swaps, the market share of SEFs for USD
6() 07)27)(8 07)27)8. 2IDFLOLW\
IRS increased from 39% in July 2020 to 48%
in March 2021. Other than that, trading Source: IHS Markit
volume changes for the other currencies
and venues were not very significant and in Figure 11: USD non-DTO/MAT – Market share by volume
fact the market share of GBP IRS trading on
UK venues grew by 2%.
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
6() 07)27)(8 07)27)8. 2IDFLOLW\
Source: IHS Markit
12European capital markets | The regulatory considerations for banks as they move beyond Brexit
Figure 12: EUR D2D IRS – Market share by volume The shift in trading volumes has
been more significant in D2D than
D2C markets and D2D markets
reacted more quickly than D2C
EUR IRS markets (Figures 12 – 17)
The same pattern can be seen in the
D2D markets as in the markets for all IRS,
although overall the swings are more
pronounced. Trading volumes on UK
venues fell across the three currencies,
while they rose for EU venues and SEFs
across the three currencies. Also, while the
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
main shifts happened in January 2021, we
6() 07)27)(8 07)27)8. 2IDFLOLW\ can observe some shifts already starting in
November and December ahead of the end
Source: IHS Markit of the Transition Period.
Figure 13: GBP D2D IRS – Market share by volume For D2C markets, we can observe a similar,
although less pronounced, pattern for
EUR IRS and to a lesser extent in GBP and
USD IRS markets. Trading volumes fell on
UK venues, but rose on EU venues and
SEFs. The fact that the pattern was less
pronounced in D2C than D2D markets may
be due to the fact that EU clients were more
likely to have already been trading on EU
venues, whereas EU banks were more likely
to access both EU and UK venues.
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
While D2D markets appear to have
6() 07)27)(8 07)27)8. 2IDFLOLW\ started to react ahead of the end of the
Transition Period, the shift to SEF for EUR
Source: IHS Markit D2C markets appears to have occurred
in March. This delayed shift to SEF could
Figure 14: USD D2D IRS – Market share by volume have been facilitated by the FCA relief,
which allows, subject to conditions, UK
banks subject to the UK DTO to trade on
EU venues with, or on behalf of, EU clients
where their EU clients do not have access
to a SEF. EU clients may have used this time
to make arrangements to access a SEF.
-XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
6() 07)27)(8 07)27)8. 2IDFLOLW\
Source: IHS Markit
13European capital markets | The regulatory considerations for banks as they move beyond Brexit
There has been little or no change in Figure 15: EUR D2C IRS – Market share by volume
where OTC IRS are cleared
Based on March 2021 data, approximately
93% of EUR IRS, 94% of GBP IRS and 96% of
USD IRS are cleared. Where OTC IRS clear
and where they trade are independent
decisions. Taking an average since July
2020, UK CCPs clear over 99.5% of the GBP
IRS market, 95% of the USD IRS market,
and 91% of the EUR IRS market. There has
been no change in this position for the GBP
IRS market, while for the EUR and USD IRS
markets, comparing Q1 2021 with Q3 2020, -XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
there has been only minor variation and
6() 07)27)(8 07)27)8. 2IDFLOLW\
nothing to suggest any significant trends.
Source: IHS Markit
Some EU and UK banks and EU and UK
clients have reduced market access Figure 16: GBP D2C IRS – Market share by volume
EU banks which do not have UK
subsidiaries can no longer access 14% of
the EUR DTO IRS market, 24% of the GBP
DTO IRS market and 9% of the USD DTO IRS
market that occurs on UK MTFs/OTFs. UK
banks which do not have EU subsidiaries
can no longer access 39% of the EUR DTO
IRS market, 8% of the GBP DTO IRS market
and 5% of the USD DTO IRS market that
occurs on EU MTFs / OTFs, except where
trading with, or on behalf of, EU clients
subject to the EU DTO which do not have -XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
access to a SEF. Clients in the UK and
6() 07)27)(8 07)27)8. 2IDFLOLW\
EU have reduced choice about where to
execute trades as, where the transactions Source: IHS Markit
are subject to a EU/UK DTO, clients in the
UK are unable to trade on EU venues and
Figure 17: USD D2C IRS – Market share by volume
clients in the EU are unable to trade on UK
venues for DTO purposes.
The location of traders, salespeople
and introducing brokers has not
necessarily changed
The execution of OTC derivative trades
can involve multiple parties, including
introducing brokers, traders and
salespeople. Even though trading volumes
may have moved from a regulated venue
in one location to a regulated venue in -XO $XJ 6HS 2FW 1RY 'HF -DQ )HE 0DU
another, the venue is often a sibling venue.
