As Brexit negotiations turn to trade this month, financial services need to make sure their systems can handle the pressure if the UK cuts all ties with the EU .
From March 2019, the UK will no longer be a part of the European Union (EU) as part of Brexit. And since June 2016, when UK citizens voted to leave the bloc through Brexit, there has been much deliberation – as well as panic – among financial services as to what kind of relationship the UK will have with the EU when it comes to trade as a result of Brexit negotiations.
As Brexit negotiations finally turn to trade this month, software development at financial institutions with associated quality assurance and testing will need to stay one step ahead for a smooth Brexit. This will be to make sure banks’ trading, risk, and collateral management systems can deal with the complexity of moving large volumes of trading business smoothly in a hard Brexit scenario.
Although there has not been a great deal of change seen in the sector, that’s not to say that nothing is happening; there’s been a lot of contingency planning going on behind the scenes this year following Governor of the Bank of England Mark Carney’s requests to banks to start planning for Brexit.
Better to be safe than sorry
What is a hard Brexit? If the UK cuts all ties with the EU and operates outside of the European Economic Area (EEA), UK-licensed financial entities immediately lose a number of rights that come as part and parcel of being an EU member state – this is what we call a “hard Brexit.”
Currently, banks operating under a UK banking licence enjoy free access to the market (via passporting of rights), meaning UK-licensed banks are entitled to trade on equal terms with their EU counterparts. The impact of losing the passporting of rights would be extremely disruptive and take effect immediately. It would affect trading relations and the mobility that we have to access the European market. In this scenario, the UK would be considered a “third country jurisdiction” as a result of Brexit impact. This means that in order to process transactions, ESMA would have the discretion to decide whether a UK bank counterparty jurisdiction has standards that comply sufficiently to EU MiFID II regulatory standards, i.e., whether the UK regime is equivalent to the EU’s.
On top of this, the London Clearing House, the central counterparty clearing house (CCP) for UK financial market participants, which acts as an intermediary between buyers and sellers, would automatically lose its CCP status under EMIR regulations despite robust Brexit negotiations. This means that its benefits as a low-risk and low-cost entity for clearing would also be lost, impacting the City’s commercial business.
UK CCPs currently enjoy a low risk weight, but with a hard Brexit, this recognition will go. At the end of the day, it’s about the jurisdiction of legal entities, and with a hard Brexit, UK banks’ legal entity status will change. This is what we need to work around. And this is what the testing is all about.
For a bank to move trading business from the UK to the EU after Brexit impact, a huge volume of transactions will need to be processed through its system, and between now and 2019, there needs to be many different forms of testing and dress rehearsals to make sure systems can cope with Brexit consequences. So far, one European bank has approached HCLTech and asked us to look at migrating certain trading book business out of the UK to another EU country, but I expect others may plan a similar approach.
One thing’s for sure: moving trading books will be a massive exercise, and systems will need to be tested. The full testing lifecycle from unit, system, integration, regression, and stress testing will all need to take place. Old and new systems will need to be tested in parallel and results will need to be checked to see that the same positions remain albeit rebooked into a new location and booking entity – if not, retesting will need to be done. Any European bank planning on doing this will need to prepare months in advance.
Out with the old, in with the cloud
With Brexit looming on the horizon, a number of forthcoming regulatory changes are set to impact the financial services industry in 2018, including the Markets in Financial Instruments Directive (MiFID II), the General Data Protection Regulation (GDPR), and the Payment Services Directive II (PSD2).
With such regulatory changes fast approaching, I see a huge opportunity for banks to review and enhance their entire digital strategy and systems. We anticipate a growth in cloud technology, and banks and financial services should take this opportunity to replace their crumbling and burdensome legacy systems with cloud-based services. When you have regulations like GDPR increasing security requirements and Brexit as major change drivers, it’s a good argument to adopt these changes sooner rather than later.
Come Brexit, if a bank’s systems are on a UK-based cloud, moving that cloud to Europe will not be such a massive challenge. The cloud is very much the way of the future, and although there’s a significant cost involved and the old adage of “if it’s not broke, why fix it,” at some point in time banks will have to update their legacy platforms; so, rather than delaying it any further, now is the time.
Are financial services taking the prospect of a hard Brexit seriously? Banks have definitely been thinking about it since the UK voted out of the EU. But I think a “wait and see” approach has been employed to date. There has been a lot of rhetoric by certain big US banks like JPMorgan and Goldman Sachs threatening to move their operations to another European country, but actually on the scale of things very little has been done. Despite the panic, I think the City is still considered the leading financial hub in Europe for conducting international business.
* Rachel Williams - Editor of QA-financial.com, interviewed Kinsuk Mitra, Head of Risk & Compliance, Global Solutions for financial services at HCLTech technologies on 21st November 2017.