Once Brexit takes effect and if the United Kingdom (UK) and the European Union (EU) do not reach an agreement on the conditions for mutual trade, financial institutions (such as investment firms and banks) based in the City of London will lose their European passport. This passport currently grants them easy access to European clients to provide cross-border financial services. The UK will no longer be part of the EU and will become a ‘third country’ in terms of the relevant EU financial regulation. Both the UK and the EU are now looking into options to mitigate the negative effects of Brexit on the financial sector. This is important to both the EU and the UK, because the EU as well as the UK financial sectors heavily rely on the passporting regime in order to provide financial services cross border.
Negative effects of Brexit
Financial institutions located in a third country are required to comply with the EU rules when they wish to engage in financial services and activities for EU clients. After Brexit, UK firms will therefore be required to be authorised by an EU supervisory authority in addition to their UK license. As a result, these firms will become subject to ongoing supervision by such EU authority in addition to the UK supervisory authorities. Conversely, EU financial service providers will also suffer from a Brexit. They will lose their access to the UK provided to them by the European passport. Also, they will need to comply with more burdensome reporting requirements for trading, clearing and settlement of financial instruments on the London exchanges.
UK financial regulation = EU financial regulation? The question of equivalence
According to news reports, the City of London hopes to mitigate these negative effects of Brexit by way of a European Commission decision to declare the UK regulatory and supervisory arrangements for the financial sector to be equivalent to the EU regime. Such decision should reduce the dual compliance burden.
Would it be realistic for the UK to rely on being granted such an equivalence decision?
It would seem so at first glance. Firstly, because the UK is currently part of the EU and therefore has implemented all EU legislation for the financial sector. Current UK financial regulation is not just equivalent, but reflects the current EU rules. Secondly, the UK government expressed its intention to ‘copy and paste’ the EU legal framework for the financial sector into the new UK rulebook that will apply post Brexit. Thirdly, the UK Financial Conduct Authority (FCA) is a respected supervisory authority and regulator within the EU.
However, notwithstanding the above, it is the sole discretion of the EU Commission to declare a third-country regulatory regime equivalent. Neither the UK nor any other third country has a right to demand it. A Commission decision on equivalence is not only a political decision, but also a favour. The conditions under which the UK maintains its access to the EU is part of the overall Brexit negotiations, with the EU holding a strong card. Also, note that the Commission may revoke its decision at any time. This will require the UK to keep updating their UK rulebook to any new EU financial rules, while not having a say in the EU legislative process.
What relief will an equivalence decision bring?
For those of you who are interested in more details, a Brexit under the ‘equivalence’ scenario will have the following impact on financial institutions operating on EU and London capital markets:
- UK financial institutions will be allowed to cater for professional investors throughout the EU only if the European Commission will declare the UK rules and supervision to be equivalent to MiFID II. But Member States will have national discretion to allow UK financial institutions to provide services limited to their territory to EU retail investors (and to EU professional investors in the absence of an equivalence decision);
- EU financial institutions may benefit from a possible EU Commission equivalence decision for the calculation of credit risk of UK lenders and UK counterparties (whilst the rules that apply to third-country lenders and counterparties are more burdensome);
- When trading on London trading venues, EU financial institutions and companies may benefit from a possible EU Commission equivalence decision for compliance with trading, reporting and clearing obligations under MiFIR and EMIR; and
- UK Alternative Investment Funds will either need an EU Alternative Investment Fund Manager (AIFM) to market their units or shares to professional investors, or they need to be authorised by the national authorities of the Member State where they wish to pursue their activities. The Commission might adopt a third-country regime under the AIFM Directive where the supervisory authorities of the ‘Member State of reference’ can issue EU-wide passports.