As the March 29, 2019 deadline approaches, the United Kingdom prepares its withdrawal from the European Union amidst political turbulence that would suit a television drama. Center stage is what to do about the financial services industry. For the UK as well as the European continent, it makes the most sense to keep Europe’s financial sector integrated with the UK and to be pragmatic in interpreting the EU Treaty on the Single Market freedoms.
UK Financial Services
The UK openly seeks an arrangement acceptable to the EU. The latest UK White Paper proposes to stay in the EU’s Single Market and customs union for goods, while leaving open the contentious issue of services. A Brexit deal on goods is very much in the EU’s interest: The UK has a large trade deficit with the EU on goods ($121 billion) but a surplus of $35.69 billion on trade in services. Finance employs about 1.1 million people in the UK, roughly 3.2 percent of the total UK workforce. As a sector, the UK financial services sector accounts for around 6.5 percent of national economic output ($156.7 billion). Financial businesses in London generate 50 percent of this output. If London alone had decided on the 2016 Brexit referendum, this post about the regulation following Brexit would not have existed. London is the financial centre of the UK but also of the European Union. About 75 percent of all euro-denominated derivative contracts are cleared in London, representing approximately €850 billion a day. About 44 percent ($35.2 billion) of total UK financial services exports goes to the EU, and 39 percent ($14.5 billion) of financial services imports to the UK originate in the EU. Both the UK and EU have a lot to lose if financial services are confined within the new legal borders of the UK. Indeed, two years ago the International Monetary Fund (IMF) described financial stability in the UK as a “global public good”.
Firms’ Access to Cross-Border Markets Within the EU
UK authorized financial firms (including global players from Japan, the United States, and China) have swift access to the rest of the EU market through the use of “passporting” rights. This allows those firms to provide services into and within the EU either on a direct cross-border basis or by setting up a branch in another EU country without the need for a subsidiary or separate licensing in that country. Passporting departs from the “single license” concept, based on the Freedom of Establishment and the Freedom of Services as established by primary EU law. While the post-Brexit regulatory framework is still up for debate between the UK and the EU, banks and other financial services firms are anticipating a wide range of possible outcomes in their Brexit contingency plans. The outcome can still be between a no-deal or “hard Brexit,” implying restricted access to the EU market for UK firms, and a “softer Brexit” that allows for more EU-UK regulatory convergence.
Passporting is unacceptable to the EU. It is clear that the current passporting available to UK firms will cease to exist after Brexit. The EU unambiguously dismissed that option in November 2017, echoed by the UK in its July 2018 White Paper (p. 29). Today, in the absence of an EU-UK trade deal, firms are weighing their options and taking precautionary restructuring initiatives to continue their operations in the EU for the post-Brexit scenarios. The most obvious options are branching and establishing a subsidiary that is incorporated and licensed in one of the remaining 27 EU states.
Branching without passporting requires local authorization by the national authorities of the respective EU member state, with different standards in each country. Authorization standards relate to corporate governance requirements, staffing, and often capital and liquidity conditions that also apply to locally incorporated banks. Establishing a branch can be a tedious process, while the ability to serve clients is limited to that EU country. A non-EU branch in the EU has no right to “passport” services to other EU countries, meaning that firms will need to go through the process of establishing a branch for each EU country they operate in.
Where the process of branches is too inefficient, UK authorized (non-EU) firms can open subsidiaries that are incorporated and licensed in an EU state. This allows for passporting across the EU. The downside is that developing the required deployable capital and operational capacities are significant investments that may take years.
Suboptimal solutions under the current EU laws. National licensing regimes such as establishing branches or subsidiaries can mitigate the immediate disruption and uncertainty when the UK and EU fail to agree on a post-Brexit financial services arrangement. However, both seem sub-optimal long-term solutions for firms that currently operate under the passporting regime.
Equivalence as a More Structural Solution
A more structural approach under the currently available EU laws would be to grant third-country (non-EU member) equivalence for UK-origin financial services. Last April, the EU’s finance commissioner explicitly recognized this option in the context of Brexit. Equivalence implies a process whereby the European Commission assesses whether the regulatory, supervisory, and enforcement regimes of a non-EU country are comparable to those in the EU. That assessment often involves negotiations with each non-EU country, sometimes requiring that country to make its regulations compatible with EU rules. The current process under EU financial law is unworkable. It not only applies under limited circumstances, whether a regulatory regime is up to EU standards is completely within the discretion of the European Commission. The UK surely wants to avoid having financial services regulations dictated by EU regulators.
After the EU rejected the UK’s proposal for mutual recognition of each other’s financial regulatory framework, the UK aimed for an expanded version of the existing enhanced equivalence model, an approach that would likely restrict UK firms’ access to the EU more than mutual recognition would. It would however be more realistic, as it won’t require an entirely new EU regime.
The UK’s latest proposal for enhanced equivalence is “based on the principle of autonomy for each party over decisions regarding access to its market, with a bilateral framework of treaty-based commitments to underpin the operation of the relationship, ensure transparency and stability, and promote cooperation.” In more detail, the negotiations will address:
- A framework for cross-border and national reciprocal supervisory cooperation, including the sharing of data and crisis management;
- Provisions for (cross-border) services that fall outside of the existing EU equivalence regimes;
- Mediated procedures for when alleged rule divergence comprises equivalence, to ensure predictability and transparency for businesses.
A balanced and efficient UK-EU enhanced equivalence regime demands an apolitical, bipartisan forum that can resolve differences between UK and EU laws. It also requires the creation of a long-term EU-UK framework, balancing the needs for convergence with the respect for sovereignty.
