This is the second in a series of articles looking at the regulatory framework for financial services after Brexit.
The new framework will have four main sources which we will look at in turn. These are:
- The UK/EU Free Trade Agreement;
- The regulatory regime in the host state – partly derived from common EU regulation but with key areas left to differing domestic law;
- Improved access and other mutual recognition benefits resulting from any EU/UK ‘equivalence’ decisions; and
- Any transitional measures intended to smooth the impact of the UK’s exit.
1. The UK/EU Free Trade Agreement
We do not know how the new UK/EU relationship will be structured. There may be an over-arching framework to link treaties or agreements in different areas. This might be a form of ‘Association Agreement’. The Political Declaration talks of an ‘economic partnership’ and it is assumed that this will include a Free Trade Agreement covering financial services.
The terms of the agreement are unlikely to provide financial services firms with mutual recognition or similar benefits. Indeed, the agreement is likely to be of more interest to regulators and government departments than to financial services firms. The agreement is expected to address two separate areas relating to financial services: (a) a WTO/GATS agreement on services; and (b) a structure and process for regulatory and supervisory cooperation. These are relatively normal free trade agreement provisions.
The new UK/EU agreement is not expected to offer any commitment to regulatory mutual recognition or any replacement for single market home state recognition. It will, however, provide new processes and procedures for cooperation between Government/UK regulators and the European Commission and the European Supervisory Authorities.
2. The regulatory regime in the host state
Financial services firms with EU cross-border business have been planning for a no deal exit from the EU and are now looking ahead to 2021. For most firms the UK/EU agreement will have little direct impact on their restructuring for exit day. The critical driver has been, and remains, compliance with the regulatory regime of the host state(s), particularly as it applies to third-country firms.
Third-country firm regulation is in many respects not harmonised under single market legislation. Member States have considerable discretion in many critical areas, including the extent to which they permit third-country firms to access their domestic market on a services/cross-border basis from their home state.
The UK regime for third-country firms is generally more relaxed than in many European States. Certain activities with UK counterparties/clients fall outside the regulatory perimeter, there is a generous overseas persons exemption for cross-border wholesale/commercial business and the UK is generally quite open to the use of a local branch (rather than requiring a local subsidiary).
Many other European States have a much more restrictive approach to third-country firms, often requiring third-country firms to ‘on-shore’ and operate via a local subsidiary or branch. Some have limited national registration regimes to permit certain activities. These anomalies (and other differences in local regulation) will be applicable to UK firms under the new framework.
UK firms have been wrestling with the switch from single market to third-country firm regulation in the European States where they are based or where they have clients and counterparties. Another important consideration has been the treatment of groups, particularly the treatment of UK groups which will fall under EU third-country firm regulation. The EU has toughened its approach in response to Brexit, particularly in the context of UK groups looking to minimise the transfer of their operations to subsidiaries in the EU.
3. Improved access and other mutual recognition benefits resulting from any EU/UK ‘equivalence’ decisions.
Our 2017 report looked in detail at the EU legislation with so-called ‘equivalence’ provisions for third-country firms. EU harmonisation in this area involves some requirements which are common to all third-countries and others which have a differentiated approach depending on whether the third-country has been judged to have regulation equivalent to EU requirements. At the end of the transitional period, the UK will have a mirror set of the EU’s equivalence provisions (on-shored via the domestic withdrawal legislation) and so can offer the EU a full set of equivalence-based mutual recognition.
The equivalence provisions have been much debated in the UK. As an alternative to single market arrangements and passporting, they are seen as unsatisfactory and a poor alternative because only a few provide real mutual recognition which assists or opens up market access, they are patchy in terms of sectoral coverage and offer no recognition/access in many important sectors. In some cases the criteria have been toughened up in response to Brexit – increasing fears that the UK would need to follow detailed EU rules in at least some areas – and the process of evaluation is seen as lacking objectivity and transparency because the EU reserves the right to grant, refuse or revoke equivalence in its own interest.
