With 12 months remaining before Brexit becomes a reality, what are the possible outcomes – and how should treasurers be preparing?
With only a year to go before the UK leaves the European Union – the departure is scheduled for 11pm UK time on 29th March 2019 – much remains unclear about the final form that Brexit will take. While some agreement has been reached on issues such as the rights of EU citizens living in the UK and UK citizens in the EU and the status of the Northern Ireland border, there is plenty yet to be decided.
More should become clear in the coming months. Negotiations are due to take place in March about the proposed transition period, with the UK aiming for a two-year period following the departure date. The next stage of talks will focus on negotiating a trade agreement, the outcome of which will have lasting implications for companies in the UK and Europe.
In the meantime, there is plenty that treasurers should be doing to help prepare their businesses for the challenges ahead. From understanding changes to the business model to carrying out quantitative analysis, Treasury Today explores some of the areas that treasurers should be looking at in 2018.
Hard or soft Brexit?
There may be only a year left before Brexit becomes reality, but there are still many questions remaining about the final form that the UK’s departure will take. At this stage, given the continuing uncertainties, there are three possible scenarios to consider, says David Farrow, Head of Global Transaction Banking, Barclays Corporate Banking.
“At one end of the scale, a ‘soft’ Brexit with the status quo largely maintained and a transition phase for EU businesses to adapt; at the other end a ‘hard’ Brexit with the UK taking a full exit from the EU/EEA with no passporting rights or transitional arrangements,” he explains. “In the middle is what we’re calling the ‘Flavours of Brexit’, essentially a blend or patchwork quilt from both ends of the scenario scale.”
The still-wide range of possible outcomes makes it challenging for treasurers to predict what the outcomes of Brexit will be for their businesses – but that doesn’t mean they shouldn’t be examining these. As Farrow notes, “The lack of clarity means treasurers should ensure they have given thought to what a ‘no deal’ Brexit would mean for them and how they would ensure continued UK-EU access in the absence of a deal.”
Understanding the impact
As a result, treasurers should consider the impact of the different possible Brexit outcomes. For example, Farrow says that a ‘hard’ Brexit could mean treasurers face material impacts on core activities. “Impacts could be felt across the spectrum of treasury activities, with many facing increased costs, increased friction or inefficiencies and potentially increased tax liabilities,” he says. “While the impacts are conceptually no greater than the complexities of doing business cross-border in other markets, treasurers used to a coherent single market with relatively low costs will need to restructure their treasury operations to mitigate these impacts.”
Profit growth at the UK’s largest companies is expected to fall by more than half in 2018.
At the other end of the spectrum, he says that in the case of a ‘soft’ Brexit, “we believe the status quo will be largely maintained and corporates will continue to be able to access financial markets across the EU and UK without material changes”. Nevertheless, Farrow also points out that there are many possible permutations within the ‘hard’ and ‘soft’ scenarios – “including the possibility that the UK could be granted continued SEPA membership even in a ‘hard’ Brexit”.
Planning for the worst-case scenario
While the final details of Brexit will become clearer in the coming months, treasurers should not be tempted to wait and see how things progress. Farrow says there is a risk that the time between an agreement being reached and the point of Brexit will be shorter than the time needed to implement mitigating strategies. As a result, “companies need to plan for the worst-case scenario and start exploring contingencies now and implement any ‘no regret’ moves”.
It goes without saying that treasurers need to make sure they are well informed about the implications that the UK’s departure from the EU will have on their businesses. David Stebbings, Director, Head of Treasury Advisory at PwC, says that a key consideration is how business models may change as a result of Brexit.
“Treasury is there because the business is there, and not the other way around,” he comments. “So if the business is amending the way it does business, your policies might not change – but the way that you do things might have to change.” He adds that changes to the business model could alter the nature of a company’s FX exposures or cash flows, meaning that FX hedging will need to be amended and cash management adjusted to take account of the new business environment.
“Our greatest focus is on regulatory developments, to which end we stay in close touch with a range of contacts at financial institutions and external counsel,” says Rick Martin, Group Treasurer at GasLog, an owner, operator and manager of liquefied natural gas carriers. “At a more general level, we monitor developments that could impact international trade, given the nature of the shipping business.” Martin notes that while there is considerable uncertainty, “we are maintaining a high degree of flexibility in our operational treasury ‘tool kit’, such that as the way forward becomes clearer, we nonetheless maximise our ability to continue operating at a high level of efficiency”.
Understanding the risks
As Brexit approaches, treasurers will need to understand the full range of possible risks and impacts. From trade tariffs to FX volatility, here are some of the areas which treasurers should be monitoring in the months ahead:
Supply chains and labour
According to Farrow of Barclays Corporate Banking, “The biggest potential impact of Brexit will be on physical supply chains, where new tariffs or restrictions could create costs or delays, and on the labour market where some employment practices may no longer be viable.” However, not all of the possible impacts are disadvantageous. As Farrow explains, “Businesses may benefit from new trade deals, a more favourable regulatory environment in the UK and the near-term benefits of sterling depreciation for UK exporters.”
