After over 47 years of EU membership and four and a half years after the UK referendum on EU membership, EU law ceased to apply in the UK from the end of 2020. With the loss of EU passporting rights for UK firms we ask “what next for financial services?” from both a UK and EU perspective.
The immediate view
Financial services, one of the UK’s key service exports, was given little priority by the UK Government in the free trade negotiations and financial services firms had known for some time that the EU/UK trade and cooperation agreement would not give access to the EU single market (‘EU-UK Trade and Cooperation Agreement: financial services’). On the first day of trading, nearly €6 billion of euro share trading moved from UK to EU trading venues and UK/EU derivatives trading only continued smoothly due to a last minute use by the FCA of its temporary transition power to ensure that derivatives transacted on European trading venues would be considered to comply with the UK derivatives trading obligation. Any decisions on UK equivalence have been delayed with the European Commission stating it would not consider these “at this time”.
However, the City was very well prepared for this scenario. Financial services firms have planned extensively for the loss of market access and the possibility of no further equivalence decisions being granted to the UK by the Commission. In practice, even were equivalence to have been granted at the last minute, this would probably have had little effect: firms have had to plan for no equivalence and, in any case, equivalence is a precarious basis on which to plan a business, given the limitations in scope and the ability of the Commission to withdraw it unilaterally on short notice . Whilst the grant of equivalence by the EU provides market access, the longer it isn’t granted, the more used firms will become to working without it and the EU will lose political leverage in its aim of requiring the UK to follow EU rules closely. Many firms have either moved EU clients and business to existing or newly-established EU affiliates to access the EU market. Some UK firms have stopped taking on EU business at all, notably some UK retail banks have closed accounts for clients from certain EU Member States. In order to counter the loss of the inbound EU passport and to make use of balance sheet efficiencies, some firms have restructured to ensure that their UK operations will henceforth be carried out by a UK branch of an EU entity. The PRA notes some 66 previous EEA entities have chosen to operate through a UK branch of an EEA entity and these have entered the UK’s temporary permissions regime (TPR) with a view to gaining full authorisation.
Indeed it could have been worse: there are grounds for optimism in the fact that a trade deal was agreed including the Joint Declaration containing an agreement for the UK and EU to set out future regulatory cooperation and dialogue on equivalence-related processes in a memorandum of understanding by March 2021.
In London, traders continue to trade on global markets. In its recent consultation on international banks, the PRA has clarified that it operates a pragmatic approach of “responsible openness” to those international groups with UK subsidiaries or branches. It does not prescribe any particular booking model nor does it require any fixed percentage of risk to be managed in the UK (‘The UK’s approach to supervision of international banks: responsible openness and steady as she goes.’). Those wishing to serve UK customers on a cross-border basis may do so with relative ease under the generous overseas persons exclusion (‘OPE springs eternal: UK Treasury calls for evidence on how financial services can be provided by overseas persons’). To date, there have been no significant teething issues following the end of the transition period. To ensure that the UK had a fully functioning financial services regime from day one, UK law “onshored” the EU’s financial services single rulebook by means of a series of Brexit statutory instruments and changes to regulatory rules, with amendments made only to ensure the UK regime was coherent and functioning as at the end of transition period. Thus on 1 January 2021, the UK had its own near identical versions of EU Regulations e.g. UK CRR and UK EMIR.
Beyond the immediate?
The UK Chancellor, Rishi Sunak, an ex-City investment banker and hedge fund manager, takes an upbeat stance saying that this could be “Big Bang 2.0” and he wants London to remain “the most dynamic place to do financial services anywhere in the world”.
But how to achieve this? Quietly behind the scenes, HM Treasury and the regulators have been preparing for a post-EU world. The HM Treasury consultation on the future of the financial services industry provides a blueprint for how the UK plans to move away from the statutory inflexibility of the EU regime to a more dynamic regulator-led rulebook. It is proposed that the Brexit statutory instruments will be repealed and replaced with a short statutory framework. This will set out the key goals to be achieved and leave it to the financial services regulators to put in place detailed rules to effect this with appropriate safeguards. No timetable has been given for this process but HM Treasury and regulators are eager to begin the transition to the new regime and already new legislation e.g. the investment firms regime due to be implemented in January 2022, will be brought into UK law using this process, with the vast majority of the regime proposed to be contained in the FCA rules rather than in statute.
