Impact of Brexit on UK Financial Services, Interest Rate Analysis and Electronic Crossing Networks

UK financial services and economy

According to the House of Lords European Union Committee, The UK financial services industry constitutes around 7% of UK GDP, directly employs 1.1 million people, two-thirds of them outside London, and contributes a significant proportion of tax revenue. Avoiding major disruption to this industry and the resulting job losses should be a high priority in the Government’s negotiations on leaving the EU (i.e. Brexit).

Financial services and the UK economy:

1) The UK is the world’s largest exporter of financial services and insurance: in 2013 UK net exports were $71 billion. London is ranked by the Global Financial Centres Index (GFCI) as the world’s leading financial services centre, just ahead of New York and significantly ahead of other EU cities. In 2011–12 the sector contributed 12% of PAYE income tax and national insurance, and 15% of onshore corporation tax received by the Exchequer, and in 2013 employed an estimated 1.1 million people. In his evidence to this inquiry Anthony Browne, Chief Executive of the British Bankers’ Association, put these figures in context: “Financial and related professional services pay over £60 billion a year in tax. Of that, banks pay about £31 billion. Of that £31 billion, slightly over half … is paid by foreign banks based here. It is worth noting that that is bigger than the entire UK net contribution to the EU budget.”

2) When related professional services are added, the UK workforce in financial services numbers nearly 2.2 million. This includes 483,000 in management consultancy, 314,000 in legal services and 391,000 in accounting services.

3) The health of the sector is thus hugely significant for the UK economy. Moreover, while ‘London’ or ‘the City’ are often used as shorthand for the UK financial services industry, the reality is that a large proportion of jobs and activity in the sector are based in other parts of the UK.

4) The UK financial services sector plays a vital role in providing services to the wider economy, both in the UK and internationally. Analysis by the consultancy Oliver Wyman calculates the annual financial revenues at around £200 billion, £90–95 billion of which is domestic business, £40–50 billion relates to the EU, and £55–65 billion relates to the rest of the world.

Task: Answer the following questions

Discuss the economic (and non-economic) impact of ‘Brexit’ on the UK’s financial services sector.

Your employer (a bank) has decided to offer five-year loans to its small business customers. You have been presented the task of determining what the appropriate minimum interest rate should be for the most credit-worthy customer. The decision to select a particular fixed rate for the loans depends on our forecast of the interest rates and our internal efficiency in managing the loan. This requires compensation for the costs of making the loan plus profit. You are to use the most recent five-year Treasury bond as the basis for determining the minimum interest rate on the small business fixedrate loans. 

Determining the minimum interest rate for loans

Your loan supervisor indicates that the bank needs to charge two percentage points more than the expected interest rate on treasury bonds for these loans. In addition, the bank has estimated the liquidity premium to be 0.9%. Given this information, and the fact that you know you will need to defend your recommendation, you start to analyze current interest rates as follows:

1. Access local or internet articles that describe theories about the form of a yield curve.

2. Obtain current information on the U.S. Treasury Yield Curve.

3. Plot the current U.S. Treasury Yield Curve and indicate which term structure do you think best describes the curve? 

4. Given the information in responses 1, 2, 3 above--use the pure expectations  theory to find the interest rate expected on a two year bond one year from now? What relationship do you find between interest rates and maturity? 

5. If the investors attach liquidity premiums of 0.001, 0.0015 and 0.0017 to the one-, two- and three year bonds what would be the interest rate on a two year security? 

6. What is your recommended minimum interest rate for the five year fixed rate loans and how would this rate be adjusted for customers that have some credit risk? 

Alex Dale is a portfolio manager at ADIA Investment Company in Europe. Alex would like to buy 50,000 shares of alpha stock which is a new IPO that was previously offered at £30, but unfortunately he couldn’t get any shares of it. Now, he is still interested in these shares, but not at a price that is greater than £45. Jill Jones works for The Global Brokerage House, which provides execution services for ADIA. In his conversation with Alex, Jill has suggested that a market order is most suitable for the trade. Alex is also interested in using a market order to sell a large block of Gamma shares. However, he is worried that if he instructed a selling using a market order the price would decline and he loses on the value of the deal. Jill argued that this should not be a problem as automated order driven trading systems provide special arrangements for small trades (which are often market orders) as well as for block trades. Alex is also interested in reducing the cost of selling of his Christian Dior shares, Jill suggested that he should use European electronic crossing network to sell some of his shares. She told Alex that these networks are cheap, preserve anonymity and allows for 6 crossing opportunities of trades per day. They also allow participants to place some restrictions such as price and minimum fill. All orders submitted to the network is good for day which is means that any unfulfilled part of an order is automatically resubmitted to subsequent crossing sessions during the day. Following Jill’s advice, Alex has submitted his 150,000 CD shares to be sold in the European crossing network with a minimum fill of 125,000. The following orders are on the network for the shares of CD at the time of the first crossing session of the day. The most recent trading price of CD at the Paris Bourse is € 37.

1.A order: a market order to buy 100,000 shares

2.B order: a market order to sell 50,000 shares

3.C: an order to buy 20,000 shares at € 36

In the next crossing session new orders are submitted. The most recent trading price of CD at the Paris Bourse is € 38.

4.D order: a market order to buy 150,000 shares

5.E order: A market order to sell 50,000

In her speech to buy side clients Jill has made the following statements about electronic communication and crossing networks (ECNs): 

Statement 1: Electronic communication networks are order driven systems, in which the limit order book plays the a central role 

Statement 2: Electronic crossing networks anonymously match buy and sell orders by a pool of participants, generally institutional investors and broker dealers

Statement 3: In an ECN, a trade takes place only during a crossing session time and only if there are offsetting orders entered by other participants.

Task:

1. For buying alpha shares, should Alex place a market order or a limit order? What would be the advantage and disadvantage of each type of order, given his purpose? 

2. In selling a large block of Gamma shares explain Jill’s argument that automated order driven trading systems must provide special arrangements for small and large trades? 

3. In the first crossing session discuss what trades would take place on the crossing network and what orders remain unfilled? 

4. In the second crossing session discuss what trades would take place on the crossing network and what orders remain unfilled? 

5. Which of Jill’s statement about electronic communication and crossing networks (ECNs) is true? Justify your answers. 

6. Indicate how you would assess the quality of financial markets?