As the UK and EU enter the next phase of Brexit negotiations, we consider the impact of losing passporting rights and possible options for a trade agreement around financial services. 

2018 has been described as the ‘decisive’ year for Brexit and the year in which the UK will finally determine its future relationship with the EU. However, a lot depends on the outcome of transition talks. A key aspect to any trade deal will be financial services.

Financial services forms a significant part of the UK economy through the number of people it employs, its contribution to UK tax receipts and its contribution to balancing the UK’s overall trade deficit with the rest of the world.

The EEA (comprising the EU and Iceland, Norway and Liechtenstein) is the largest market for the UK’s financial services exports. In this article, we consider some possible outcomes of the Brexit negotiations for UK financial services.

What is passporting?

At present UK financial services firms are able to carry on business in other member states of the EEA by taking advantage of passporting rights.

Under passporting rights, a firm can conduct business in other member states without needing to obtain additional authorisations in those states. It may do this either on a cross-border basis (e.g. by providing services by telephone, post or internet) or through establishing a branch in the relevant member state.

Although passporting is often spoken of in general terms, there are a number of distinct and separate passporting regimes as set out in sectoral EU directives. Examples of passporting regimes include:

  • CRD IV (banks and building societies)
  • MiFID II (investment firms)
  • AIFMD (alternative investment fund managers)
  • UCITS IV (UCITS management companies)
  • The Mortgage Credit Directive (mortgage brokers)
  • Solvency II (insurance and reinsurance)
  • The Insurance Mediation Directive (insurance intermediaries).

If the UK ceases to be a member of the EEA then such passporting rights will cease to be available. The UK and the EEA will need to agree the extent to which firms are able to access each other’s markets.

Early rhetoric

It was announced in December that 'sufficient progress’ had been made in the Brexit negotiations and that discussions could now turn to reaching a trade deal. Since then, negotiators on both sides have publically indicated their positions on cross-border financial services.

First, Brexit Secretary, David Davis called for a ‘Canada Plus Plus Plus' (“CETA +++”) trade agreement, which would use “the best of Canada (CETA), the best of Japan and the best of South Korea and then add to that the bits that are missing, which is services”.

A few days later, such an agreement covering financial services, appeared to be dismissed by Michel Barnier, the EU’s chief negotiator, who said that “There is no place [for financial services]. There is not a single trade agreement that is open to financial services.”

More recently, in his Brussels speech on 9 January, Michel Barnier, suggested that any free trade agreement could not include all the benefits of the Customs Union and the Single Market and therefore, UK cross-border services after Brexit would be based on one of equivalence "where allowed by our legislation" and after an assessment by the EU. This has been seen by some as a softening of the position.

The UK has not waited in relation to financial services imports into the UK. It has publicly stated that EU firms can continue to participate in the London market as currently.

What are the possible outcomes?

In essence, the basis for the UK’s trade with the EU will either take the form of a bespoke free trade agreement or otherwise fall back to the UK trading with the EU on the basis of both parties’ World Trade Organisation scheduled commitments (assuming the UK’s position on participation in the single market does not change). Within these possibilities there are a range of factors that will determine the level of market access available to UK and EEA firms in practice.

1. No deal

If the two sides fail to reach agreement on ‘financial services’ they would each be required to fall back on the limited commitments made in respect of financial services under the World Trade Organisation rules, in particular the General Agreement on Trade in Services or ‘GATS'. Under such rules WTO members must ensure the “treatment of services and suppliers from other members [is] no less favourable than that accorded to like services and suppliers of any other country” (the so-called Most Favoured Nation or MFM obligation). Derogations from MFM treatment are possible in a number of forms including preferential trade agreements or free trade areas, of which the EU itself represents the highest degree of integration currently available (a single market).

However there is no obligation to allow financial services imports from any third country and there is a specific carve-out from MFN rules in respect of financial services which provides considerable flexibility for members to introduce restrictions on access for “prudential reasons” including for the protection of investors or to ensure the integrity and stability of the financial system. As such, the function of GATS is essentially for members to set out the maximum commitments they will accept for granting market access in the absence of a free trade agreement.

Without passporting rights or a free trade agreement the UK would have the right to trade in services with the EU under the conditions and limitations imposed by the EU in its specific schedules of commitments and its rules for third country access (i.e. ‘equivalence’) but no more.

Some UK firms have opted to set up subsidiaries in EU member states to pre-empt such an outcome and allow them to continue to provide their services to clients across the EU using their subsidiary’s authorisation and passporting rights. The establishment of a regulated EU subsidiary, however, is likely to involve considerable cost as well as compliance with additional legal and regulatory requirements and related risk.