UK politicians and regulators welcome the new freedom to strike regulatory cooperation and equivalence deals with other major non-EU jurisdictions, including the US. The Biden administration is likely to be more open to international cooperation than the previous regime and there are many areas of common interest to build upon, including the promotion of sustainable finance. The UK’s comprehensive economic partnership with Japan, whilst not extending far beyond the EU-Japan agreement, does offer some extra rights for UK firms offering financial services in Japan and UK-Japan regulatory cooperation and collaboration on emerging areas of interest. Other trades deals, whilst taking longer to negotiate, might go further in promising mutual access and recognition. In an early post-Brexit decision and breaking from the EU position, the UK has brought back the trading of Swiss shares to the London markets.
In respect of the move to European trading venues for euro share trading, it remains to be seen whether there are longer term implications in respect of liquidity if EU venues begin to offer trading in UK stocks and the traders follow the liquidity.
Will there be divergence from the EU?
The UK has been, and will continue to be, instrumental in developing and upholding global standards and has been a major player in international fora including the Basel Committee, the Financial Stability Board (FSB) and IOSCO. The Treasury and regulators are clear that there will be no watering down of any international standards. Rather the UK might look to the text of international standards rather than the EU implementation of such standards when implementing changes e.g. the UK has not adopted the post-Brexit changes to MREL proposed in the BRRD 2, but will ensure that its rules continue to reflect the underlying FSB’s TLAC standard. At the level of individual relationships between the regulatory community, it is difficult to see existing supervisory cooperation for cross UK/EU groups being sacrificed to prove a point given the potential for harm to financial stability this might cause.
With UK rules being drafted largely by regulators, these will be able to adapt quickly to new situations, processes or products. Thus the UK may become an early adopter of new international standards, which the EU, with its more cumbersome statutory process, might find more difficult to match, despite its political aspirations to be at the forefront of international standard setting e.g. the world-leading sustainable investment taxonomy. Or the UK may react more swiftly to ban or regulate emerging harmful products or practices creating a more resilient environment for investment.
The UK might choose to follow a different route to the EU to achieve the same outcome. Examples are emerging already including the decision not to require systemic investment firms to re-authorise as credit institutions (as the EU will) since these are already supervised by the PRA and subject to the Capital Requirements Directive. Andrew Bailey, Governor of the Bank of England, has stated that the UK should not “become a rule-taker”, even if this risks equivalence. Such areas of different approach will become more prevalent with time, as the EU begins to enact legislation on which the UK has had no input in the consultation and legislative process. So, yes there will be some divergence, not on the major principles which are forged at international level, but on how to put these into effect and on timing, and it won’t be at the expense of a strong regulatory system.
The future of the City
The Chancellor points out that the history of the City shows it has “constantly innovated adapted and evolved to changing circumstances and thrived and prospered as a result” and identifies the “culture and creativity of our people” as being a key to this success. The UK financial services regime remains welcoming to international business, both from the EU and beyond, and there is no shortage of ideas of how the City can flourish in this new independent world. Despite the changed circumstances and some loss of EU-based business, the City will remain a centre for expertise and an important centre for global business and international activity particularly in investment and insurance.
The immediate view
With the expiry of the transition period, Brexit preparations on the continent have come to an end, at least temporarily, while repercussions of Brexit will remain on the agenda for the years to come. Throughout the Brexit process, and with even higher intensity upon the approaching end first of the withdrawal period and then of the transition period, both EU authorities and UK market participants have been working hard on preparing for the loss of EU passporting rights and on mitigating financial stability concerns.
In order to ensure continued access to EU markets, UK financial services firms relocated their EU businesses either by setting up new businesses or expanding their existing presence on the continent. As opposed to concentrating in a single location, activities moved to a number of countries within the EU27 and concentrated in a few centres, reinforcing the multi-centricity of the EU financial system. Those relocation 'hubs' include mainly Germany, Ireland, Luxembourg, the Netherlands, Spain and France, whereby sector-specific differences emerged. While international banks, in a sizable fraction, chose Frankfurt and Paris as their new main location, also given the physical proximity to the regulators, European Central Bank (ECB), European Banking Authority and European Securities and Markets Authority (ESMA), asset managers and insurance companies opted mainly for Ireland and Luxembourg, while Amsterdam attracted firms such as trading platforms, exchanges and fintechs. According to estimates by the ECB, relocating banks alone, when their target operating models are achieved, plan to move more than €1,200 billion of assets to their euro area entities.
