Two years ago, the Governor of the Bank of England made a speech warning of a fork in the road in terms of the global approach to financial services (FS) regulation and supervision. The high road - founded on a shared commitment to markets, common minimum global standards, strong regulatory cooperation and resilient institutions and markets - would likely lead to benefits for all. By contrast the low road would involve countries turning inwards and reducing reliance on each other’s financial systems, leading to fragmented markets, less competition and disrupted cross‑border investment.
Two years on, and with Brexit looming, which road are we on?
The evidence from the Brexit negotiations is hardly encouraging. It once seemed as if the UK would advocate a future relationship with the EU based on "mutual market access" or “mutual recognition”. In broad terms, this would envisage firms in each territory having licence-free access to FS markets in the other territory, based on the already aligned legal and regulatory regimes in the UK and EU. However, the UK Government's starting position, as articulated in the post‑Chequers White Paper, was that the future relationship between the UK and the EU in terms of financial market access should be based on "equivalence" - essentially the framework that the EU currently uses in its relationship with any third country. Perhaps this was inevitable, reflecting the UK and EU’s “wish to maintain autonomy of decision-making and the ability to legislate for their own interests”. But it meant there was no opportunity to try to take advantage of the fact that if and when the UK leaves the EU both of them would have the same rules which would, in the Governor’s words, have “ideally positioned [them] to create an effective system of deference to each other’s comparable regulatory outcomes”.
The UK Government supports outcomes‑based equivalence, as a way of maintaining some autonomy in rule‑making. It has also made clear that it will seek to improve and expand the EU’s current equivalence framework in a number of key areas, including to make equivalence decisions more transparent, predictable and durable. This will be no easy task, and there is little evidence so far of the EU being willing to make the changes that the UK seeks. Indeed, as I set out below, there are signs of it moving in the opposite direction.
Two recently-agreed laws stand out in this regard. The Investment Firm Regulation (IFR) augments - and tightens - the equivalence provisions in MiFID II. In the case of third‑country firms whose activities are likely to be of systemic importance in the EU (many of which are likely to come from the UK), the IFR allows the Commission to apply some specific operational conditions to an equivalence decision to ensure that the European Securities and Markets Authority (ESMA) and national competent authorities have the necessary tools to prevent regulatory arbitrage and monitor the activities of third country firms. The IFR also envisages that the Commission may, where appropriate, adopt equivalence decisions limited to specific MiFID II services and activities, in contrast to the “all or nothing” approach that seems to exist today. This opens up the prospect of the Commission selecting some but not all of a third country’s services and products which it deems equivalent. The provision of services not deemed equivalent would be able to continue under Member State national rules, rather than being banned outright. In some respects, firms may prefer partial equivalence, if the choice is none at all.
EMIR 2.2 introduces a new regime for third-country central counterparties (CCPs), including a provision - to be used as a “last resort” - that would lead to third‑country CCPs of such “substantial systemic importance” in the EU being refused recognition and, in effect, required to set up a new subsidiary CCP in the EU in order to be able to continue offering clearing services within the EU. This measure reflects the EU’s long-standing concern about the scale of clearing in euro-denominated derivatives that takes place outside the Eurozone, particularly at UK CCPs. This last resort power, if deployed, would result in significant market fragmentation and inefficiencies, including through the reduction of netting benefits. And this measure is not timely - it comes just when not only the UK, but also some in the US are advocating the high road in relation to CCPs. As J Christopher Giancarlo, the outgoing Chairman of the CFTC has acknowledged: “We have a rare and precious opportunity to trust one another; to put into place contemporaneously laws, rules and regulations that enshrine regulatory and supervisory deference in how we treat third country firms and transactions”.
A third EU legislative development is also worth highlighting. The fifth Capital Requirements Directive (CRD5) requires third-country banks or investment firms with more than €40bn of assets (including assets in branches) to set up an intermediate parent undertaking (IPU). This is essentially a holding company for all the EU subsidiaries of a third‑country group operating in the EU, and many believe this to be the EU’s response to the US Intermediate Holding Company requirements. While the IPU will clearly have advantages for the EU authorities in terms of supervising third‑country groups with multiple subsidiaries in the EU and will increase the options available to them in a resolution, neither is necessary in a world of robust global regulatory standards and trust built up through intensive supervisory cooperation.
Looking back, it is important to bear in mind what might have been. The IFR might have been even more restrictive, had some amendments tabled by the European Parliament been adopted. The IPU threshold might have been set at €30bn and might also have automatically included the operations of all third‑country global systemically important banks, regardless of their size in the EU. In addition, some of the original proposals in the review of the European Supervisory Authorities that would have given ESMA greater oversight over delegation and outsourcing arrangements in relation to third countries were significantly diluted. So there is evidence of some moderating forces at work in the EU institutions that seek to preserve some of the benefits of the high road. We will however have to wait and see whether, once the new Commission is in place, some of these tougher proposals reappear in new FS Regulations and Directives.
In addition to these developments, there are two structural features which may make the high road more difficult to take. Once the UK leaves the EU, the EU will be reluctant to allow its main financial centre to sit outside its borders and direct jurisdiction. (The same would be true of the US.) Second, the UK has been and remains a very strong proponent of adherence to global standards. In the past it has often brokered deals and helped deliver the EU’s agreement to these standards. The UK’s departure from the EU may increase the likelihood of the EU diverging from global standards.
Against this background, the UK has consistently maintained an open approach to wholesale FS, a stance which has historically served it very well and continues to be in its own interests. It put in place a framework early on in the Brexit process to give branches of EU banks and other FS firms and EU-headquartered CCPs the certainty that they would be able to continue to operate in the UK, even in the event of a “no deal” Brexit. The Prudential Regulation Authority has reconfirmed its approach to third‑country branches. MOUs between the UK regulators and their EU counterparts have been put in place, enabling supervisory cooperation and information exchange and the delegation of portfolio management by EU asset managers to UK firms.
One test of the UK’s willingness to remain on this high road will be its reaction to ESMA’s approach to the share trading obligation under MiFID II. In effect this means that EU investment firms and credit institutions will not be able to trade EU and certain UK shares on UK venues, even if the more liquid market is in the UK. The Financial Conduct Authority, in a strongly-worded press release, pointed out that if the UK were to adopt the same approach, it would disrupt market liquidity and impair client best execution. Experience to date suggests that the UK will - rightly - not reciprocate.
In my view, the UK’s openness, whether to branches undertaking wholesale markets business or to the location of share trading, is essential to it retaining its role as the leading global financial centre.
All in all, it does appear that the EU has started down the low road. But it is possible that, over time, the low road rises to meet the high road and eventually reunites with it.
What might cause this to happen? A calmer, more normal environment following the conclusion of the Brexit negotiations may allow regulators to get on with the “business as usual” of regulatory cooperation and coordination. Andrea Enria, the recently‑appointed chair of the Single Supervisory Mechanism, has spoken very positively in this regard: “To me, one thing is clear: post-Brexit, withholding cooperation is no solution... And I can reassure you that constructive solutions are being found”. Moreover, as noted above, most of the new powers give the EU authorities the discretion to act - they do not (with the exception of the IPU) requirethem to use them. And over time it may become apparent that trying to create an EU capital market by regulation which seeks to force, rather than attract, business into the EU will not succeed. In response, FS firms may choose to minimise their activities and presence in the EU, diverting business, instead, to more open and liquid markets in the UK and the rest of the world.
Whatever lies in store for post‑Brexit regulation, we are not at the meeting of the roads yet.