The need for a new legal framework
The EU is firmly opposed to replicating the European passport, on the ground that this would offer the UK financial services sector the benefits of single market membership without the costs. Unless the UK joins the EEA as soon as it leaves the EU – a scenario envisaged by a number of Europhiles but rejected by Brexiters as limiting the UK’s independence – Brexit will strip 8,008[13] British companies that currently hold at least one European passport of their ability to trade freely in financial services with the 30 other EEA member states and to set up offices in those countries. Reciprocally, 5,476 companies in the EEA will also face significant losses given the importance of the UK in the field of financial services. Thus, bankers from the rest of the EEA will have to repatriate their sellers. Banks originating from the UK and third countries that have previously used London as a bridgehead to trade with the EEA will have to go through subsidiaries in the other 30 EEA members.
The continuity of contract should be ensured
Immediately following Brexit, most of the contracts existing pre-Brexit between the UK and the EEA will remain valid for their remaining term. This will be true even in the event of a hard Brexit, as indicated by the Legal High Committee for Financial Markets of Paris (Haut Comité Juridique de la place financière de Paris - HCJP), the European Insurance and Occupational Pensions Authority (EIOPA) and the Autorité de Contrôle Prudentiel et de Régulation (ACPR).
The European and British authorities already have taken initiatives in this sense for clearing and insurance activities. In order to ensure financial stability, the European Commission (EC) has granted a 12-months reprieve to clearing houses established in the UK continue to serve their EEA customers in the event of a no-deal Brexit. The BoE also estimates that the GBP 55 bn in insurance contracts between the UK and the rest of the EEA parties have essentially been transferred to the EU (most often by subrogating to the UK part one of its subsidiaries established in the EU) to ensure their viability. In any case, they will be covered by two Memorandum of Understanding (MoU) signed by UK supervisors and those from the rest of EEA. They aim to foster supervisory cooperation, enforcement an information exchange in the insurance sector. They will only come into force in case of hard Brexit.
The same is true for the three MoUs concluded between the European Securities and Markets Authority (ESMA) and the FCA:
- The first relates to the supervision of ratings agencies and trade repositories and will allow ESMA to continue its work.
- The second concerns the sharing of information between the FCA and national regulators in the EU on subjects such as market supervision and asset management. It will allow continued delegated fund management, for EEA clients, by entities established in the UK.
- Lastly, a third MoU relates to the recognition of clearing houses and central depositories installed in the UK, in order to minimise the shock for markets of a possible hard Brexit on April 12, 2019. It also allows UK central depositories to continue to handle Irish securities.
With or without a withdrawal deal, the United Kingdom will become a third country
In leaving the EU, the UK will become a third country and will face significant barriers to trade in financial services. UK companies, having lost their European passports, will have to submit to the equivalence regimes already in place in certain market segments, if they wish to continue to trade with the EEA or conduct business there directly without establishing a subsidiary. For the other businesses, relationships between the UK and the EEA would primarily be governed by World Trade Organisation (WTO) rules, unless a bilateral agreement is concluded covering the sector.
For several months, the City of London has argued that trade in financial services after Brexit should follow the principle of mutual recognition[14], which it believes is an intermediate solution between the European passport and the equivalence regime. However, Theresa May chose not to include this option in her White Paper of 12 July 2018, preferring an enlarged system of equivalence on the basis that this would be consistent with the legal independence of both the UK and the EU and that it would be easily achievable and would help reassure markets. This proposal has not so far received EU support and nothing has been revealed relating to the operational scope of the proposed enlargements.
In November 2018, a political declaration from UK and EU heads of state on the future relationship between the EU and the UK was published alongside the draft withdrawal agreement. The financial sector is evoked through four of its principles:
- Preservation of financial stability and market integrity, the protection of investors and consumers and of fair competition.
- Respect for the respective regulatory and decision-making autonomy of the parties and of equivalence decisions being made as a function of their interests.
- Commitment of the parties to close cooperation in the regulation and supervision of international agents.
- Consideration of equivalence decisions from the date of the UK’s withdrawal with the aim of these being concluded by June 2020, bearing in mind that removal of equivalence must be transparent.