Whilst all these points are well made, for some areas, EU equivalence decisions would provide distinct advantages and, in some cases, provide what might be regarded as important, or even critical, mutual recognition-based access for UK firms and market infrastructure. The Chequers White Paper did not seek treaty-based mutual recognition but suggested that the EU might be persuaded to broaden the scope of mutual recognition available to third countries generally and to agree treaty provisions with the UK relating to equivalence decision making, to increase transparency and provide UK firms with a less uncertain outlook. The Political Declaration text does not contain any hint of the UK proposal on broadening the scope of equivalence based mutual recognition. Indeed, the text leaves each side to broaden or restrict the regime as it pleases.
The Political Declaration text envisages that the UK/EU cooperation processes and procedures – which might operate under a ‘Joint EU - UK financial regulatory forum’ – will have a role in liaising and consulting over equivalence decision making. This is helpful but the EU believes that the Free Trade Agreement will not restrict the EU’s freedom to act ‘autonomously’ ‘in the protection of its own interests’.
The Political Declaration text provides for each side to conduct equivalence assessments with a view to these being completed by 30 June this year. The timetable has not been adjusted, so this is now only 5 months away. The text however is not binding and is carefully worded so as not to include any confirmation that equivalence decisions will actually be granted.
The EU’s position on equivalence is something of a charade. First, the talk of equivalence being ‘discretionary’ and decision making ‘autonomous’ ‘in protection of its own interests’ is a code for the EU’s use of equivalence (i.e. the threat of not granting/withdrawing equivalence) as a broader political or trade policy tool. Whilst documentation is always carefully crafted to suggest objective criteria, the EU has shown (for example in recent dealings with Switzerland and with the UK over no deal planning) that equivalence is used as a trade tool to secure objectives both in the context of financial services and beyond.
Secondly, there can, of course, be no doubt that the UK will be fully equivalent – if not super-equivalent. At the end of the Transitional Period, the UK will have an exact mirror of EU regulation with greatly superior supervision than many EU states. The question will be over potential UK divergence after the Transitional Period (in relation to both future and current EU requirements). This is, of course, a contentious issue for the Government and Mr. Johnson. Equivalence decisions will feature in the negotiations and the UK, in particular, will be looking to secure these in time for single market exit.
4. Any transitional measures intended to smooth the impact of single market exit (either unilateral or bilateral under the Free Trade Agreement)
It is clear that there will be a dramatic change when the UK exits the EU’s single market. Extensive single market mutual recognition, such as passporting, between the UK and the EU Member States will be turned off. Normally one would hope that such a substantial change would be accompanied by transitional measures, particularly when firms may be uncertain about the timing and exact impact of the change until shortly before single market exit. The Political Declaration text on financial services makes no reference, however, to agreement of bilateral transitional measures. It is not, apparently, even a UK ambition and the EU has made no reference to this possibility. It perhaps cannot be ruled out, but it does not appear likely.
It therefore seems that even on a smooth path, with a Free Trade Agreement covering financial services in effect from single market exit, financial services firms may face a sudden loss of mutual recognition. Therefore the critical questions are:
- For firms/market infrastructure which stand to benefit from equivalence decisions – whether the relevant equivalent decisions are in effect (even if only on a temporary or time-limited basis); and
- Whether there are (other) transitional measures in effect, most likely under the regulatory regime of the relevant host state.
In the preparations for exit without a withdrawal agreement transitional period, the UK put in place broad and generous temporary regimes which maintained single market passporting for EU firms on a unilateral basis to give firms time to restructure. The EU did not reciprocate, although some EU States did adopt limited transitional measures under their national regimes.
In our next article, we will look at the factors in play in the negotiations, the potential outcomes and the likely asymmetry between the open position of the UK market for EU firms and the more protected restrictive position faced by UK firms in the EU.