19 October 2016

Open Europe’s new report, ‘How the UK’s financial services sector can continue thriving after Brexit’, has drawn widespread attention among media, practitioners and policymakers alike. This is the first of a series of blog posts presenting in a bit more detail some of the key findings of what is, admittedly, a hefty piece of research.

I will look at regulatory equivalence, which is often being cited as the main fall-back option should UK-headquartered financial firms lose their ‘passporting’ rights – the ability to do business across the EU either via branches or on a cross-border basis – after Brexit.

What is equivalence?

Certain EU financial regulations envisage the possibility for third countries to obtain ‘equivalence’. In practice, this means the EU acknowledges that the legal, regulatory and/or supervisory regime of a third country is as good as its own. Equivalence is outcome-based – that is, the regulations of the third country do not need to replicate the EU’s word-by-word as long as they achieve the same objectives – and can bestow passport-like rights in some cases.

Equivalence is not granted to individual firms but to countries. The European Commission’s Directorate General for Financial Services (DG FISMA) is responsible for carrying out technical assessments of equivalence. These are usually based on advice from the three pan-EU financial supervisors – EBA, ESMA and EIOPA. Only after such an assessment is successfully concluded can the Commission make a formal decision to grant equivalence.

While this may sound like a purely technocratic process, it can easily trespass into politics – not least because the Commission can wait as long as it wishes to issue its final verdict. In fact, previous experience shows it can take a third country several years to obtain equivalence. This being said, the UK starts from a very different baseline – as it currently has the exact same regulations as the EU. This should make equivalence much easier to achieve.

Several third countries have already obtained equivalence in some areas. A summarising table is available here. The US, Australia, Canada and others have been judged equivalent with regard to Central Counterparties (CCPs) for the clearing of over-the-counter derivatives, for instance. Switzerland and Bermuda have obtained full equivalence under Solvency II – the EU directive setting out prudential requirements for the insurance sector.

What does equivalence cover?

Equivalence is a more piecemeal approach than the passport. The EU grants it on specific aspects of individual regulations. There are currently nearly 40 equivalence requirements in place in total. For example, there are three separate areas for evaluation under Solvency II (calculation of capital requirements, group supervision and reinsurance) – meaning that equivalence in all of them is needed in order for a third country’s regulatory regime for insurers to be considered as fully equivalent to the EU’s.

Secondly, and linked to the previous point, some EU regulations offer no equivalence at all. The largest ‘hole’ is arguably the Capital Requirements Directive (CRD IV) – which covers a number of key wholesale and retail banking services such as deposit-taking, commercial lending, and payment services. This explains why the UK should aim for bespoke deals to replicate passport-like arrangements in areas where equivalence is not available. The EU has done it in the past – see the bilateral agreement with Switzerland on the provision of direct insurance (not including life insurance) via branches.

Retaining the CRD IV passport for wholesale banking should be a top priority for the UK Government, as there are currently no effective alternatives to it.

In fact, the Undertakings for Collective Investment in Transferable Securities Directive (UCITS V), which covers investment funds targeted at retail clients, makes no provisions for third-country access either. However, as we point out in our study, asset managers are generally less exposed to the loss of the passport as they have a wider range of fall-back options at their disposal. It is already common practice, for example, to keep EU clients’ assets in funds domiciled in another European hub – mostly Dublin and Luxembourg – and then delegate their management to the UK. In theory, this kind of arrangement could continue after Brexit.

Similarly, Solvency II only offers equivalence for re-insurance services but not for direct insurance. However, insurance is a globally diversified industry and tends to make much less use of the passport. The overwhelming majority (87% according to research by the Bruegel think tank) of insurers that operate across borders do so via independent local subsidiaries – which are not reliant on the passport.

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Thirdly, equivalence can potentially be lost over time if the regulations of the third country begin to diverge from the EU’s. However, the Commission has never withdrawn equivalence from a third country so far – although in some cases it has opted to grant it only for limited periods of time.

This all goes to show that equivalence is, at best, a partial solution. In some cases – such as investment banking, derivatives clearing and re-insurance – it can provide passport-like rights for firms based in the equivalent third country. However, as we have seen, it is not available at all in other areas – wholesale banking being the main one.

Why the UK should seek ‘pre-emptive equivalence’

In light of these premises, we believe the UK should indeed seek equivalence with the EU in areas where it is on offer and de facto grants passport-like rights. We recommend that the Government negotiate what we have labelled ‘pre-emptive equivalence’ as part of the Article 50 talks. This would ensure that the UK is deemed equivalent by the EU as of Brexit Day and would therefore avoid a regulatory limbo. Importantly, there is a precedent for this. The Commission has granted equivalence on Solvency II to several third countries before the directive came into effect on 1 January 2016.

However, as I mentioned above, the UK should also aim to bolster this with bespoke agreements in areas where equivalence is not on offer and there are no obvious alternatives to the passport. I will come back to this point in future sector-specific blog posts.

In order to address concerns over UK and EU regulations diverging over time, thereby potentially putting equivalence at risk, the option of establishing joint financial regulatory committees deserves thorough consideration. The EU has already taken tentative steps in this direction by establishing the so-called Financial Markets Regulatory Dialogue (FMDR) with the US and Japan. The US group meets twice a year, but it goes without saying that cooperation between the UK and EU would likely have to be more comprehensive – a UK-EU committee should either be in place permanently or come together regularly, at least every quarter.