Security Implications of Post-Brexit Fragmentation in European Financial Governance
Combating illicit finance, ensuring the stability of capital markets, and preventing crises are not purely financial concerns anymore. Not only has the relevance of military power arguably declined and that of economic power rose since the end of the Cold War, but financial markets themselves underwent major securitization. Budgetary and financial considerations have always constrained foreign policy, but finance and security now merge in less obvious ways. The intensified surveillance of banking after 9/11, rising popularity of financial, rather than trade, wars, and the growth of government interest in acquiring financial data are all making it ever more difficult and dangerous to treat the governance of finance and security as only loosely connected.
The expanding overlap between finance and security should raise additional concerns over the so-called “Brexodus,” the shift of financial power and competence away from the UK and toward the Continent. The UK’s loss of access to the integrated financial market will not only hit bankers and investors. Its implications are of national, regional, and global security importance. The European Supervisory Authorities (ESAs), created to integrate financial supervision within the EU, are now preparing to relocate the headquarters of its major regulatory agency, the European Banking Authority (EBA), from London to Paris. The UK’s departure from the EU will exacerbate preexisting gaps in cross-border cooperation in combating illicit finance, which previously allowed for the movement of dirty funds revealed in the Panama Papers and the Global Laundromat series. Meanwhile, British firms continue to benefit from massive inflows of foreign capital, a significant portion of which the British government believes to be laundered, and London remains one of the most attractive destinations for potential ‘golden visa’ holders. Considering the reputation of the city as the money-laundering capital of the world, the relocation of such a prized regulatory body as the EBA is an especially salient issue, since Britain will now have to assume responsibility for building an independent administrative capacity to counter the estimated £90 billion worth of illicit financial flows that go through London each year. This number constitutes a staggering 17 per cent of total global money laundering – an amount challenging to handle in the absence of Europe’s regulatory framework the UK will lose access to. Having more than one-sixth of the world’s money laundering transactions face less regulation than ever before opens new opportunities for proliferation and terrorism financing, let alone tax evasion and anonymous shell companies.
Back in 2016, British authorities lamented the deterioration of the UK’s status as a world leader on anti-corruption due to the continuing lack of transparency domestically. Now, its reputation as the upholder of European financial market stability is under threat, too. More than 90 percent of the euro-denominated derivatives business of euro banks are currently cleared via central counterparty clearing houses (CCPs) in the UK. Central clearing is a crucial function of the global financial system that ensures investors can access liquidity in multiple currencies across multiple markets. Britain handles the majority of euro banks’ interest rate and credit derivative transactions, as well as a significant number of commodity and equity derivatives. In light of Brexit, EU experts worry the potential CCP failure will result in massive, volatile movements in the comparative cost of using UK CCPs, which might trigger the transfer of hundreds of thousands of trades worth trillions of euros. Such disruption is likely to cause a liquidity drain and erode profitability in the short-run and leave systematic consequences on the global financial system in the long-run. With those concerns in mind, Yves Mersch, Member of the Executive Board of the European Central Bank, encouraged EU authorities to consider taking action to ensure the Eurosystem has adequate control over the impact of clearing activities in the UK. What it ultimately means is a transition towards a new European and global clearing system, over which London will have considerably less influence. Such a dramatic departure from the “London-centrism” of regional financial markets will undoubtedly give Britain more autonomy, but it will also weaken the UK’s ability to impose its preferences on regional and, consequently, global financial governance.
Some view fragmentation of financial governance as less detrimental, claiming it decreases chances of systemic risk due to more diversified and thus more robust regulatory systems. Jon Danielsson of London School of Economics and Political Science argues that divergent governance regimes protect against synchronized reactions of financial firms – one of the few mechanisms capable of triggering a collapse of an entire financial system. However, many consider it undesirable for the new British regulatory system to differ too dramatically from that of the EU. Fearing Brexit might pose a systemic risk not just to the domestic market but to the global financial system, Piers Haben, Director of Oversight at the European Banking Authority, has called for Britain’s exit from the EU’s financial system to be “as smooth as possible,” implying that the UK and EU should not do much to alter their regulatory regimes. Depending on what side of the argument one is on, Brexit can mean both greater and lesser systemic risk. What is certain is that there should be a balance between centralization, which provides convenience for market participants, and decentralization, which mitigates risks. Achieving such delicate balance requires key actors’ trust in one another and an environment conducive to successful negotiations. Brexit is very unlikely to encourage either of these things.
On the Continent, however, things are not looking entirely grim for the future of financial governance without extensive British involvement. While the prospects of a hard Brexit are becoming more and more likely with each week of unsuccessful negotiations, European financial governance is growing its emphasis on operational, rather than regulatory, functions, both regionally and globally. Scholars speculate that the UK’s presence in the EU was, in fact, a major friction preventing the euro area from further centralization of institutional governance. Now that this impediment is removed and the political support for a financial union is sufficiently high, the ESAs will find it easier to come to cooperative positions without the need to factor in the peculiar preferences of the largest financial market in Europe. The ESAs will be able to take a more assertive position and assume a more prominent role internationally. “If you’re tired of London, you’re tired of life,” the famous saying goes, but Brussels will have no choice but to make the most out of its inevitable break from the City.