Saxo on Brexit: City of London may be forever changed
- London is world's leading financial centre with 40% of FX trade
- Some 20% of global hedge fund assets are London-based
- Shares of big UK banks are down some 35% in past year
- Brexit could spark exodus of foreign banks from London
- Employing a Barclay's call option to tackle EU referendum
Even after considering the economic slowdown, negative interest rates and fragile financial markets, shares of UK-based banks in the FTSE 100 Index are down 36% on average in the past year. Since the recent highs in mid-May, shares have gone down again as surveys on average point to strength for the Leave campaign. Why could a Brexit change everything for the City of London?
Under current law, any UK authorised firm is free to do business within the European Economic Area (EEA) through a “passport” from UK regulators. This option makes it possible for non-EU banks such as JPMorgan Chase to access Europe from only one financial hub. Should the UK vote for leaving the EU, the price of the passporting right would increase dramatically, making it a very tough negotiation point for British prime minister David Cameron.
Brussels would likely not accept the Norwegian model whereby the UK would leave the EU but stay inside the EEA unconditionally. This would be political suicide as other member countries without the euro, such as Denmark and Sweden, could be tempted to hold referendums on EU membership as well. The Norwegian model also only makes sense for countries that never were inside the club.
The hard exit model means the UK would lose key influence over EU legislation and passporting would be off the table. A softer version would allow the UK to keep passporting but on certain conditions such as convergence of EU and UK laws governing financial markets.
In any case, Brexit poses a huge risk to financial firms and many are already implementing contingency plans in case of a messy outcome. Many banks have warned of massive layoffs and HSBC has said that around 1,000 of its investment banking employees would have to move to Paris. The City of London may never be the same again after a Brexit.
A good indicator of the high risk discounted in financial markets is implied volatilities for FTSE 100 compared to banks. The implied volatility for FTSE 100 July-15 ATM options is around 25% compared to around 58% for Royal Bank of Scotland (RBS). Investors can collect 7.1%-points in premium before commission by selling ATM straddle on RBS and buying ATM straddle on FTSE 100. The option market also shows that the market is less worried about HSBC. However, puts are generally more expensive than calls on UK banks.
How should investors navigate the Brexit event?
It is clear that no other segment of the UK equity market is more vulnerable to a Brexit than UK domiciled banks. A lot of downside risk has already been priced into these banking stocks. As such a short trade is not very attractive from a risk-reward perspective. GBPUSD risk-reversals (at around minus 8) are already indicating the direction of the flow and thus how worried the market is over the recent momentum to the Leave campaign.
Barclays daily share price since June 2015
This has influenced calls on a bank such as Barclays. The C165 July-15 is priced at 12p translating into around 7.2% premium. With around three weeks from the UK referendum to expiry of this call option a no Brexit would very quickly be incorporated fully into Barclays share price.
There is around 14% upside to recent highs at the end of May based on prices on June 13) While the premium may seem steep, it would easily be overcome should the UK decide to remain in the EU.
– Edited by Clare MacCarthy
Peter Garnry is head of equity strategy at Saxo Bank