Brexit, the City and equivalence

As discussions on an EU/UK trade deal post transition are now nearing the end, the City of London continues to worry about where it will be left from 1^st January 2021. Financial services are not part of the main FTA agreement as had been hoped. Instead the City feels like it has been left in limbo. And there is a fear that the sector, badly hit by, but also blamed for, some of the excesses and bad behaviour that brought about the financial crisis of 2008/9, does not draw much sympathy from the electorate and its voice therefore gets ignored.

Yet as we know the financial sector accounts for some 7% of UK GDP, employs some 1.1 million people directly, and not just in the City of London, creates lots of additional high value jobs indirectly, contributes positively to the balance of payments and also to the coffers of the Treasury. The estimates are that in the twelve months to March 2018 the government collected some £72b from the wider financial sector, including insurance companies, equivalent to some 10% of total tax receipts that year[1]. At a time when the UK is facing the prospect of having to borrow as much as £400b this year to provide stimulus to the economy during the pandemic, with VAT, corporation tax, income tax all sharply down on last year, losing some of that tax backup in the future if negotiations go wrong is a real issue.

EU banks for EU clients

But the ECB has made it clear through the course of the past year that as a general principle all activities which relate to European customers and European products should also be managed by and controlled by entities which are located in the EU. Financial institutions operating in the UK and regulated in the UK have already been voting with their feet – or with their money. They have been either moving funds under management to EU centres or setting up proper functioning subsidiaries in the EU to be able to still operate under the old passporting rules which cease to apply in the UK once it is deemed to be a third country following the end of the transition period on 31^st December.

As mutual recognition and therefore passporting arrangements cease, the only alternative is an equivalence regime. It won’t be ‘enhanced’ equivalence, as that has been rejected by the EU; in other words, it won’t apply across all services provided by the financial sector. It will instead have to be negotiated more or less on a service per service basis[2].

Equivalence – better than nothing

However unsatisfactory, at least equivalence gives some sort of certainty, although either side can unilaterally terminate it, which in EU legislation can be with just 30 days’ notice. Even then there will be areas such as basic lending and deposit taking, payment services and investment services to retail clients[3] that are not covered by EU wide equivalence regimes and these services may have to either revert to WTO rules of trade or be negotiated bilaterally with individual EU countries.

The expectation had been that an equivalence regime would have been agreed between the two sides by July 2020. But this deadline came and went except for the decision by the European Commission to grant temporary equivalence to UK central counterparties. This decision allows European customers to continue to have access to Euro clearing houses located in the UK until mid- 2022[4], giving the industry more time to adjust and to avoid, as they put it, ‘new cliff edge risks at a later date’. But the ECB made it clear at the time, and there is no reason to think that it may have changed its view since, that all activities which relate to European customers and European products should as a general principle also be managed by and controlled by entities which are located in the EU.

The UK perspective

The UK has at least taken some extra positive steps here. In early November 2020, the Chancellor Rishi Sunak launched the UK’s own guidance for this country’s Equivalence Framework for Financial Services[5]. In it, the Government stresses its commitment to ‘open, safe, and resilient financial markets; a commitment to robust and high-quality regulation, guided by international standards; a desire to facilitate international financial services business by reducing barriers and frictions where possible; a desire to reduce global market fragmentation; and a desire for friendly and effective collaboration with international partners’. The Treasury has legislated under its Temporary Permissions Regime for a system that allows firms that were already “authorized to carry on regulated activities in the UK under passporting arrangements immediately before the end of the transition period to obtain a ‘deemed Part 4A’ permission (or a deemed variation of an existing ‘top-up’ permission)” to carry on business while seeking new authorization from the Prudential Regulation Authority (PRA) or the Financial Conduct Authority (FCA). They will be authorized to carry on with the activity for 3 years and possibly longer should the Treasury decide to extend it a year at a time[6].

The EU’s perspective

That shows at least the UK’s intent. But the EU has so far not responded in kind and UK firms are still in the dark on how they would be operating from the beginning of next year[7] and even if the principle is agreed there have been concerns expressed recently about the time the Commission may take before issuing “equivalence” certificates to British financial firms after 1^st January 2021. What can be done to mitigate this? Though the importance of the City for European corporates, particularly for debt and equity issuance should not be underestimated, the EU has the upper hand here as its row with Switzerland over its stock exchanges has shown[8]. The underlying reality is that the UK needs a friendly and more certain equivalence regime more than does the rest of the EU. And this is a weak position to be finding oneself in just a few weeks before the transition period ends. The ECB in July urged banks likely to be affected ‘to act now and prepare for the future and be ready for all possible eventualities’. This still sounds like the best advice just over a month before transition ends. Those banks and other financial institutions who accepted the expense and effort of setting up bona fide continental subsidiaries since 2016 will now be congratulating themselves on their foresight. Those who left it too late may be ruing their over-optimism.