What is equivalence?

Equivalence is a mechanism provided by some (but not all) European single market directives through which financial institutions located outside the EEA are able to provide services to clients within the EEA where the EU considers their home jurisdiction to have equivalent regulatory regimes. As such, if the EU is willing to determine the UK an "equivalent" jurisdiction for the purposes of the relevant directive, UK financial firms might benefit from limited access rights into the markets of EEA member states.

In Michel Barnier’s Brussels speech, he suggested UK cross-border services would be provided under the EU’s existing equivalence regime. It is, however, unlikely that the UK government would consider reliance on the existing EU equivalence regimes to be a satisfactory outcome. Philip Hammond, the UK Chancellor has commented that the existing EU equivalence regime is “not a basis on which to operate serious cross border financial services business”. This is for a number of reasons:

  1. The process for obtaining an EU equivalence decision is typically lengthy and there is no guarantee that the European Commission will grant equivalence. As things stand, the UK would need to wait until it had left the EU before it could apply for such an equivalence decision creating further delays and uncertainty.
  2. Certain EU single market directives (such as CRD IV) do not provide for third country access based on equivalence so it is unlikely that such third country firm access would extend to key financial services (including key banking services such as deposit taking, lending, payment services or mortgage lending as well as insurance mediation and activities relating to UCITs funds) as well as certain categories of clients.
  3. The European Commission reserves the right to withdraw its equivalence decision at any time. In order to continue to benefit from equivalence, the UK would need to ensure that its regulatory regime remains closely aligned with the EU regime.
  4. The EU is currently in the process of imposing increased requirements for the basis on which the EU grants equivalence so that the UK may be required to adhere to more stringent regulatory requirements than under the existing system.

Equivalence regimes may also be dependent on the laws and further discretion of individual member states in some instances.

2. Bespoke trade agreement

WTO MFN trading arrangements are not an ideal solution for UK cross-border financial services exports. Hence, (assuming the UK leaves the common market) in order to avoid a no deal scenario following the expiry of any transitional period there would need to be a bespoke trade agreement extending to financial services.

As Michel Barnier has noted such a trade agreement would be unprecedented and the practical and political obstacles involved would be significant. In particular, any deal providing equivalent access rights without accepting the EU’s four freedoms (including the free movement of persons) would arguably undermine the integrity and proper functioning of the single market and risk setting a precedent that other member states might seek to follow.

Nevertheless, the UK government position is to retain as much access to the single market as possible and a trade agreement including certain agreements around mutual recognition for the purposes of equivalence and delegation regimes has been mooted.

A number of UK politicians (including the Chancellor and members of the House of Lords) have called for UK access to the EU market based on an 'enhanced' equivalence regime. In its report on financial services after Brexit, for example, the House of Lords argued that “the main purpose of any bespoke agreement, so far as financial services is concerned will be to supplement the current equivalence regimes to mitigate any loss of access and ensure the continuation of equivalence decisions in order to maintain access".

The UK government might therefore look to expand the existing equivalence regime by:

  1. introducing a framework that recognises international standards as ‘equivalent’ giving the UK greater scope to break away from EU regulations
  2. removing some of the existing conditions for equivalent third country firms to provide cross-border services
  3. introducing certain protections so that the EU may not withdraw any equivalence decision or put up additional barriers to entry for UK firms
  4. expanding the scope of the equivalence regime to include single market directives (and, potentially, client types) not currently included.

In his Brussels’ speech, Michel Barnier claimed that the EU would not be prepared to give up its "regulatory autonomy" and that a "system of generalised equivalence of standards" would not be possible. However, the UK government may look to enhance the EU’s equivalence regime as far as the EU's parameters allow it.

If the aim would be to replicate as far as possible the existing passporting rights enjoyed by the UK, this would involve the negotiation of a trade deal in financial services that is on a scale otherwise unseen in other such agreements. It might also be seen to undermine the EU’s existing trade agreements with Canada, the US, Switzerland and other countries, who might seek to renegotiate their agreements or bring claims against the EU. CETA, for example, contains a “Most Favoured Nation” clause which provides that neither party can treat the other less favourably than they treat third countries, so that the EU could (subject to certain exemptions contained within CETA) potentially be obliged to offer the same terms to Canada.

Next steps

Over the next few months, as the negotiations progress, the basic outline of a trade deal will hopefully become clearer. In this article, we have discussed some possible options for financial services after Brexit and some of the obstacles to reaching an agreement acceptable to both sides. However, it is hoped that the significance of financial services in reaching any trade deal will give both sides the impetus and political will to overcome these difficulties and reach a satisfactory outcome.