Why should markets care about a Brexit?

The UK has delivered its verdict and Brexit is now a distinct possibility. Equity, currency and commodity markets are tanking in fear.

While the move might seem to be an over-reaction, financial markets have reasons to worry if a Brexit happens.

The UK is a leading global financial centre, home to some of the leading markets and exchanges and a thriving fund management industry.

Many of the global mutual, pension and hedge funds are managed out of UK.

These funds will cut back on fresh investment as they adjust to the new regulations in post-Brexit UK. Global fund flow into equity could therefore be impacted.

George Osborne, the UK Chancellor of Exchequer, while outlining the difficulties in transition, says that as the old ties with the EU are broken and new ones are formed, businesses will be unable to take any decisions.

It will be a few months before new contracts are signed based on which the governments and businesses can function. There could be a virtual freeze on activities in this period. UK Treasury has warned that UK’s GDP can be 3 to 6 per cent smaller if there is a shock after Brexit.

A global risk-off trade on fears of recessionary impact of Brexit on the UK and EU and the global economy can impact currencies, thus leading to a run in emerging market debt as well.

According to The CityUK, an organisation that promotes UK as a financial services hub, UK has been growing in dominance as a global centre for financial trading.

Its share in Over The Counter interest rate derivatives turnover increased from 35 per cent in 2001 to 49 per cent in 2014.

Similarly, share in global forex turnover (41 per cent in 2014), marine insurance (29 per cent) and hedge fund assets (18 per cent) too, recorded a steep increase between 2001 and 2014.

London is home to some of the largest global markets such as the London Stock Exchange, London International Financial Futures and Options Exchange (LIFFE), Lloyd’s of London – a large insurance market that provides specialist insurance services to businesses in more than 200 countries and territories, London Metal Exchange and ICE futures exchange.

These exchanges had been benefiting through trades put in by investors from other EU countries.

They have also been governed by the EU regulations which will have to be re-worked if the Brexit becomes a reality.

The conducive eco-system in the UK has made many fund managers base their operations in the country.

The UK had £6.2 trillion of assets under management towards the end of 2013, making it the top jurisdiction for asset management in Europe. It was the second largest source of global funds in 2013, after the US.

It is therefore possible that global flow of funds into equity markets can be impacted in the short-term as these funds rework their strategy, once the UK ceases to be a member of the EU.

The uncertainty regarding the status of various funds located in the UK, their taxability and other regulatory aspects can make these funds maintain status quo with regard to fresh investments in the transition period lasting at least six months.

That said, flows into India are not likely as Foreign Portfolio Investors from the UK do not have too much holding in Indian equity assets, accounting for 5 per cent of the entire FPI assets.

Rise in global risk aversion and currency weakness can however trigger fund outflow.

Another reason why global financial services sector will be hit is due to the ‘passporting’ facility that firms operating in the UK enjoyed so far.

Entities in UK were given passports that helped them do businesses or provide services to clients in the other member countries of the EU.

These services could be offered remotely, without a physical presence in the country where the service was provided.

Similarly, businesses based in other EU countries could provide services to UK citizens with the aid of passports.

With Brexit, these passports will be nullified and the services will have to be halted. This will be a big blow to financial firms operating from the UK. These firms might now want to rethink their location.