By now, Brexit has become an inescapable reality. Hopes on the UK aborting its exit from the EU have been shattered by Theresa May’s recent speech in Mansion House. In this speech, May pleaded for a tailored regime to ensure that the British financial sector will keep access to Europe to provide financial services after Brexit finally takes its full effect. There is a lot at stake for both the UK and the EU. Financial services provide about seven per cent of UK GDP, eleven per cent of UK taxes and a million jobs. Conversely, the UK is the predominant supplier of certain financial services to the rest of the EU and is therefore sometimes dubbed the ‘EU’s Banker’. How to solve this? In this blog we will look at the options from a UK perspective.
In the months before the speech, the British financial sector (often dubbed ‘the City’ after its location in ‘the City of London’) had increasingly exerted pressure on the UK Government to provide clarity on its stance on the provision of cross-border financial services after Brexit. After Brexit takes effect, financial institutions such as investment banks, investment funds and financial infrastructure providers, will lose their European passport that allows them to freely provide services in the EU. Some 5,000 UK institutions rely on this passport to service their European clients. This is a vital part of their business. Many of them have therefore drawn up contingency plans to mitigate the negative effects of Brexit on their business. The City needs to know whether to execute these plans to ensure that implementation is complete by the time the UK exits the EU. Last week’s agreement between the UK and the EU to an additional transition period of 21 months therefore only delays the negative effects of Brexit, rather than solving them.
Although the City must have largely approved May’s call for a tailored agreement, it was not necessarily what Brussels had hoped for. From the perspective of the EU, the UK is still trying to have its cake and eat it. It is therefore unlikely that the EU will accept her proposals. The City is thus still exposed to uncertainty: how will firms be able to provide their services after Brexit? Although May has ruled out becoming a member of the EEA or a Canada-like trade agreement, there are several conceivable options.
First option: subsidiaries
Firstly, UK firms could create subsidiaries in the EU. By doing so, they would be fully licensed and supervised in an EU member state and maintain access to the European passport to cater for the needs of their clients across the EU. The flipside is that relocation will inevitably come with complexity and costs. It means that their business will have to be split into two legal entities. This is especially the case as the European Securities and Markets Authority has given notice that it will not accept ‘letter box’ entities that simply outsource their activities to their UK counterparts. Although some firms have already set up subsidiaries in the EU, it is far from an ideal option given the costs and impracticalities.
Second option: equivalence
Secondly, in case of a ‘no-deal Brexit’, financial institutions will have to rely on existing EU third-country equivalence rules, as explained in a previous blog. However, as already noted there, this option is awkward. The City has already signalled that equivalence regimes will provide too little certainty to rely on. First of all, the scope of the equivalence regime for financial services is rather narrow. The current equivalence regime mainly applies to EU wholesale markets with little relief for services to non-professional clients. Secondly, the equivalence rules are fragmented along different regulatory instruments. Technically, it will not be difficult for the EU to issue the various equivalence decisions needed. However, it remains a (political) decision that is subject to the discretion of the EU Commission and can be withdrawn at any time. The Commission has already signalled that equivalence is not a given and has even proposed stricter changes to the investment firms equivalence regime. Moreover, even if the EU would be willing to commence equivalence procedures before Brexit, there will be a significant delay as previous equivalence procedures have lasted up to two years.
Third option: reverse solicitation-rules
In the same scenario, UK firms could rely on reverse solicitation-rules in EU legislation. These rules entail that cross-border services can be provided if a sophisticated EU investor solicits the firm to provide those services at its own initiative. This may present a solution for wholesale investment services to a very limited number of clients. The main objection to this solution is that it will severely constrain firms’ marketing activities. Any marketing to EU clients by UK firms will trigger the EU rules for providing financial services and thus the need for an EU license or permission.
Fourth option: horizontal equivalence regime
Another option, which has particularly been suggested by academics such as J. Armour and N. Moloney, is that the EU will, or will be enticed to, create a new ‘horizontal’ equivalence regime that encompasses all financial services. It would provide the opportunity to address the flaws associated with the current patchwork of equivalence provisions. Politicians at the Brexit negotiation table seem, however, not to have moved in this direction. Even if they would decide to do so at this point, it will be questionable if the new regime could be completed in time, as it requires the amendment of all relevant EU directives and regulations. This political cold-shouldering is particularly salient as the UK traditionally was one of the member states opposing an EU-wide policy for access by third country firms to the EU market.
Fifth: tailored agreement
Finally, a tailored regime for financial services could be agreed upon by the UK and EU. This is what May suggested in her speech. In her vision, this would entail ‘the ability to access each other’s markets, (…) maintaining the same regulatory outcomes over time, with a mechanism for determining proportionate consequences where they are not maintained’. Furthermore, May called for ‘a collaborative, objective framework that is reciprocal, mutually agreed, and permanent and therefore reliable for business’. For an EU trade agreement this would be ground-breaking as it would entail mutual recognition between regulators. For that reason it was also immediately rejected by Brussels because mutual recognition is unique to the single market. Professor Niamh Moloney (LSE) recently commented that she deemed it unlikely that the EU would accept a tailored agreement, save perhaps for certain services that are vital to the EU – think of financial infrastructures. Nonetheless, this is the kind of option the City is hoping for. Recent industry reports have called for similar outcomes.
It will be interesting to see how things play out. Both the UK and EU have significant interests in a workable solution. For now, however, they do not seem to be seeing eye to eye. The EU seems to steer towards current equivalence regimes or relocation, whereas the UK prefers an agreement tailored to financial services. And we must not forget about a third determinant factor: time. The EU has indicated it wants a deal by October 2018 in order for national parliaments to be able to endorse it. With October creeping up and no substantial breakthroughs in the negotiations, the probability of a ‘no-deal Brexit’ increases by the day. Even though a transition agreement has now been reached, this would succumb financial institutions to the mercy of the EU Commission or force them to relocate after the transition period. This week the City therefore only obtained more time to consider the latter option…