The City of London is the predominant financial centre in Europe. It does six times more financial services business with the EU than the EU does with the UK. More financial services business is done in Canary Wharf than in the whole of the EU combined. London accounts for 40% of Europe’s assets under management (and 85% of hedge fund assets), 60% of its capital markets business, 78% of its foreign exchange trading, and 74% of its derivatives trading. The UK securities market is the biggest in Europe, the UK banking sector is the biggest source of cross-border lending to EU banks and corporates with more than £1tn of loans outstanding, and the UK is by far the largest market in Europe for ‘alternative finance’. Exports of UK financial and insurance services are around £82bn, of which £33bn or 40% go to the EU.
Fishing, by contrast, contributes 0.02% (£437m) to UK GDP. So financial services is around 300 times more important to the UK economy than fishing. Yet the new UK-EU Trade and Cooperation Agreement (TCA) gives the EU a 5.5-year transition agreement on EU fishing boats in UK waters, but has no transition for financial services sold into the EU.
Instead, all that has been agreed is a non-binding commitment for the UK and the EU to cooperate in order to reach a ‘memorandum of understanding’ (MOU) on financial services regulation, with negotiations beginning before March 2021. Each side is able to suspend any agreement for a number of reasons, ‘including in order to preserve financial stability and the integrity of financial markets’.
Under current EU rules, the UK financial sector can only access the single market if the EU determines that the UK financial regulatory system is deemed to be ‘equivalent’ to that of the EU, meaning that it achieves the same outcomes as its own rules, as well as preserving financial stability, investor protection, market integrity and a level playing field in the EU single market.
However, equivalence only allows for market access in specific areas and excludes most types of banking (such as deposit-taking, lending and payment services), as well as the provision of fund management services to retail customers. Equivalence can also be withdrawn at short notice (typically 30 days). Furthermore, despite being a technical matter of determining whether a third-country’s regulations are equivalent, there is a ‘clear political dimension’ to the decision. In the case of the UK, the EU is concerned about ‘possible divergence from EU rules’ as a reason for withholding equivalence.
It is clearly not a sustainable long-term position for the UK to operate a £30bn+ business in the EU which can be stopped on a whim with 30 days’ notice. There is also the question of costs as Omar Ali, the head of financial services at EY, points out: ‘Equivalency isn’t just about access; it’s about the cost of doing business. A lack of equivalence decisions would increase the cost of doing business for financial services firms and the clients they serve’.
Furthermore, the nature of the political dimension is clear. The EU sees Brexit as an opportunity to force significant chunks of UK financial services to move to the EU. More than £1trn of investment funds have been moved from London to the EU since 2016. The EU is particularly keen to see euro-denominated business – most of which has been carried out in London ‒ moved into the Eurozone. For example, it has refused to allow trading in euro-denominated shares on platforms outside the EU after Brexit. As a result, Monday 4 January 2021, the first day of trading following the introduction of the TCA, witnessed the first-ever trading of shares ‒ some £6bn-worth in total ‒ on the Cboe NL and the London Stock Exchange’s Turquoise platforms both in Amsterdam and Aquis Exchange’s platform in Paris. This means that trading was split across three separate trading platforms, thereby reducing liquidity.
While the UK has granted a temporary permissions regime to a large number of EU companies, allowing them to continue to do business in London and to allow UK firms to use venues in the EU, the EU has refused to reciprocate and has banned EU companies from trading swaps and other derivatives on platforms in London. The euro-denominated derivatives market in London is worth €78trn.
There are two additional important issues of concern and these are movement of people and data. While the TCA permits visa-free travelling for 90 days in any 6-month period to attend meetings, conferences and conducting research, any sale of goods or services to the public will require a visa. In terms of data, financial services firms need to ensure they comply with EU data sharing rules, which covers client paperwork and personal data under GDPR.
The UK’s City Minister, John Glen, who is leading the UK negotiating team on the MOU says ‘what we want is a model of structure and co-operation with the EU that allows us to maintain that stability and mutual market access’.