EU authorities have been calling for adequate preparations by the private sector throughout the Brexit process, and have made it very clear that no regulatory relief would be granted. In fact, supervisory guidance and expectations emerging in the Brexit context rather lead to a tightening of the regulatory landscape for the establishment and operation of banks in the EU and, more specifically, in the euro area. With a view to avoid 'empty shell structures', the ECB expected from the outset new euro zone banks to be operationally self-standing, in particular by not relying excessively on back-to-back set-ups with entities outside of the EU for their risk management. Rather, euro zone banks are expected to be capable of managing all material risks potentially affecting them independently and at the local level. By end of November 2020, the ECB was confident that most of the banks had already reached their target operating models or were well on track to do so.
As far as cross-border business of non-EU firms with EU clients is concerned, Brexit created an unhelpful trend within the EU to tighten standards more generally. Where national regimes allow the provision of cross-border services from a third country, the ECB generally expects banks not to use such set-ups as a means to carry out large volumes of activities in the EU in a business-as-usual environment. In the same direction goes a recent statement from ESMA of 13 January 2021, reminding market participants of the narrow limits of relying on reverse solicitation for the purposes of providing cross-border investment services to EU clients.
Equivalence and related temporary relief have only been granted by the EU authorities in the area of financial market infrastructures. Given the heavy reliance of the EU financial system on UK-based central counterparties (CCPs), especially with regard to euro-denominated derivatives clearing, the Commission adopted in September 2020 a time-limited equivalence decision that aims to protect financial stability in the EU. The decision was accompanied with a clear expectation for EU financial entities to reduce their exposure to UK CCPs, and for EU CCPs to build up capacity. This message was reassured very recently by Commissioner Mairead McGuinness. Yet, another equivalence decision was taken in November 2020 to grant time-limited access to the UK central securities depository for the settlement of certain EU securities.
Beyond the immediate?
Brexit will result in a substantial structural change in the EU's financial architecture over the coming years. This is especially relevant for areas where the pre-Brexit EU financial system strongly relied on UK financial services firms and the London market, including derivatives clearing, investment banking activities and securities and derivatives trading. Moreover, the relocation of parts of the financial services industry to the EU contributed to the already pre-existing multi-centre financial architecture. While the EU's multi-centric financial system may have the benefit of reducing concentration risks, without a high level of liquidity and efficient interaction between the different centres, financial fragmentation may arise, at least temporarily.
In order to address this concern, the Commission, in its renewed Capital Markets Union (CMU) action plan from September 2020, acknowledged that fostering the integration of EU capital markets and the optimal flow of information and capital across the EU is a key priority. The CMU aims to develop new sources of funding for companies, remove barriers between EU capital markets and broaden the role of the non-bank sector, especially fostering equity financing, and provides for a political agenda to tackle challenges related to market fragmentation and the potential reduction in market depth and efficiency resulting from Brexit.
Also beyond the CMU, the Commission considers that, with the withdrawal of the UK as a major financial hub, there is a strong need and opportunity to develop EU market infrastructures and enhance the attractiveness of EU's capital markets more broadly on the global stage. On 19 January 2021, the Commission presented a new strategy to stimulate the openness, strength and resilience of the EU's economic and financial system for the years to come. As part of a broader set of actions to better enable the EU to play a leading role in global economic governance, the communication promotes a stronger international role of the euro, supporting the development of euro-denominated instruments and benchmarks and fostering its status as an international reference currency. Moreover, the strategy aims for strengthening the EU's financial market infrastructures, also with a view to building up clearing capability of EU CCPs, especially for euro-denominated contracts. This most recent initiative ties in with other ambitious projects, including the EU's Digital Finance Strategy and Sustainable Finance Strategy, whereby especially sustainable finance is seen as an opportunity to develop EU financial markets into a global 'green finance' hub.
Future relationship between the UK and the EU
As for other major third countries, the relationship between the EU27 and the UK in the area of financial services will depend on regulatory developments in both jurisdictions as well as on economic and political considerations, including the development of domestic EU capital markets.
The degree to which the UK will be able to benefit from market access under EU equivalence regimes will be decided unilaterally by the EU. While equivalence is normally the end of a process of convergence, the situation of the UK is very different. The UK begins from a position of close convergence but may gradually diverge from EU rules. In its communication on Brexit readiness from mid-2019, the Commission noted that, given the close interconnectedness between the EU and the UK markets, any decisions on equivalence must, therefore, take into account potential risks to the EU on a forward-looking basis. Even if equivalence is granted to the UK in some areas, the dynamic nature of the regulatory and supervisory frameworks will require regular monitoring of these decisions.
Upon taking office in October 2020, Commissioner Mairead McGuinness noted that any decision to grant equivalence will be based on the best interests of the EU but also emphasised that she stands ready to engage with the UK on a self-standing, voluntary, structured and flexible framework for regulatory cooperation.