The principle of equivalence is particular to each legislative act and must be appropriate to the market concerned[15]
Where they exist, equivalence regimes are drawn up by the European Commission with contributions from the EBA, EIOPA and ESMA[16] depending on the business segment concerned. The Commission’s approach in deciding whether or not to award equivalence is based on a comparison between the spirit and effects of the legal framework in the EU, on the one hand, and in the third country on the other. In theory, even an exact transposition of European legislation into the law of a third country does not guarantee that an equivalence regime will be granted. Thus, decisions on the award of equivalence are not limited to mechanical criteria alone. In granting equivalence, the European Commission seeks, in effect, to evaluate the risk its economic agents will be exposed to in trading with financial agents from third countries. Therefore it consider it can be particularly strict in equivalence decisions with regard to the UK, given the weight of the British finance sector and the exposure to risk that this implies for EEA agents.
The equivalence regimes are based on the different types of European passport and presuppose a relative concordance of prudential requirements and supervision between the EU and the third country considered.
Equivalence regimes are very different from each other and do not exist at all for certain areas of financial services (such as retail banking or investment services). In practice, UK firms would have to complete processes with European and/or national authorities depending on the type of activities that they want to conduct (see Table 1). Equivalence regimes applicable to a third country are partial in that they do not necessarily give the same rights as a European passport, and may be geographically limited depending on whether they are awarded by the European Commission or a member state. Lastly, equivalence can be withdrawn at any time – at 30 days’ notice – if the granting authority considers that the beneficiary country has diverged from European regulation. The European legislator has recently highlighted the need to move towards a harmonisation of practice within the member states given the already high, and growing, interconnection between financial markets.
Insurance activities (under IMD and Solvency passports) on the one hand, and securities businesses (under the MiFID passport) on the other, have the largest number of businesses operating under passports that could benefit from a partial equivalence regime granted by the European Commission following Brexit. A section of business dependent on IMD and MiFID passports could continue across the EEA (on condition that they are accepted by the relevant European authorities) but it is likely that numerous insurance policies would have to be relocated to the client’s country of residence. Meanwhile, certain banking activities, such as retail banking, are not covered by an equivalence regime[17].
The principle of equivalence regimes assumes a base of common rules that contributes to the smooth functioning of the financial markets. It therefore ask for a matching of the prudential requirements an dht supervision of a country with that of the country in which it seeks equivalences. In practice, this assumes that the prudential requirements and banking and financial supervision applied by the UK do not differ significantly from those of the EU. This is a sticking point between the Treasury and the BoE, with the former wishing to converge with the European spirit in this area in order to increase the probability of receiving equivalence and the latter seeking to defend its prerogatives. This is also the reason for the EU’s rejection of Theresa May’s enlarged equivalence proposals, arguing that they would link EEA and UK regulation too tightly.
The UK would keep a regulatory framework close to that of the EU
The Treasury plans to draw on a major survey it has carried out amongst sector stakeholders to determine whether it would be acceptable to continue to conform to the EU regulatory framework for financial services or rather to diverge from it. For the time being, the UK’s plan seems to be moving towards continued convergence with the EU framework, if only to guarantee the continuity of operations. Thus, the Treasury uses Statutory Instruments (SIs) to remove from British law reference to the texts and supervisors of the EU.
In addition, a law has been adopted in the UK in favour of a temporary authorization and recognition scheme whereby EEA markets agents will be able to practice in the UK for three years, provided they obtain the renewal of the authorization each year. The PRA has also reformed its approach to the supervision and accreditation of banks, insurance companies and clearing houses from the EEA such that non-systemically important branches (those with assets, including intra-group assets, of less than GBP 15 bn) must declare their activities in order to continue to conduct them.
Concern removed for clearing businesses
In September 2009, G20 heads of state expressed their desire that all transactions in standardised derivatives should be handled by a clearing house, as was already the case for transactions made on organised markets. In the European Union this resulted in the EMIR regulation (see Table 1) and the encouragement of the development of clearing houses.
The United Kingdom: the world’s largest OTC derivatives market
The derivatives market has been examined in a number of surveys by the Bank for International Settlements (BIS). Its triennial surveys are the biggest, covering 54 countries around the world. In 2016 the survey estimated that the notional value of daily OTC transactions for forex and interest rate derivatives alone was USD 9,553 bn (see Chart 6).
BIS’s more frequent half-yearly surveys cover 13 countries and in 2016 suggested that global outstanding OTC derivatives had a market value of USD 36.1 trillion. At the time, clearing houses covered 39% of the market (or 62% in terms of notional values, see Chart 7).