Clearly, simple equivalence is not the answer. A number of other alternatives have been put proposed. These include:
* ‘Enhanced equivalence’ under which the gaps in existing equivalence regimes – such as deposit-taking and lending – are filled in and regulations are accepted as being sufficiently similar, but without actually being identical. There would be two key issues to resolve: the EU and UK agree to treat each other fairly in assessing rules as being equivalent; and they would agree terms on which equivalence can be withdrawn without political interference.
* ‘Mutual recognition’ (including professional standards). A different alignment concept is ‘mutual recognition’ through ‘mutual market access’. This achieves a similar result as enhanced equivalence, but assumes that financial services regulation and supervision in the UK and EU would remain sufficiently aligned in the future. It would be jointly monitored by a committee to ensure regulatory alignment.
The EU has said it will refuse a financial services agreement based on mutual recognition, but a leaked draft of an annex to the EU’s Guidelines for negotiating a future trading relationship with the UK suggested that the EU might be willing to consider ‘improved equivalence mechanisms’ to cover financial services. The UK’s financial regulator (the Financial Conduct Authority) has issued a statement saying that ‘The FCA continues to view the agreement of mutual equivalence between the UK and EU as the best way to avoid disruption for market participants and avoid fragmentation of liquidity in [derivative] products [such as swaps], reducing costs for investors’.
Yet despite signing up to a G20 commitment to improve the functioning of financial markets (including over-the-counter derivatives markets), the EU has acted in a way that has deliberately contributed to the fragmentation of those markets. It seems to be determined to harm the UK’s financial sector, even if EU users of financial services are also harmed.
The TCA specifically makes ‘framework’ commitments on lowering barriers to services trade and the mutual recognition of professional qualifications. However, we know that the EU always takes a very long time to make decisions, typically 5-7 years. To circumvent this, the UK might end up having to negotiate 27 bilateral arrangements with each member state on mutual access to financial services.
This is clearly not as good as a formal EU-wide financial services deal. However, the UK’s bargaining position has been greatly weakened by what was agreed in the TCA. It’s déjà vu all over again. Our leverage in the negotiations between David Frost and Michel Barnier had effectively been destroyed because Theresa May and Boris Johnson had given away our strongest bargaining chips by committing to paying the £40bn divorce bill and agreeing to the disastrous Withdrawal Agreement which preserved the EU single market but at the cost of splitting the UK single market between Great Britain and Northern Ireland. The EU would never have backed itself into a corner like this. As it is forever saying: ‘nothing is agreed until everything is agreed’.
Yet we fell into precisely the same trap again by accepting the sequencing of the negotiations for the TCA that suited the EU. The first thing it wanted was a deal on fishing that preserved indefinitely its full existing access to UK fishing grounds. The final thing it wanted was a deal on financial services that would only be negotiated after the TCA was signed. And this is what it got, almost in its entirety. It was only last-minute pressure on Angela Merkel from German carmakers, fearful of losing their one million per annum car sales in the UK, that forced the EU to compromise and agree a 5.5 year transition deal for fishing. Surely, the UK-side could have insisted on a 5.5 year transition deal for financial services in exchange? But it was not to be.
It has been clear for some time what the EU’s terms for agreeing the MOU will be – for the UK to become a rule taker from Brussels in respect of financial services by adopting its financial services regulations and changes in those regulations over time, so-called ‘dynamic alignment’. It is not hard to work this out, because it is exactly the same as the EU demanded – and which Theresa May would have conceded had she still been in power ‒ for the TCA.
But this is the last thing we should accept. For a start, the EU hasn’t got a clue how to run a financial system. The main banks on the continent ‒ big names like Deutsche Bank, Société Générale, BNP, Santander, ING and UniCredit ‒ are in very serious financial difficulties (i.e., as close to insolvent as you can get) and the Eurozone is teetering on the edge of collapse. Further, the single market in financial services – one of the supposed four freedoms of the single market – has barely got off the ground, poleaxed under the weight of excessive regulations, like Markets in Financial Instruments Directive (MiFID) II, the Alternative Investment Fund Managers Directive (AIFMD), Capital Requirements Directive IV and Solvency II.