FX and interest rate volatility
Eric Peterson, Director and corporate treasury services lead at KPMG UK, notes that the main issue for corporate treasurers is how to deal with the volatility which has arisen in the currency market and interest rate market from the uncertainty about how exactly Brexit will play out.
“The key aspect when we’re speaking with corporate treasurers is that they really understand their cash flows,” he says. “When you’re dealing with some of the volatility in the FX market, a lot of the outflows in your purchases are in pounds, but actually your transactions might be linked to other currencies like dollars. So if I’m buying energy, I’m probably paying pounds for energy – but that energy price is very much dependent on another currency. Commodities are similar. Then you might have outbound expenses in other currencies.”
Once treasurers have mapped their exposures and inflows, Peterson says the next step is to use value at risk (VaR) or cash flow at risk (CFaR) quantitative models to test whether a company has the flexible liquidity and the tools needed to make it through any adverse shocks. This might involve modelling a range of different scenarios to test what specific shocks could mean to the business, from losing 20% of revenue to being unable to access commercial paper.
Peterson says that that the use of quantitative analysis is a notable development. “Far more treasurers are using quantitative analysis instead of ‘back of the envelope’ types of calculation,” he says. “So they are looking at their FX risk, what that means from a CFaR perspective and what mitigations they can take – Should I enter into derivatives? Should I get additional liquidity? Do I have the right balance to make it through a period of instability?”
Treasurers should also be monitoring the impact on their companies’ cash management arrangements. Andrew Marshall, Managing Partner of Covarius, notes the importance of engaging with banks to discuss the impact of Brexit on cash pooling and sweeping structures, “in particular where eurozone cash pool structures may be swept/centralised to a London-based account”.
According to Marshall, there may be possible disruption to the normal operations of the sweeping structure. “Exactly how disruptive is unclear but the discussions need to begin with your banking partners to better clarify and understand the risks, and to start formulating a ‘Plan B’ – which may ultimately mean moving/relocating cash pool centres away from London-based accounts,” he says.
Certainty of contracts
Joe Cassidy, Partner and Brexit lead for Financial Services at KPMG UK, says that another issue relates to the certainty of contracts such as commercial contracts, insurance contracts and derivative contracts. “The only thing we’ve got any certainty on is the consumer side of insurance contracts – everything else is up in the air,” he says.
For derivative contracts used to hedge the interest rate risk and inflation risk associated with long dated bond issuance, Cassidy says that a key question will be about the basis for that contract going forward. “If you talk to regulators, our own view is that’s not a bilateral discussion about the certainty of that contract,” he says. “It’s an industry-wide global challenge, with interested parties including the reserve currency banks as well as the various jurisdictions under which the contract has been papered.”
Certainty of counterparty
Meanwhile, Cassidy says that another concern is certainty of counterparty, given that banks may be subject to “significant reconfiguration”. “They may have to get reauthorised in terms of their branches,” he says. “In a bad situation, they may need to create new subsidiaries, which may affect the quality of the counterparty you’re facing in terms of its credit risk.”
A further concern is the issue of market access. Farrow warns that in the event of a ‘hard’ Brexit, treasurers may need to make fundamental changes to their treasury models to ensure continued access to European markets, and to mitigate the increased costs of doing business. “At the extreme, some firms may even choose to relocate European treasury centres from the UK to the EU to ensure continued access,” he says.
Market access may be more problematic for some companies than for others. “The irony is that UK domiciled institutions with treasury, funding and even FCA-regulated entities domiciled in the UK are going to be the least impacted,” says Cassidy. “Those who will be most impacted are the regional corporates. If they need to access FX markets and interest rate hedging, or do some form of securitisation, those markets, on a cross-border basis, tend to be anchored in the UK.” In a worst-case scenario, Cassidy says that regional corporates could be inhibited from accessing these markets, meaning that access becomes far more expensive.
However, Cassidy also points out that corporates which have FCA-regulated entities in the UK, such as car manufacturers with consumer finance and banking capabilities, may have an advantage where market access is concerned. “This provides them with a platform to almost bypass the worst of Brexit in terms of their means of accessing capital markets, liquidity, hedging and funding,” he explains. “If you have entities in London which are regulated, you don’t have to worry about facing a weaker banking entity in continental Europe to access London markets.”
As talks continue it is important to remember that Brexit is not taking place in a vacuum – and treasurers should be monitoring a number of other geopolitical risks and developments alongside the issues specifically relating to Brexit.
“Beyond Brexit, it is clear that US politics will have a disproportionate impact on decisions for corporate treasurers,” says Farrow. “Legislatively, the recent tax changes will have a real impact on firms with US exposures, whilst politically, the Trump twitter handle will continue to shape important geopolitical issues from North Korea to the prospects for US trade and relationship with China.”
Likewise, Farrow notes that political risks in Europe include the upcoming Italian elections, as well as increasing tension in Poland. “Finally, the Middle East will always remain a focal point but particularly, the ongoing proxy war between Saudi Arabia and Iran,” he concludes.