Therefore, the location of the traders, 6() 07)27)(8 07)27)8. 2IDFLOLW\
salespeople and introducing brokers may
Source: IHS Markit
not have changed.
14European capital markets | The regulatory considerations for banks as they move beyond Brexit
Increased market fragmentation does from both the EU and the UK to use US does not appear to have had a direct
not appear to have had a direct impact SEFs, has had the effect of driving some impact on liquidity.
on liquidity (Figure 18) former UK venue volume to SEFs and
OTC derivative markets are global in nature a number of EU venues, primarily in January 2021 saw generally reduced
and very agile. Trading liquidity in OTC IRS Amsterdam and to a lesser extent in Paris. activity, both in terms of volumes and
tends to concentrate on a currency-by- notional traded compared to January 2020.
currency basis; liquidity begets liquidity. These shifts in market share have This could be explained by low volatility,
However, the combination of a relatively created a more geographically fragmented caused by a low and stable interest
hard Brexit for financial services, the lack market in EUR and GBP IRS and a more rate environment. However, volumes
of EU – UK equivalence (or a progressive, geographically concentrated market rebounded in February and to an even
detailed financial services agreement), in USD IRS on SEFs. IHS Markit has not greater extent in March. This rebound has
combined with the equivalence available performed a liquidity analysis. However, been primarily driven by inflation fears in
anecdotally the geographical fragmentation the US.28
Figure 18: 2021 trading volumes versus five-year average
-DQ )HE 0DU 4
(85Ζ56 *%3Ζ56 86'Ζ56
Source: IHS Markit
Capital and operating model efficiency the ECB expect some degree of oversight TLAC/MREL
The changes UK and RoW banks have at the local level limits the extent to which Changes to legal entity structures may
already made to their legal entity individuals can “dual hat“. New legal entities have resolvability implications, including for
structures, booking models and business also require supporting infrastructure, the distribution of bail-in-able resources,
models as a result of Brexit, and those they including real estate and IT hardware reflected in total loss-absorbing capacity/
will continue to make as they deliver on and software assets, entailing additional minimum requirements for own funds
the substance of their “Day 2“ plans, have overhead costs. and eligible liabilities (TLAC/MREL)
introduced and/or increased a number of requirements. For example, according to
inefficiencies in terms of banks’ capital and Capital and liquidity the resolution strategy of a given group, a
operating models. In Box B, we provide a New legal entities must meet capital and new legal entity or sub-group may require
case study on the effects of splitting up liquidity requirements on a standalone additional internal or external MREL/TLAC
a portfolio of cleared IRS transactions basis, fragmenting and reducing the issuance. This is particularly relevant for
between two entities. fungibility of financial resources which may IPUs, if they are designated as material
previously have been located on a single entities or resolution entities.
Duplication (UK) balance sheet. The capital needs of
New legal entities require both senior new EU subsidiaries of foreign banks have Booking model fragmentation
management and supporting staff, been estimated to be in the order of EUR Prior to Brexit, global banks typically used
according to the remit of the entity, 35-45 bn.29 In addition, once the IPU comes their UK entities as a risk hub for a subset
entailing a split and some duplication of into effect, affected banks will have to meet of products within their global trading
senior leadership roles between EU and UK capital and liquidity requirements for the books. However, these risk management
operations. The fact that both the PRA and consolidated IPU sub-group. “centres of excellence“ have been
15European capital markets | The regulatory considerations for banks as they move beyond Brexit
fragmented between multiple locations
across different products, splitting the Box B: Understanding the effects sets were kept together, SA-CCR capital
relevant front and back office staff, senior of portfolio fragmentation for requirements increased by 8%, whereas
leadership, supporting infrastructure, cleared derivatives in the more severe scenario, where
and capital and liquidity resources, while Banks’ RWAs, and consequently their hedging sets were split, SA-CCR capital
reducing the potential for netting of capital requirements, will have increased requirements increased by 51%. This
exposures at the portfolio level. This comes because of the need to split cleared extreme variation in the capital impact
at a time when overall business conditions portfolios between their UK and EU of splitting the portfolio illustrates the
in Europe are extremely challenging clearing entities post-Brexit. The extent sensitivity of capital to the specific ways
and adds to the difficulty banks have in of the increase will depend on the in which these portfolios are constituted,
achieving sustainable profitability across composition of the assets within the and the challenges of splitting those
their combined European operations. portfolio and the extent to which the portfolios as a result of Brexit.
split broke up hedging sets which could
Infrastructure memberships previously be netted. Banks can achieve While it is very difficult to generalise,
Fragmentation of trading between the lower aggregate capital requirements by, given that the impact will be very
UK and EU – particularly if certain products to the extent possible, grouping together sensitive to the specific portfolios
must be cleared through EU CCPs – transactions which can be netted within under consideration, the RWA and hence
may lead to banks becoming members one entity. Where EU supervisors have capital increases arising from disrupting
of additional market infrastructures. been prescriptive about the transactions hedging sets may cause more trades to
Participating in any given market which must be booked in an EU entity, be done in EU entities if the result of this
infrastructure entails membership costs. this could “pull“ into the EU entity is to create new – or preserve existing –
additional transactions within the same hedging sets.