Andrew Bailey, the Governor of the Bank of England, has made it absolutely clear that the UK must not become a rule taker from Brussels. Speaking to the Treasury Select Committee, he said: ‘the UK must be able to make its own rules for the City, even if it means EU authorities refusing to allow access to markets across the Channel. If the UK agreed to take EU rules, it would be bound to follow Brussels’ decisions even when regulators in London thought they were unsuitable for British banks, or even threatened financial stability’. He pointed out that the UK already wanted to change the Solvency II rules governing the insurance sector and to reject the EU decision to count IT systems towards banks’ capital buffers.
So what is the alternative to the UK refusing to be a Brussels rule taker and the EU refusing to agree a financial services deal based on enhanced equivalence or mutual recognition? The straightforward answer is that the City of London is strong enough to go it alone and adopt what is known as the World Financial Centre model.
This would allow the UK to continue doing business in the EU – even without single market access via passporting, an enhanced equivalence regime or mutual recognition – by making maximum use of international law protections: exploiting ‘reverse solicitation exemptions’ or ‘overseas persons exemptions’ which allow financial institutions to provide certain cross-border services to a wholesale client without being registered or authorised in that client’s member state, so long as the services are provided on the initiative of the client; making use of existing EU and member state laws that allow private placements and cross-border dealings – including multiple on-the-ground visits – without a local branch or licence; and making use of human rights legislation – the European Convention on Human Rights and the EU’s own Charter of Fundamental Rights – that protects property rights under contracts between UK and EU27 businesses that existed prior to Brexit.
In addition, it is common for financial regulators to permit the ‘delegation’ of certain financial services to entities regulated in other jurisdictions. This is typical of portfolio management, where fund managers frequently operate a portfolio management hub, enabling economies of scale and other efficiencies. In Europe, this hub is London. Two key questions are whether the EU will: a) allow EU fund managers to continue to use London as their European portfolio management hub and b) allow UK portfolio managers to enter into arrangements with a third-party ‘host’ EU fund manager, subject to complying with EU delegation rules.
An Institute of Economic Affairs report discussed the financial services regulations that would be needed to support the World Financial Centre model. The regulations must: not restrict growth in financial services, not encourage regulatory arbitrage, not prevent sections of the economy from accessing capital or other financial products, help to develop safe but competitive markets, and facilitate the growth of new and small businesses.
With these aims in mind, the report recommends that London should form an alliance with other major financial centres, such as Switzerland and Singapore, to enable further and deeper integration opportunities. A UK regime of multilateral mutual recognition would allow the UK to strengthen its involvement in global regulation formation and dispute resolution.
Freed from burdensome and costly EU regulations – equivalent to 2-3% of the financial sector’s annual costs – Economists for Free Trade have estimated that the City would grow by £20bn over the next ten years under this model. Chancellor Rishi Sunak argues that Brexit will be equivalent to ‘Big Bang 2.0’ and that the City’s ‘culture and creativity’ will see it rise to greater global heights. He said he was keen to re-examine the listing regime, so that London became a more compelling listing destination for the biggest new firms. He was also keen for London to become a global centre for financial innovation, such as in green bonds and digital currencies.
There are grounds for optimism coming from the industry itself. Immediately following the Brexit Referendum in 2016, there were scare stories about massive job losses in the City of London as firms moved workers to Paris and Frankfurt. Consultant Oliver Wyman predicted 75,000 job losses, while Xavier Rolet, then chief executive of the London Stock Exchange, predicted 200,000 job losses. In the event, just 7,000 jobs were relocated. This indicates strong confidence that the UK can thrive after Brexit even in the absence of a deal.
