The UK’s economic future outside the EU is nowhere near as bleak as it has been painted. A considered approach would mean a smooth transition to a post-Brexit world, says Barnabas Reynolds.

Barnabas Reynolds embedded

Post-Brexit referendum commentary has been, on balance, negative, anticipating disaster for the UK financial community, particularly for banks and investment banks in the City but also for fund managers and others. This is neither constructive nor the inevitable impact of Brexit on the City. The current legal underpinnings for the City are in fact likely either to continue, or to be replaced by a system which achieves quite similar outcomes.

The implications for the City hinge on the future of the so-called ‘services passport’, which allows institutions licensed in one EU member state to provide cross-border services into another EU member state without establishing a presence in that state. A firm exercising passport rights does not need additional regulatory approvals in the EU and is regulated only by its home member state regulators.

For a UK firm, the regulators are the Prudential Regulatory Authority and/or the Financial Conduct Authority. The investment business passport covers much of cross-border EU activity taking place from the City. There are passports available for banking, insurance, payment services, exchanges, fund management, credit ratings agencies and other businesses under various EU regulations and directives.

Two options

To maintain the City’s position as a global centre for finance, the UK needs to consider its position within the global regulatory architecture post-Brexit and how it wishes to fit in with EU and US regulatory arrangements. As regards its relationship with Europe, there are two basic options.

The first option is that the UK negotiates a version of the existing passport arrangements, which would likely involve not only continuing the application of all existing EU financial services laws and regulations but also generally adopting them going forwards. If the UK were to sign up to the European Economic Area (EEA), this would bring with it the passports for almost all activities. The current EEA arrangements would need to be modified somewhat. There would need to be new working arrangements established between the UK and EU regulators and collaboration on rulemaking such that the UK extricated itself from supranational oversight. Furthermore, the EEA framework brings with it the requirement for freedom of movement of persons, which is likely to need significant adjustment if this option is to be politically acceptable.

The second option for the UK is to adopt an equivalence-based route. Many EU directives and regulations on financial markets contain equivalence provisions, due to post-credit crunch global initiatives to remove regulatory arbitrage and provide for effective management of cross-border systemic risk. The US interacts with the EU under equivalence frameworks, most notably for reinsurance and derivatives central counterparties. By this route, the UK could either go for a quick solution or a more negotiated one. The quick solution would be to implement almost all EU laws and regulations for the financial sector as is, which would likely result in close to automatic recognition from the outset. Identical (or nearly identical) implementation going forward would require minimal effort and be uncontentious.

The alternative is to take the lengthier approach of adapting some aspects of current European laws and regulations for the City, removing or amending points that are unnecessary and which are not perceived to be business friendly. There would be a more line-by-line examination of the new laws to verify they achieve similar outcomes overall.

Reciprocal arrangements

EU financial institutions will want continuing access to the City of London and so reciprocity in the above approaches would need to be put in place.

Critics have talked down the above options. In relation to passporting, they say that this would involve applying laws the UK has had no influence over, having no seat at the table. However, this rejects the possibility of a solution involving joint law-making in this area. Given that most EU financial services laws have been drafted by or heavily influenced by the UK, and the status of the City as the largest market covered by these laws, some collaborative arrangement ought to be practicable going forward. Furthermore, much rule making is driven by the G20, the Financial Stability Board and International Organization of Securities Commissions (Iosco), where the UK has a very influential voice.

Another criticism is that equivalence also involves implementing EU laws pretty much to the letter in order to obtain access. This is not the case. Experience of equivalence under the European Markets and Infrastructure Regulation, where equivalence has been granted for central counterparty derivatives regulation for the US, Mexico, Singapore, Switzerland and others, shows that the process does not require identical laws and regulations. It is a mature process between sovereign jurisdictions designed to ensure there is little or no regulatory arbitrage but does not involve dictating standards for third country states.

The Markets in Financial Instruments Directive (MiFID II), which is due to come into effect in January 2018 and covers investment business, contains an equivalence regime for third country entities, which would apply to UK-headquartered entities post-Brexit. Under MiFID II, equivalence decisions will be outcomes-based. International standards are invoked, for instance by a requirement for the European Commission to take into account the Iosco principles for securities regulation.

Size matters

It is also said that the UK will be at the back of the queue for any equivalence determinations. However, the EU has stated in the preamble to MiFID II that it will consider the size and importance of the relevant markets when prioritising its equivalence work. Some then assert that the equivalence process requires undue ongoing effort. Yet that effort has the obvious and worthwhile side-effect of having sovereignty in making one’s own laws and regulations.

There are areas that are not currently subject to the equivalence regime, such as cross-border lending, insurance mediation, Undertakings for Collective Investment in Transferable Securities (Ucits) funds and trade repositories. Primary insurance can be added to that list, although there is an equivalence-based regime for access to the EU to some extent, for local EU-entity solvency and supervision issues at group level. But there are potentially structural solutions available to each of these areas, which involve limited adjustments to current set-ups.

Lending is often said to be the most problematic point to deal with. However, this is permissible into various EU member states in all sorts of different ways that the City has found for US institutions operating outside the current passport arrangements, such as using sub-participations and bonds. A non-EU Ucits fund would become an alternative investment fund, and there is a passporting regime for such funds.  Fund management of Ucits (and indeed other funds) can be delegated back from an EU fund manager to an entity based in the UK. And so on.

Additional costs

The question is often posed as to why the EU would grant equivalence status to the UK, particularly if UK laws differ from the EU’s. First, the EU has much to lose from not engaging in this process. Its international credibility and attractiveness as a place to do business would suffer by any capricious or protectionist approach.

Second, the EU will wish to preserve and enhance cross-border capital flows to finance growth within the EU economy. This is the core theme of the European Commission’s capital markets union proposal.

Third, EU financial institutions will wish to preserve their own ongoing access to the UK’s financial markets. Currently many of these institutions operate through significant and often systemically important UK branches. The UK generally requires much of that business to be conducted through subsidiaries, except where the existing EU passporting arrangements override this requirement. Without the continuance of current passporting arrangements or the introduction of access arrangements based on equivalence there would most likely be significant additional costs and restrictions for those EU financial institutions wishing to do business in the UK.

Even if the passport ceases to exist and equivalence is not possible for all sectors, curtailment of UK-to-EU financial business is not inevitable. Much of the banking and investment business activity that takes place in the City is not cross-border as a matter of law. In English law and most European laws, deposit-taking is regarded as taking place where the deposit is taken, not where the customer is located, for example. There are some EU countries that see, for instance, the marketing of deposit taking to persons in their state as triggering some licensing requirements, but even in the absence of any passport or equivalence-based recognition, these restrictions can generally be navigated using other exemptions. In some instances the issue, once navigated, becomes one between sovereign authorities rather than a commercial one for institutions located in the UK.

In reality the continuance in some form or other of current access arrangements is in everyone’s interests. In order to guard against brinkmanship, the UK should not serve its Article 50 notice until an overall structure has been agreed, ensuring either a continuance of passporting in some form or an ongoing relationship providing for broad equivalence. It might help to establish ongoing working groups to ensure that for areas where the UK or EU wishes to have equivalence, both sides can work together to ensure this transpires and that there is no break in regulatory coverage while the negotiations take place. The UK may also want to push for any gaps in the equivalence framework to be plugged. Sensible solutions should prevail.

Barnabas Reynolds is a partner at law firm Shearman & Sterling.


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