CCP default funds and margin hedging set (e.g. the same currency and
Additional CCP memberships entail maturity), even if there is no requirement Of course, SA-CCR is only one piece
contributions to additional default funds to do so. of the capital puzzle for derivatives,
and reduce the potential for multilateral relating to counterparty risk. Banks
netting of exposures within any one CCP, To understand the mechanics of how will in practice also need to factor in
increasing aggregate exposures and portfolio fragmentation feeds through capital requirements for the market
therefore aggregate margin requirements to capital, we modelled RWAs using SA- risk exposures associated with
across multiple CCPs. Increased margin CCR for a stylised hypothetical portfolio their positions, whether using the
also indicates increased risk caused by of cleared EUR-denominated IRS Standardised Approach or advanced
fragmentation, which may lead to increased trades.31 In the initial pre-split scenario, methods such as IMM. Another
capital costs. According to a 2017 ISDA all trades were initiated by one entity, consideration is whether UK CCPs will
survey of banks, a requirement for EUR- cleared through one CCP, with several continue to be recognised by the EU
denominated IRS to be cleared post-Brexit netting sets based on maturity. We then when the temporary equivalence for UK
at an EU-based CCP would increase initial modelled two subsequent scenarios with CCPs expires; without this recognition,
margin requirements between 15% and the portfolio split across two separate UK CCPs would no longer be classed
20%, with some larger clearing members entities, with each entity clearing as “qualifying“ CCPs and hence capital
reporting a more significant impact on through a different CCP. In the first requirements on these exposures
initial margin (up to 54%), or a more scenario, we split the overall portfolio would increase for EU entities, rendering
significant impact on client accounts than between entities, but kept the hedging the use of these CCPs uneconomical.
on house accounts.30 sets together. In the second scenario, we There are also a number of other
split both the portfolio and the hedging considerations banks would need to take
Tax sets. In the first scenario, where hedging into account, for example, in relation to
Transfers of business also give rise to market liquidity and client preferences.
corporate tax considerations, including
whether potential exit taxes can arise
on moving activity from the UK to the
EU, along with questions around the
appropriate transfer pricing and profit split
of the new model. The VAT treatment of the
new model also needs to be considered,
as does the employment tax and other
mobility implications of moving any staff
from the UK to EU entities.
16European capital markets | The regulatory considerations for banks as they move beyond Brexit
Interim assessment for the foreseeable future. This makes it
At this stage, four months after the end of difficult for some banks to achieve RoEs in
the Transition Period, while some capital Europe which meet their targets or in some
markets activity has migrated from the UK cases even exceed their cost of equity and
to the EU, there is no doubt that the UK will put them under further pressure to
remains the largest capital markets hub in reduce costs.
Europe. According to the Global Financial
Centres Index, London has retained its In many cases the immediate
place as the second ranked global financial consequence of Brexit is to leave the
centre, although its rating has dropped. UK entities with reduced profitability and
Frankfurt, the next European city, is ranked the new or expanded EU entities struggling
in ninth place.32 to develop viable business models and
achieve sustainable profitability. These
The business and people moved from pressures come at a time when both the
the UK to the EU so far has been to PRA and the ECB are scrutinising business
enable the banks to continue to service model viability and profitability very closely.
their EU customers and meet initial
regulatory requirements and supervisory In our view, the situation which banks
expectations. In short, they have find themselves in today across their
been driven more by regulatory than combined European operations is not a
commercial considerations. stable equilibrium, particularly when we
take into account the future regulatory
But the inefficiencies highlighted above developments which will shape European
clearly have commercial consequences. capital markets which are set out in
The aggregate costs across banks’ the following section. Banks face some
European operations have risen difficult decisions about how to reconcile
considerably as a result of fragmentation, regulatory and supervisory requirements
without so far a corresponding increase with commercial realities.
in revenues to offset this rise. In addition,
the economic environment in Europe is The more important question is therefore
particularly challenging both now and not so much what has happened so far,
but what happens next.
“Banks face difficult decisions about how
to reconcile regulatory and supervisory
requirements with commercial realities.“
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