An invitation to the EU
While waiting for an EU proposal, the UK introduced precautionary measures to avoid disruption among passporting EU firms and funds in the UK. If there is no implementation period after the UK leaves the EU in March 2019, the UK will grant temporary permission to EU firms for continuity of cross-border financial services in the UK.
In the long run, both the EU and UK benefit from mitigating the risk of regulatory arbitrage in financial services, but some EU countries wouldn’t mind attracting firms from London to, say, Frankfurt or Paris. Other countries are more open to the UK. For example, the Netherlands is proposing new national legislation that would enable the designation of non-EU settlement systems for local purposes.
The EU should embrace the idea of equivalence, not only to stay consistent with its existing policies, but also to avoid unnecessary fragmentation of European financial markets. It is due process and predictability that render enhanced equivalence a “frame of reference” and not a short-term fix. The EU and UK will negotiate post-Brexit financial services with coordinated regulatory frameworks, as well as strong supervisory collaboration practices. The latter is especially at risk and a loss for the EU if no deal is reached, which is unlikely but still possible. To the benefit of the UK as well as the EU, is there enough trust left after the past negotiations?
 After the so called “soft-Brexit” Chequers deal on Brexit within the UK cabinet, in the second week of July, two cabinet ministers resigned within a 24-hours: Foreign Secretary Boris Johnson and Secretary for Exiting the European Union David Davis. Their departure was followed by that of two Tory vice-chairs.
 UK Government (July 2018), “White Paper: The future relationship between the United Kingdom and the European Union,” available at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/725288/The_future_relationship_between_the_United_Kingdom_and_the_European_Union.pdf.
 Statistics on UK-EU Trade, available at: https://researchbriefings.parliament.uk/ResearchBriefing/Summary/CBP-7851.
 Tim Edmonds (June 28, 2018), ”Brexit & Financial Services,” House of Commons Library Briefing Paper (07628).
 IMF (June 2016), ”UK financial system stability assessment,” p. 6. Available at: https://www.imf.org/external/pubs/ft/scr/2016/cr16167.pdf.
 Firms that can passport their services are alternative investment fund managers (AIFMs) such as hedge funds, private equity firms, credit intermediaries and institutions, electronic money institutions, insurers and reinsurers, insurance intermediaries, investment firms, payment institutions, and UCITS managers.
 For example, UCITSs are regulated investment products established and authorized under an EU legal framework. When a UCITS is authorized by a regulatory authority of an EU member, it can be promoted and sold to investors throughout the EU based on passporting.
 In the words of the EU chief negotiator Michel Barnier: “The legal consequence of Brexit is that UK financial service providers lose their EU passport. This passport allows them to offer their services to a market of 500 million consumers and 22 million businesses.” See: Michel Barnier (November 20, 2018), Speech at the Centre for European Reform on ‘The Future of the EU’, available at: http://europa.eu/rapid/press-release_SPEECH-17-4765_en.htm.
 Valdis Dombrovskis (April 24, 2018), “Speech by Vice-President Valdis Dombrovskis at City Week in London,” available at: http://europa.eu/rapid/press-release_SPEECH-18-3523_en.htm.
 To make it even patchier, for older financial instruments, the national supervisory authorities decide on equivalence. See country-level data on equivalence decisions by the EU, as published by the European Commission: https://ec.europa.eu/info/sites/info/files/overview-table-equivalence-decisions_en.pdf.
 Under current EU laws, most core banking and financial activities (especially those involving retail clients) are outside the equivalence regime for access to the single market. This includes the laws on key activities such as deposit-taking in accordance with the Capital Requirements Directive; Lending in accordance with the Capital Requirements Directive; Payment Services in accordance with the Payment Services Directive; and Investment services to retail clients.
 The concept of enhanced equivalence is developed by UK lawyer Barney Reynolds (2017), ”The Art of No Deal. How Best to Navigate Brexit for Financial Services,” Politeia, available at: https://www.shearman.com/-/media/Files/Perspectives/2017/11/Reynolds-Barnabas-The-Art-of-the-No-Deal–How-Best-to-Navigate-Brexit-for-Financial-Services.pdf?la=en&hash=E254B49B801FE2BE2C69F0E6A9C32B54F3EFEE66.
 UK Government (July 2018), ‘White Paper: The future relationship between the United Kingdom and the European Union’, p. 30, available at: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/725288/The_future_relationship_between_the_United_Kingdom_and_the_European_Union.pdf.
 HMT statement (June 27, 2018), available at: https://www.gov.uk/government/publications/financial-services-legislation-under-the-eu-withdrawal-act; FCA statement, available at (July 24, 2018), available at: https://www.fca.org.uk/markets/eu-withdrawal/temporary-permissions-regime.
 Barnabas Reynolds, ‘Brexit Equivalence Model’, available at: https://www.shearman.com/perspectives/2018/08/brexit-equivalence-model.
 HMT statement (August 23, 2018), available at: https://www.gov.uk/government/publications/banking-insurance-and-other-financial-services-if-theres-no-brexit-deal/banking-insurance-and-other-financial-services-if-theres-no-brexit-deal, see also Bank of England’s Governor Mark Carney warning for the economic chaos following a no-deal scenario (September 13, 2018), https://www.ft.com/content/984b15e0-b76b-11e8-bbc3-ccd7de085ffe.
This post comes to us from Georges Ugeux, chairman and CEO of Galileo Global Advisors and a lecturer in law at Columbia Law School.