Brexit: What corporations should look out for in the wake of Brexit

On 31 January 2020 , approximately three and a half years after the Brexit referendum, the United Kingdom left the European Union. The country will remain a member of the European Single Market and the Customs Union until the end of this year. So at this point, hardly anything will change for either corporations or people. However, new uncertainties could arise after the transition period ends on 31 December 2020.

Commerzbank is ready to support you with preparing for the scenarios you might face as of next year, regardless of whether you are based in Germany or the UK.

Developments until the end of the year

The exit from the European Union (EU) has been formally completed, the British Brexit ministry has been dissolved. By the end of the year both parties intend to finalise agreements on their future relationship. The key issue is a free trade agreement. The UK is likely to be particularly keen on reaching such an agreement, as so far close to 50 per cent of the country’s exports have been shipped to EU countries without any trade barriers. On the European side, a trade agreement merely has to be approved by the European Parliament. Should additional agreements be made, for instance on data protection, services or financial transactions, votes by national parliaments and in some cases even regional representative bodies might also be required.

However, the schedule for negotiations is extremely tight. To give you a frame of reference: Negotiations on a free trade agreement between the EU and Canada began in 2009, and a preliminary contract did not become effective before September 2017. According to the Brexit withdrawal agreement, the UK has to decide by 1 July 2020 at the latest whether it wants to extend the transition period by one or two years. So far, Prime Minister Boris Johnson has categorically rejected this idea. If talks with the EU fail, the prospect of a no-deal Brexit looms once again. In this case, trade relations would be based on the rules of the World Trade Organization (WTO), meaning that the movement of goods would be subjected to customs duties.

Issues of particular importance to both sides

There is a positive aspect: Even after the end of the transition period, under the withdrawal agreement UK citizens lawfully resident in the EU and EU citizens lawfully resident in the UK will retain their existing rights with regard to residency, working, studying and family reunion. This ensures, for example, that British citizens (who are lawfully resident in EU member states) can continue to live and work in that EU member state. It is not clear whether British citizens living in EU countries will be able to move freely to other EU countries after Brexit. That will be dealt with in the negotiations on the UK’s future relationship with the EU.

In addition, it is the EU's position that free movement of goods and services between the two sides can only exist in the future if there is free movement of labour as well, i.e. the freedom of citizens to work anywhere in the EU and the UK without problems. This is another proposition the UK categorically rejects.

The prospective talks about a trade agreement received a blow before they even started. Earlier this year, the UK’s Chancellor of the Exchequer, Sajid Javid, stressed that the UK would no longer abide by the EU’s legislative framework after the conclusion of the transition period at the end of 2020. This would spell an end to the free movement of goods.

Apart from the ongoing validity of EU legislation, a number of other issues are particularly contentious, among them data protection, transport and the financial sector. If corporations are to keep exchanging customer information between the UK and the EU, corresponding arrangements are absolutely imperative. And although the EU is aiming to maintain close transport links with its former member state, it does not intend to grant the UK unchecked access to air traffic within the union.

Brussels also intends to keep the financial sector out of any free trade agreement. The EU is only willing to grant unimpeded access to UK-based financial companies if they are subject to the same body of legislation as the EU.

The consequences of a failure of negotiations

With regard to European financial services providers in the United Kingdom, the UK government takes a different stance.

EU banks will be able to continue to operate through their UK branches as before during the transition period, and – if authorisation from the UK regulators has not been granted during the transition period – for a period of up to three years thereafter by opting-in to the Temporary Permissions Regime that will take effect from the end of the transition period. "After the transition period, UK branches of EU banks must be authorised as third country branches by the UK regulators. Commerzbank submitted its application in September 2018. We expect this to be approved by 31 December 2020 and, should the transition period not be extended, are therefore prepared for 1 January 2021. As a result, little will change with regard to the general status of Commerzbank as an EU bank with a London branch," says Antje-Irina Kurz from Commerzbank's legal department.

Also, Brexit will initially have no effect on the clearing of derivatives via central counterparties (CCPs), a mechanism that is instrumental in certain hedging activities. According to the European Securities and Markets Authority (ESMA), three UK-based central counterparties will continue to be covered by their current accreditation until 31 January 2021. Consequently, CCPs such as the London Clearing House (LCH) will be able to continue to offer their services to EU banks. However, CCPs that intend to continue working for EU financial institutions after February 1st of next year must obtain recognition as third-country CCPs within this year.

