The U.K. is set to leave the European Union on March 29 — and that could give the country’s financial-services industry a big headache.
Banks, insurers and fund managers — including many U.S. firms that have come to use London as their European base — face losing their automatic right to do business across Europe. That is a problem, as cross-Channel trade is worth many billions (in pounds and euros) to both sides.
U.K. and EU leaders signed off on a formal Withdrawal Agreement on Nov. 25, and, under its terms, financial-services trade can continue under the EU’s so-called equivalence rules.
The agreement still has to pass in Parliament on Dec. 11. If it is voted down, all bets are off. But, assuming it passes, U.K.-based banks, insurers and fund managers still have substantial worries about how these rules will work in practice.
Here, we take a look at what the rules are, how they work at present and whether they might be reformed:
What is equivalence? The EU’s single market, a single economic zone that stretches from the Atlantic to the Russian border, makes life easier for big international banks, insurers and fund managers. It allows them to sell products and services to any of the bloc’s 450 million consumers from a base in any EU state. This is known as the financial “passport.”
The EU also allows companies that are not based in one of its member countries to access the single market. The equivalence regime is its set of rules for doing so.
But, unlike the passport, equivalence decisions are taken piecemeal, on a sector-by-sector basis. For example, the U.S.’s prudential rules for banks and stock exchanges have been judged equivalent to the EU’s, but the rules governing reinsurers have not.
What’s more, equivalence rules don’t apply to all sectors. The Financial Conduct Authority, the U.K.’s market regulator, said on Nov. 29 that the rules “operate as a patchwork, with equivalence a possibility in some areas, such as wholesale trading activity, but not in others, such as retail investment funds.”
Is it widely used? Increasingly so. As of September 2018, the EU had issued 379 equivalence decisions with 35 countries, from Abu Dhabi to Singapore, winning the status for at least one finance sector. The U.S. is the leader, having had its rules governing 22 sectors declared equivalent to the EU’s, followed by Japan and Canada, with 20 each.
So this is what U.K. firms will have to use in future? It is looking that way. The Withdrawal Agreement contains the promise that the U.K. and EU will begin “assessing” each other’s financial- services rules under the equivalence regime “as soon as possible” after Brexit. Both sides aim to complete this review by June 2020.
So what’s the problem? Substantial business links have developed between the U.K. and EU over the U.K.’s 44 years of membership. U.K. banks underwrite about half of the debt and equity issued by EU companies, and 40% of those companies’ shares trade on U.K. markets, according to figures from the U.K. government.
Almost 5,500 U.K. financial-services firms use EU passporting to do business on the continent, and around 8,000 EU firms do the same to serve U.K. customers, according to figures from the FCA.
The prospect of swapping all this for equivalence decisions has some people worried. In March, the U.K. chancellor, Philip Hammond, said the equivalence rule book was “wholly inadequate.” But the government has now accepted that equivalence is the only game in town.
It can be time-consuming and politically fraught to get an equivalence decision. Sometimes it takes years. The EU declared the U.S.’s rules governing clearinghouses — a critical part of international financial markets’ architecture — to be equivalent in 2016. But that only came after four years of negotiations, and heavy pressure from the Chicago Mercantile Exchange
and the EU banks that use its clearinghouse.
Even more problematically, once granted, equivalence decisions can be withdrawn with 30 days’ notice. This is to cover the EU against the risk that a nonmember country might win equivalence, and then make its regulations more lenient afterward to give its companies an unfair advantage.
But U.K. firms are dismayed at having to run the risk that politicians and regulators on the EU side could pull the plug on their EU operations at any time.
Can equivalence be reformed? That is what the U.K. side is hoping.
In the first place, the U.K. should find it a reasonably easy ride to get its rules declared equivalent in the next two years — firstly because there is so much actual business riding on it, and secondly because the two sides are starting with identical rules in the first place, given the U.K. is currently an EU member.
The FCA has said it hopes that both the scope of equivalence — the number of sectors it covers — and the process itself can be improved. But there is little detail as yet as to what reforms might happen, or when.
EU regulators and politicians will also have to bear in mind that if the U.K. were to win equivalence concessions, the U.S. and Japan will be queueing up behind demanding the same.
So what happens next? All eyes are on the crucial Dec. 11 vote in the U.K. Parliament. If the Withdrawal Agreement is voted through, expect the U.K. and EU regulators to get down to business in the new year on how equivalence is going to work between the two jurisdictions.
If it does not, then absent any other change, finance companies face the prospect of suddenly losing their automatic right to do cross-Channel business, overnight, at the end of March. That is sure to be highly disruptive.
But the good news is that both the regulators and the firms themselves have been doing a lot of contingency planning. London-based banks and fund managers have been busy setting up subsidiary companies in the EU to carry on business as before. Certainly hundreds, possibly thousands, of staff are already being moved to places like Paris and Frankfurt.
U.K. authorities have said they will give EU firms in the U.K. temporary permission to continue. In limited fashion, the EU has done the same — but only for financial products known as derivatives, since in Europe most of these are processed through London. But that still leaves vast swaths of the financial industry exposed.
Unsurprisingly, the FCA has concluded that the risks of a no-deal exit “remain significant.”
But of course, that assumes that nothing happens, politically, in the meantime. If the U.K. Parliament fails to approve May’s deal in December, a fresh general election, an extension of the country’s leaving date or a second EU vote that could lead to the U.K.’s remaining in the EU, after all — all are potential outcomes.
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