This is confirmed by a New Year survey conducted by the strongly anti-Brexit Financial News on 4 January 2021:
* The City of London is going to be fine. London has adapted to changing circumstances time and time again and will continue to be a global financial hub (Bob Diamond, former Barclays chief executive)
* London will remain one of the world’s leading financial centres and an attractive place to do business. It has a diverse pool of talent, a reputation for innovation and a business friendly regulatory and legal environment. Many financial institutions have long factored Brexit into their plans (Farmida Bi, chair EMEA, Norton Rose Fulbright)
* London will remain one of the world’s leading financial hubs – I don’t think there is any city in Europe that can compete with its combination of infrastructure and quality of life and it will continue to shine (Manolo Falco, co-head of banking, capital markets and advisory, Citigroup)
* Financial services was one of the first industries to prepare for Brexit, because of the importance of having the right licence to operate, and it moved quickly to set up new operations to continue operating in the EU. I expect many financial institutions to step back now and consider how they conduct business across Europe, and where efficiencies can still be made. An evolving regulatory environment in the UK could spark innovation, attract new talent and push UK financial institutions to consider new areas of growth, like investing in clean technologies (Richard Hammell, UK head of financial services, Deloitte)
These quotes from senior industry practitioners make clear two things. First, they believe that the UK financial services industry was so well prepared for Brexit by setting up operations in the EU that they are now in a position to rationalise their pan-European operations to reduce costs. Second, they believe that London’s future as one of the world’s leading financial centres is secure so long as London adopts an evolving regulatory environment that sparks innovation and attracts new talent. This is very good news.
But we should not underestimate the battle ahead. The even more anti-Brexit Financial Times reports a ‘senior EU official’ as saying ‘you can’t expect the UK to remain a [financial services] hub for the EU. It’s not sustainable, and makes no sense in the mid-to-longer run, even if that drives up costs for some businesses’. Peter Foster, the author of the article, states that ‘The prevailing view in Brussels seems to be that given that dual regimes [for financial services and food etc] will emerge over time…it makes no sense to have the UK as an EU hub for very much. This penny is now starting to drop’.
We should also expect to see more scare stories like these over the next few months:
* City faces years of Brexit limbo in equivalence snag: ‘The liquidity has already shifted‘
The key issue is equivalence: ‘The UK is now in a very difficult position where Europe has the upper hand in any negotiation as the liquidity has already shifted.’
City firms may have to wait for ‘years’ for a meaningful UK-EU agreement on financial services, according to experts in the field.
The prospects are so bleak for anything more than the current bare-bones arrangements, according to some, that as far as the City is concerned it will be operating under no-deal Brexit conditions for the foreseeable future (Financial News, 6 January 2021).
* Morgan Stanley bolsters Frankfurt syndicate desk in wake of Brexit
Morgan Stanley is set to bolster its syndicate team in Frankfurt, as part of the US bank’s efforts to comply with new post-Brexit rules for UK-based finance firms (Financial News, 7 January 2021).
The idea that liquidity has already shifted to the EU is ridiculous. The idea that Frankfurt will replace London as Europe’s financial hub is equally ridiculous.
We should also expect to see regular attempts by the EU to block access to EU customers by UK firms, despite these being allowed under international law. A recent example is the warning by the European Securities and Markets Authority, the EU’s financial regulator, about ‘reverse solicitation’ being a ‘questionable practice’ and warning about MiFID II ‘requirements on the provision of investments services to retail or professional clients by firms not established or situated in the EU’.
The EU’s hostility to our ‘Anglo-Saxon’ financial system runs very deep and goes back to the very origins of the European Economic Community.* We should therefore expect it to be very insistent that we follow its rules in order to access its single market. We should be equally insistent that we will do no such thing. This time we must not compromise. It’s time to stop another disaster.
* David Blake (2021) Striking Similarities: The Origins of the European Economic Community, Advances in Politics and Economics, Vol. 4, No. 1, 2021, http://www.scholink.org/ojs/index.php/ape/article/view/3581/3613
Professor David Blake, City, University of London