The effects of a hard Brexit

Uncertainty could increase again

Should it become clear over the course of the year that negotiations on a free trade agreement will fail, uncertainty is likely to increase once again on the part of corporations that maintain business relations with the UK or produce goods in the country. One recurring topic in consultations with clients is the hedging of currency risks. "In my opinion, a no-deal Brexit will lead to a devaluation of the British Pound (GBP). Already, before and after the referendum over the EU withdrawal, the GBP was weakened and the cost of hedging currency options rose significantly," says Dr Michael Braun, a currency expert with Commerzbank. At the moment, the situation is still relatively calm, adds Dr Braun. "If, however, a clear trend towards a no-deal Brexit emerges, I expect a strong increase in volatility for options and a corresponding rise in hedging costs for currency options," he emphasises.

Stocktaking as a basis for currency hedging*

Generally, the volatility for EUR-GBP options stands at 7 to 8 per cent. However, we have recently seen lows in these fluctuations that make currency hedging with foreign exchange options more attractive. As a general rule, companies should take stock first, recommends currency expert Dr Braun: "To what extent does Brexit change their hedging volume? How much is covered by hedging already? They should also observe the market in order to be able to bring forward certain hedges, so they are not forced to buy in a phase when the market is stressed." He also recommends: "Talk to us. We can assess the risks and develop a hedging strategy with you." In collaboration with experts from its research department, Commerzbank offers information events via telephone or video conference exclusively for its clients. These sessions focus on both fundamental developments regarding Brexit and company-specific issues.

The prospects for payment transactions

There's a more positive outlook in the areas of payment transactions and what's known as cash pooling. Martin Cordes, Commerzbank's Head of Payments Corporates & Innovation, does not expect many changes in terms of processing, even in the event of a no-deal Brexit. An application lodged by UK banks with the European Payments Council (EPC) to remain part of the SEPA payments system was approved by the EPC at its meeting on 7 March 2019. Consequently, SEPA payment transactions can continue to be processed. Commerzbank will meet the expanded regulatory requirements by requesting a complete set of payer details in transfers. As principals, companies employing direct debiting with UK debtors will have to provide the corresponding payer details. They can prepare for this now and already transfer the address data for their clients as part of the SEPA file. This may result in slightly higher fees.

Similarly, foreign payment transactions are subject to the rules that apply to third countries – payer information must be recorded in full. With regard to this, Commerzbank clients profit from an advantage: "We have been offering real-time conversion for international payment transactions for some time," says Cordes. Clients are no longer dependent on reference rates that are fixed once per day – instead, they are continuously aware of the conversion rates for financial transfers.

Cash pooling – nothing changes

Cash pooling is the intragroup balancing of liquidity via a finance management system that centrally pools the excess liquidity of affiliated companies and equalises liquidity shortages. Commerzbank expects no changes with regard to processing. The reason is that cash pooling is regulated individually by each country. It is not substantially dependent on European law.

Potential delays in goods deliveries

In case of a failure of negotiations for a free trade agreement, the resulting customs and border checks will likely cause delays in the delivery of goods. Contractual partners engaged in foreign business transactions with the UK that are hedged by means of letters of credit should factor this in and provide for appropriate contractual stipulations. In addition, goods from the UK no longer formally originate from the EU. This, as well as all potential delays, should also be taken into account when drawing up letters of credit. The resulting bottlenecks in terms of delivery will also affect days sales outstanding (DSO). This can have an impact on the buyer's creditworthiness. Higher supplier credits cause massive problems in the event of default.

The most severe consequences of a no-deal Brexit will affect businesses involved in trading goods with the UK. The customs and border checks that will be established in this case can cause considerable delays as described above, which can in turn cause delays of payments for the goods delivered. This may result in liquidity bottlenecks on the part of the suppliers. Please contact your personal customer advisor for information about feasible methods of hedging other than the aforementioned letters of credit.

