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Brexit and the Impact of ‘equivalence’ on UK’s Financial Sector

Joshua Sung

The United Kingdom’s (UK) imminent departure from the European Union’s (EU) Single Market presents a number of substantial legal and regulatory hurdles in providing services to EU-based customers for its financial industry.

The current, automatic right of market access for banks, insurers and investment firms based on their UK-issued licence—known as ‘passporting’—will automatically become obsolete when EU law ceases to be applicable in the UK.

On October 22, the House of Commons European Scrutiny Committee (the Committee) published its first report of session 2019/20 (the Report). Section 10 discusses UK’s access to the EU financial services markets after Brexit and, more specifically, the European Commission’s recent review of the EU law on ‘equivalence’. This is a legal procedure that allows the EU to grant preferential treatment to non-EU financial services providers, if their home country has a regulatory and supervisory system that delivers the same financial stability and consumer protection standards as the EU’s own rules.

The notion of equivalence, and its importance in this context, was explained by the European Commission in a Press Release dated July 29 where it stated that:

“EU equivalence has become a significant tool in recent years, fostering integration of global financial markets and cooperation with third-country authorities. The EU assesses the overall policy context and to what extent the regulatory regimes of a given third country achieves the same outcomes as its own rules. A positive equivalence decision, which is a unilateral measure by the Commission, allows EU authorities to rely on third-country rules and supervision, allowing market participants from third countries who are active in the EU to comply with only one set of rules.”

Gains from ‘equivalence’?

The EU assesses whether the standards of regulation and supervision in a bank’s home market are ‘equivalent’ to those of the EU in considering the operational rights or treatment of foreign banks within the EU.

A determination of equivalence can be beneficial for a foreign bank or for an EU bank dealing with a foreign bank, foreign stock exchange, or central counterparty for clearing securities transactions (‘CCP’).

Typical advantages could include: i. granting foreign banks limited market access rights inside the EU for certain services,

ii. more favourable treatment for branches of foreign banks located in the EU, or iii. more favourable treatment for EU banks having exposures to a foreign bank, stock exchange or CCP.

Equivalence is determined in different ways in different areas. It is based not on exact transposition of EU laws, but on a comparison of the intent and outcome of laws. In some cases, the EU will require that another country extend reciprocal recognition as a condition of granting equivalence.

Summary of advantages

For UK-based banks:

  • Some limited market access or operational rights in the EU

  • Some limited rights for EU banks to trade in the UK or with UK-based banks

For the UK:

  • May facilitate the use of the UK as a base for exporting financial services to the EU in the limited areas where equivalence-based market access rights apply

The limited ‘equivalence’ framework

Firstly, the scope of EU equivalence is limited and patchy. Significantly, there is no equivalence regime for a number of important financial services which are not part of the 15 EU acts that contain “third- country provisions”. These include: deposit taking, lending, payment services, mortgage lending and insurance mediation and distribution.

Secondly, the conditions for equivalence depend on the particular EU act. This means that there is no uniform process of assessment and what constitutes equivalence varies.

Thirdly, the process for designation is a slow, one-sided system where the European Commission determines whether a country’s rules and supervisory mechanisms are equivalent.

Finally, and perhaps most importantly, equivalence may be altered or withdrawn. Changes can be at short notice and consequently there is little security against a policy change in Brussels, making it a comparatively unattractive framework on which to do business. An example of this precariousness is the EU’s decision that ongoing equivalence recognition of the Swiss stock market will be conditional on progress towards a new institutional framework.

The EU position that the UK should simply rely on existing equivalence regimes is based on a mixture of its unease at the prospect of having little influence over a large financial centre on which it would continue to rely, together with the opportunity to lure financial services away from the City.

Summary of Disadvantages

For UK-based banks:

  • Granting of equivalence is always uncertain. Activation for the UK of key equivalence regimes such as the proposed MIFID third country framework is uncertain

  • Equivalence-based market access frameworks are not available for most areas currently covered by EU passports

  • Loss of equivalence can materially affect operational or market access rights

For the UK:

  • Some loss of regulatory freedom: maintaining stability for UK-based firms trading with the EU means committing to sufficient alignment with EU rules now and in the future

Implications of ‘equivalence decisions’

Seeking to use ‘equivalence decisions’ to access the EU market for financial services after Brexit carries significant risks for the UK.

It would mean staying aligned with EU financial services law in the areas covered by any such decisions, as well as other EU rules related to tax evasion and money-laundering. Any future changes to these rules would be decided by the remaining EU Member States without the UK having a say.

While the UK would be free, legally, to diverge from EU rules, this could have political and economic consequences. In the most extreme cases, UK divergence from EU rules would lead to a loss of preferential trading arrangements, since equivalence can be withdrawn by the EU unilaterally and at short notice.

Moreover, a recent review by the European Commission of the way equivalence has been used to date makes clear that the EU would be wary of granting the UK equivalence in the most economically- important sectors—especially investment services—without safeguards that it will not substantially diverge from EU regulations. The EU recently adopted changes to its legislation on both investment services and derivatives trading that make clear any cross-border market access would be very closely monitored.

The way forward for UK and ‘equivalence’

Equivalence therefore appears to offer little by way of long-term stability for cross border trade in financial services after Brexit.

However, a decision by the UK not to seek ‘equivalence decisions’ could result in a transfer of economic activity from the UK to the EU if British firms could no longer provide certain financial services to EU customers for legal reasons.

Industry body UK Finance has argued that, to preserve smooth trade flows, “the scope of current equivalence regimes would need to be expanded to include core products and services currently not covered”, in particular with respect to banking services.

Going forward, the UK has several options for retaining some form of enhanced market access beyond what the current equivalence framework makes possible.

One would be to join the European Economic Agreement, effectively remaining in the Single Market. The passporting rights of financial institutions would be maintained but would come at the cost of accepting all relevant EU rules and regulations (including free movement and the jurisdiction of the European Court of Justice). Politically this seems an unlikely way forward, especially as it has been ruled out by the leaderships of both major political parties.

Alternatively, the UK could persuade the EU that both sides should develop a more comprehensive equivalence approach that addresses some of its stated limitations. This is a significant challenge, but not impossible. Given British regulation and supervision is currently compatible with (and partially constituted by) EU law, it is arguable that, on Brexit day, they should be considered equivalent where an equivalence regime is available.

The challenges would be to broaden the range of financial services for which equivalency can be agreed, to establish a uniform and transparent process for determining equivalence and to obtain commitments on how and in which circumstances such determinations could be withdrawn. Appropriate cooperation, oversight and dispute settlement mechanisms would of course be needed but these are already envisaged as part of a future EU-UK FTA.

Ultimately, such reform to the EU’s current equivalence regime in order to provide comparable (but still not equal) terms of trade in financial services will require not only dynamic thinking on both sides, but tremendous goodwill.

References: mean-equal-to framework-for-financial-services-final.pdf

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