The End of London

London’s days as the world’s premier financial centre are numbered, with New York set to take over.

Walking through the City of London, I am struck by the number of impressive skyscrapers being built – the Shard, the Can-of-Ham, the Walkie-Talkie, the Cheese-Grater, the Helter-Skelter, the Heron. The City appears to be booming. But the gleaming mirrored windows do not reflect reality. London’s days as the world’s premier financial centre are numbered, with New York set to take over.

The reason is simple – US regulators are out-competing their UK and European counterparts, pioneering a new market structure with a singularity of purpose and an ambition that will fuel the repatriation of financial market flows, stimulate the domestic economy and create jobs for Americans. The intention is explicit and by design. Any opportunity US regulators can identify to create rules that will help the US economy gain market share in global finance is being seized.

Here are the key areas:

Libor– In his remarks on September 24 to the European Parliament Economic and Monetary Affairs Committee, CFTC (Commodities Futures Trading Commission) Chairman Gary Gensler identified those banks with the longest period of unchanged 3-month Libor submissions. 61% of the firms he named came from Europe or the UK, compared to just 17% from the US (Exhibit 1). Chariman Gensler observed that while the CDS rates on these institutions spiked, their Libor submissions remained largely the same. This was a non-too subtle attack on the integrity of Europe’s financial institutions. Barclays was singled out by name 13 times. On Tuesday, the British Bankers Association (BBA) formally ceded control of its role overseeing Libor, marking the end of a 28-year period of UK financial market self-regulation. The decision was taken in response to a review of Libor that is being co-chaired by Gary Gensler, the findings of which will be released on September 28. Do not be surprised to see the recommendation for a new supra-national authority for Libor and other indices.

DoddFrank – Extraterritoriality guidelines under Dodd-Frank will give the CFTC oversight of European financial institutions and rare insight into European bank balance sheets, by virtue of the registration requirement. This is being resisted by European regulators who are arguing for effective equivalence, or substitutive compliance as it is called by Chairman Gensler. Effective equivalence will allow for the mutual recognition of the rules between the two regions, so that one does not attempt to supercede the other. But Europe is losing the battle. Should the extraterritoriality guidelines remain as they stand, it will massively enhance the CFTC’s ability to oversee and regulate Europe’s financial institutions.  On the flip side, the idea that European institutions may be competitively advantaged compared to their US peers because of the more aggressive US implementation timeline, is a mirage. As we discuss in our research, The Global Risk Transfer Market II, extraterritoriality benefits will not be realized since most global banks do not see enough of a window of opportunity to exploit. The time gap may be one or two years – not enough to justify the effort. In other words, the clearing and transparent trading mandate for OTC derivatives as outlined by the G20 will march to a Dodd-Frank beat, not to one set by EMIR or MiFID II/MiFIR. This said, Wednesday’s vote on MiFID II by the European Parliament Economic and Monetary Affairs Committee curbing High Frequency Trading will also harm London. Europe, it seems, is not only shutting down the OTC market, but the exchange-traded one as well. London’s only real hope now is that Mitt Romney wins the US election and rolls back Dodd-Frank, in turn undermining European zeal. But this is an unlikely scenario. Even if the Republicans win the election, they will not win enough support in Congress to repeal Dodd-Frank.

Basel III– New, more stringent capital requirements will apply first and foremost to European institutions which have traditionally implemented Basel rules sooner than US banks. The reason for this tradition is unclear but well-established. US banks are notorious for dragging their feet on Basel compliance, with many firms still not up to speed with Basel 2.5, let alone Basel III. The capital requirement directive does call for more uniform international implementation but we expect US banks to delay. The capital requirement is only a directive, not a law, and slow compliance in the US will place European banks at a distinct disadvantage.

The Volcker Rule – US Restrictions on bank proprietary trading will massively impact the ability of US banks to make markets and compete with their European competitors, which is why US firms continue to lobby heavily against it. Rather than concede, however, US regulators appear to be pursuing international unanimity on Volcker through the Liikanen Report, which has been initiated by European Commissioner Michel Barnier and proposes a hybrid approach between Volcker and the UK alternative – the Vickers Report. Vickers only advocates for ring fencing between deposit-taking banks and investment banking operations, but does not prevent banks from proprietary trading. Recent comments by Paul Volcker make it clear that the US does not see ring fencing under Vickers as sufficient. We see the Liikanen Report as an attempt to extend the Volcker rule into the UK over Vickers. The findings are due this month.

The problem facing London is two-fold. The first is that it has patronized and courted the OTC derivative markets which, under the G20 mandate of 2009, are now being forced into a transparent, exchange traded environment. The US sees a huge opportunity to win significant market share under an exchange-traded model. It is home to the largest exchange in the world, the CME. It sees product standardization as the future. Bespoke, tailored financial instruments can remain in the “London Loophole”, as it is known in the US. This is a shrinking market. Second, the US regulatory landscape is relatively uniform. Many bemoan the fact that Dodd-Frank missed an opportunity in failing to merge the Securities and Exchange Commission (SEC) with the CFTC and end the long-standing battle between the two agencies, but the fact is US oversight is rational compared to Europe with its 27 member national regulatory bodies, the European Parliament, the European Commission, the European Council, the European Central Bank and the European Securities and Markets Authority.

US banks have regulatory fatigue. They are coming to see lobbying and compliance as expensive and pointlessly defensive. They want to build out for the future and they are turning their attentions forward. The attitude is: “We don’t care what the rules are, just hurry up and write them so we can get on with business.”  Meanwhile Europe’s London-based banks are obsessed with lobbying, struggling for amendments and delays, and further fragmenting the regulatory process by encouraging internecine Continental fighting. This strategy will only secure the City’s dismal fate.

Like the US, London’s banks should instead be looking to the future. They need to throw their weight behind Martin Wheatley, head of the recently-established Financial Conduct Authority (FCA). The FCA is the best chance that London has to show that the UK can get tough on finance. Wheatley is co-chair of the Libor review, alongside Chairman Gensler. This alliance should be fostered in the hope that it supplants the current close relationship between Chairman Gensler and Commissioner Barnier, whose negative views on London as a financial centre are well-documented. London also needs to focus less on the OTC derivative market and build up FX. Few financial centres can compete with London’s position in the world time zone. The more it does to develop itself as the hub for global FX flows, the stronger its position as a financial centre will be.

Should London’s banks fail to formulate and implement a unified industry response to the challenges they face, the City they helped to build will be left behind.

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