Changes to Entity Structures

Commerzbank will monitor political and regulatory developments and make changes to its operating model as well as legal and entity structures where required to continue servicing Europe-based clients post Brexit. However, Commerzbank will continue to operate as a bank headquartered in Germany with foreign branches. The majority of activities are already transacted and booked with Commerzbank AG Frankfurt. Commerzbank AG Frankfurt uses well-supported and well-maintained centralised Group systems. Consequently, any services will continue to be provided by existing entities and Commerzbank does not anticipate any changes to outsourcing arrangements as a result of Brexit.

Repapering of existing transactions/contracts

UK-based counterparties who are in the process of establishing themselves in the EU should direct their repapering request to Commerzbank’s Brexit repapering email, including details of affected positions and the intended repapering approach. Commerzbank also requires details of new entity structures for Know Your Customer (KYC) and onboarding purposes.

* Section on Stocktacking as a basis of currency hedging is not valid for Singapore.

"From an economic point of view, the UK scored an own goal with Brexit"

Commerzbank's chief UK economist, Peter Dixon, on the future prospects in the wake of the country's exit from the European Union:

Mr. Dixon, do you consider it a realistic prospect that a free trade agreement will be reached by both parties by the end of the year?

Peter Dixon: I'll give you the economist’s standard answer: yes and no. This will mainly depend on what kind of free trade agreement the parties aim for. If it is to be very comprehensive and intended to replicate the current close connections, then the answer is a resounding no. Other countries have needed between five and seven years to finalise a trade agreement with the EU.

However, as the UK government no longer wishes to comply with all EU regulations in the future, an agreement could be ratified by the end of the year, providing for just those product categories on which no real disagreement exists between the UK and the EU, e. g. automobiles and pharmaceuticals. Such a limited agreement would also allow the UK government to say: "Look, we did it by the end of the year without any extension of the transition period." However, should the Johnson administration fail to settle all of the issues it deems important, it may have to request an extension after all.

What will be critical for the successful achievement of an agreement by the end of the year?

PD: Both sides must remain open-minded with regard to their respective partner's positions. They also mustn't be too quick to draw red lines that cannot be crossed. To seek consent rather than confrontation could be a recipe for success.

In addition, the UK should clearly disclose the main areas in which it aims to achieve an agreement to the EU as soon as possible. The country has a vested interest in retaining a maximum degree of freedom of movement of goods to minimise economic difficulties. For example, the automotive industry can only run smoothly if suppliers are able to ship goods back and forth without having to pay customs duties. Other important segments are food and beverages as well as pharmaceutical products. The UK government should tone down its rhetoric in the run-up to the negotiations and instead focus on keeping the costs to the economy low.

If the two parties fail to reach an agreement by the end of the year, a no-deal scenario looms. How can companies prepare for this?

PD: Commerzbank does not expect a no-deal Brexit by the end of this year. Nevertheless, if a no-deal Brexit should indeed come to pass, companies can hardly prepare for this. Like last year, they should keep inventories high, of course, so there are no production bottlenecks in the event of deliveries being delayed. However, this only constitutes a small step.

In general, foreign companies should ask themselves why they want to continue to operate or set up business in the UK. For example, in the past the cost of labour has been somewhat lower there than in other EU countries, and the business environment has been very flexible. In addition, companies could produce in the UK and were able to export the goods to all other EU member states without having to pay customs duties. American enterprises had no language barrier in the UK and at the same time, they were able to profit from unimpeded access to the European Union's entire common market. Many of these advantages are likely to disappear in the future.

Will many companies leave the UK for this reason?

PD: Some large multinationals have already moved their European headquarters to the mainland and I expect this trend to continue slowly but steadily. In any event, we will see considerably fewer foreign direct investments in the future. The UK government should realise that a no-deal scenario might result in an immense burden on the country’s domestic economy. Therefore, the Johnson administration clearly has a vested interest in preventing a no-deal scenario. The EU also wants that. It’s a positive that the political setting in the UK is much clearer now than it was in 2019.

Given all these risks, didn’t the UK score an own goal with Brexit?

PD: Definitely. For years, business representatives from the UK have been emphasising that leaving the EU will not solve any of the country's economic problems. Brexit has never been an economic issue, but always a political one.