Brave New World

Introduction

1. As Donald Tusk remarked recently, in response to a comment from Boris Johnson that the UK could have its cake and eat it “…there will be no cakes on the table, for anyone. There will be only salt and vinegar…”    Teresa May confirmed last month that the UK will come out of the single market (and the customs union).    On any view therefore, unrestricted single market access is no longer on the table, even as pipe dream, let alone anything more.
 
2. Whilst London will continue to have a robust financial services centre post-Brexit, the most likely outcome in the absence of access to the single market is the fragmentation of the services currently provided by UK financial institutions, as firms will have to maintain offices in both London and the EU.   As a consequence, the regulatory burden and cost of doing business within the EU will increase.

Brexit Options

3. Although the UK government has remained silent about what exactly Brexit will entail, it is safe to assume that the Swiss option and the Norwegian option will not be pursued, since both would require the UK to accept free movement of persons.   
 
4.  It has been made clear by EU ministers on numerous occasions that the four freedoms are not separable – in the words of Juncker, “…there can be no àla carteaccess to the single market…”  Given May’s firm position, it seems inevitable therefore that, absent a bespoke agreement with the EU, the UK will not be granted unrestricted access to the single market, with the consequence that “passporting” rights will not be preserved.  

Passporting Rights

5. The CRD IV (which contains the prudential rules for banks, building societies and investment firms) and MiFID (a directive which, in broad terms, governs the conduct of business by investment firms) both contain a passporting regime, with the effect that an institution that is authorised and supervised by the FCA/PRA in London, is free to provide (or ‘passport’) those services into the EU, without needing to be separately regulated in each of the member states, or without having to establish a physical presence in that state.  If a firm choses to have a physical presence, it can be in the form of a branch rather than a subsidiary, which does not need to be separately capitalised.  This has been a key attraction for non-EU institutions in particular, who have viewed London as a convenient gateway to the rest of Europe.  Indeed, one of the specific requests in the memo published by the Japanese banks was “…maintenance of the freedom of establishment and the provision of financial services, including the “single passport” system…” The memo noted that nearly half of all Japanese investment in the EU in 2015 went to the UK and the bulk of Japanese companies have a presence in the UK.
 
6. The FCA has published data which shows that in respect of passporting:
(i) 5,476 UK-authorized firms hold one or more outbound passports to do business in the EU;
(ii) 8,008 firms authorized in other EU/EEA Member States hold inbound passports to do business in the UK
 
7. If passporting rights are not preserved, firms based in the UK, which provide services currently covered by the passport, will need to set up an EU-authorised subsidiary within the EU.    Depending on the expected volumes of trade, this could be a costly exercise as it could require the presence of a sizeable workforce, and the establishment of appropriate systems and controls.   EU banks that have branches, which are located in the UK, may need to be separately capitalised; this is likely to be a huge cost for those institutions.

Equivalence

8. Once the UK has left the EU, it will become a third party country.   Is at this point that the notion of ‘equivalence’ becomes relevant.   Broadly speaking, a number of EU directives contain equivalence provisions which enable a non-EU member state to provide services to the EU, without needing to be separately authorised by the EU regulator, as long as the regulatory ecosystem of its own country is deemed to be equivalent to that of the EU.   Hence, at a superficial level, this appears to be a satisfactory alternative to the loss of passporting.
 
9. In truth however, equivalence as it currently stands is a limited and piecemeal tool.    It is principally a political decision, as it is the European Commission that has to issue a declaration of equivalence (albeit with input from technical agencies).   The recognition of US CCPs under EMIR, which took some three years to resolve, is an example of this.   Moreover, the Commission can alter or withdraw a decision of equivalence at will, with little or no notice.  In terms of ongoing equivalence, the UK would be tied to the EU regulatory framework as it would have to ensure that any changes in the EU legislation were also reflected in the domestic legislation.    Hence not only would the maintenance of an equivalence determination be uncertain, but politically, maintaining equivalence would, arguably, undermine the objective of leaving the EU in order to be ‘sovereign.’
 
10. It should also be noted that some directives do not contain any equivalence provisions at all (e.g. under the CRD IV, in respect of activities such as deposit-taking and lending there is no third country regime) – hence for these services, unless the equivalence regime were extended to cover these activities, there would be no alternative to the loss of passporting rights other than to establish a subsidiary within the EU.    Even those directives that do contain equivalence provisions, are limited in their scope: whilst MiFID II/MiFIR has a specific third country regime (see articles 46 – 49) the equivalence provisions only apply with respect to the provisions of investment services to per se professional clients and eligible counterparties: it does not cover retail investors or elective professional clients.     
 
11. Accordingly, equivalence it is plainly not an adequate alternative to the loss of passporting.

Practical Outlook

12. Whilst London will always have a strong financial centre given its global reputation and the large concentration of expertise it has in this area, the issue is the extent to which that status will be eroded.  The attraction of London from an industry perspective is that a financial institution can establish itself in London and from that base provide a range of services:  London effectively operates as a ‘one stop shop’.   If this alters post-Brexit, which is likely if certain services cannot be carried out from the UK, most institutions will need to establish a subsidiary in the EU.   The required scale of the EU operation will depend on the view taken by the local regulator, which will in turn depend to a large degree on the nature and volume of trade being transacted via that office.  It could however be a sizeable undertaking.
 
13. The cost of business is therefore likely to rise, with the accompanying operational and regulatory complexities that arise from essentially having two offices to maintain.    The extent to which businesses can absorb the additional costs remains to be seen; one suspects that the cost will be passed back to the users of the service.
 
14. This fragmentation is not only problematic from a cost perspective, but if an operation is spread out over a number of geographical locations, which are subject to different regulatory regimes it also gives rise to questions of systemic risk.   It must be remembered that much of the regulation implemented in the UK is actually derived from international standards (e.g. Basel, IOSCO).    The need for harmonisation at an international level was driven by a recognition that, given the global nature of large financial institutions, the regulation of those institutions also had to operate seamlessly at a global level.    That rationale still remains and hence from a financial stability perspective, it is important that the UK and the EU maintain similar frameworks, which are mutually recognised.

Conclusion

15. The Government’s desire to preserve passporting, but without acceding to free movement, is ambitious.  Given the EU’s current position that it is either a ‘hard’ Brexit or no Brexit, the EU will need a strong incentive to agree to this: it is rumoured that one proposal the Cabinet is discussing is that in return for the preservation of passporting rights, Britain would continue to pay large sums into the EU budget – whether this is politically acceptable remains to be seen, but it demonstrates that the Government understands the importance of the financial markets to the UK economy.  

16. If passporting rights cannot be preserved, the equivalence regime, even if extended, will not be a satisfactory alternative.  It is likely therefore that UK firms seeking to do business within the EU will need to set up a subsidiary in the EU: there will be some degree of fragmentation in the way that companies operate, which will invariably lead to an increase in the cost of doing business.    
 
17. The relationship between the UK and the EU may never have been much of a “love affair,” but with respect to financial services, it is questionable whether separation will result in a better outcome.

Saima Hanif is a barrister practising from 39 Essex Chambers, London.  She has a commercial regulatory practice and specialises in contentious financial services work, covering regulatory and civil proceedings. She is listed in the legal directories as a leading junior in financial services (“a high profile in the field”, “great knowledge of the FS industry”, Chambers & Partners).    Her practice is cross-border and she is currently acting in a major banking investigation in Singapore.  Saima has written extensively on the impact of Brexit on financial services.  She is a member of the FMLC’s Brexit Advisory Group and the COMBAR Brexit working group.”

Saima can be contacted on +44 (0)20 7832 1111 or by email at saima.hanif@39essex.com