Despite the Brexit negotiations between the EU and the UK being labelled as some of the ‘most transparent’ ever, the uncertainty over the end result has been daunting for companies.
Probably no sector has been subject to quite as much uncertainty and political considerations as the financial services industry in the City of London, home of the EU’s largest wholesale financial market.
As company boards prepare their contingency plans and strategies to deal with Brexit and their access to EU27 markets beyond March 2019, confusion abounds on the options that the EU-UK split may deliver for financial services, bearing in mind the institutional rigidities on both sides.
Especially from the EU27 perspective, this is no longer a matter solely of EU financial services policy and legislation but touches on the EU’s approach and competences to international trade with the rest of the world. This briefing seeks to outline the options for the financial services industry that are likely to emerge from the negotiations between the EU and UK.
Financial Services & International Trades Rules
Trade in services is governed within the World Trade Organisation by the General Agreement on Trade in Services (GATS). The core principles of the GATS are commitments on market access and extending national treatment to non-domestic firms for each sector and sub-sector, expressed in schedules of commitments by each member of the WTO.
The EU has, for example, committed to give market access for insurance services as well as for banking and other financial services, subject to some specific and general limitations.
In the area of financial services, the most far-reaching general limitation (applicable to all WTO members) is the so-called Prudential Carve-Out (PCO), laid down in the GATS Annex on Financial Services (Clause 2(a))1: “Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system.”
Under the PCO, the EU has been able to issue the vast number of sectoral pieces of legislation regulating financial services without breaching its legal obligations vis-à-vis other signatories to the GATS.
For financial firms, one of the main hurdles when offering services in multiple jurisdictions is not market access but the need to comply with local regulatory requirements that may differ from the regulatory framework of its home market.
Complying with local requirements can take different forms such as different licensing requirements, which may require a degree of physical presence, substance requirements, which can generate high costs.
It can also generate inefficiencies in managing capital and liquidity requirements across various entities within the same corporate group, substantially raising the costs of doing business. Finally, local rules and restrictions on how financial services are sold and distributed may lead to cost duplication and limit the scalability of business lines across different markets.
In the context of Brexit, an ideal outcome for financial firms would be for both the EU27 and UK frameworks to remain closely aligned, allowing them – as far as possible – to comply with one set of requirements.
To maintain this fragile status quo for a prolonged period of time would require the EU and UK to design and agree an arrangement that mutually aligns the scope of the PCO. From an EU perspective, one of the key questions then is: who gets to negotiate this arrangement and then ratify it?
The EU & Free Trade Agreements (FTA): who decides?
In bilateral trade agreements, as with other areas of EU policy, the EU acts within the limits of the competences conferred upon it by the Treaties. Trade policy is an exclusive power of the EU – so only the EU, and not individual Member States, can legislate on trade matters and conclude international trade agreements.
The scope of the EU’s exclusive powers covers not just trade in goods, but also services, the commercial aspects of intellectual property and foreign direct investment. The European Commission negotiates with trading partners on behalf of the EU. It does so by working closely with Member States and keeping the European Parliament fully informed. Indeed, before the Commission can begin negotiations with a trade partner, it must seek a mandate to do so from the Member States which sets out the terms and objectives of negotiations.
This is important because Member States and the European Parliament are the ones to formally agree the outcome of the negotiations and prepare the way for ratification of the agreement.
However, while the EU has exclusive power in negotiating trade policy, it does not have exclusive competence to ratify all aspects of a proposed bilateral Free Trade Agreement (FTA), such as may be in prospect between the UK and the EU27.
This is particularly true for what we call ‘new generation’ FTAs – agreements which go far beyond traditional tariff cuts and trade in goods to include provisions relating to services, investment and dispute settlement (examples include the EU-Singapore and EU-Canada (CETA) agreements).
Member State Ratification
While the Commission began negotiations in the understanding that their ultimate ratification would be a matter for agreement among Member States and consent from the European Parliament, the agreements ended up containing elements which strayed into areas of ‘shared competence’ between the Commission and Member States. These agreements are deemed to cover ‘mixed’ competences and, for mixed agreements to formally enter into force, they also need to be ratified in each of the 28 EU Member States.
The practical effect here has been a significant delay in the formal ratification of FTAs such as CETA, because domestic ratification procedures vary across Member States. While relatively straightforward for most Member States, some ratification procedures also involve approval by the chamber of the national parliament representing the regions (such as the Bundesrat in Germany) or the approval of the regional and community parliaments (as in the case of Belgium).
Individual Member State ratifications (a total of 38 regional or national parliaments) would come on top of the normal ratification by the Council and European Parliament, thereby delaying the process by months if not years.
The Commission ultimately sought clarity on the issue of mixed agreements by referring the EU-Singapore FTA to the Court of Justice of the EU (CJEU) for its opinion. In May 2017, the CJEU 2 found that the FTA in question falls within the exclusive competence of the EU with the exception of a limited number of provisions relating to non-direct investment and investor state dispute settlement in particular. The latter provisions are deemed a shared competence and would therefore need to be ratified accordingly.
In the meantime, the CETA ratification process made it into the international spotlight when the Belgian region of Wallonia blocked the EU’s ability to sign that agreement. This episode, combined with the CJEU judgement on the EU-Singapore FTA, has led the Commission to adopt a fresh approach to overcome these issues in the future. In a communication published on 13th September, the Commission emphasises the need for the EU to be a “credible negotiating partner” i.e. “institutional decision-making must be clear, predictable and fit for purpose”. The aim here is to enshrine a more predictable and transparent process for ratifying and implementing trade agreements in order to avoid the issues experienced in the past.
A new approach
Thus, the Commission is attempting to fast-track upcoming FTA negotiations. This is evident in its recommendations to open FTA negotiations with Australia and New Zealand where the Commission proposes to negotiate a broad list of subjects fully covered by the EU’s common commercial policy (liberalisation of trade in goods, services and foreign direct investment, public procurement) but does not include investment protection and the resolution of investment disputes. Instead, the Commission wishes to further discuss these issues with the Council and European Parliament before proceeding. Moreover, it aims to conclude negotiations with both partners by March 2019. With negotiations expected to kick-off in December 2017 at the earliest, this deadline is very ambitious.
The scope of the EU’s exclusive powers covers not just trade in goods, but also services, the commercial aspects of intellectual property and foreign direct investment.
While this new approach should make that process more predictable and straight-forward for future agreements with most trade partners, it is unlikely to ease the complexities of an EU-UK FTA post Brexit. A meaningful EU-UK FTA will need to go far deeper than the FTAs the EU has negotiated to date. There is one considerable difference between the EU-Canada situation and the EU-UK situation: unlike the EU and Canada, the UK and the EU already share full free trade and full regulatory compatibility.
The UK is a services economy and will be seeking to maintain as much access as possible to the EU market for its investment and services sectors, especially financial services. The CJEU opinion on the EU-Singapore FTA deemed financial services to be an exclusive EU competence. However, the provisions on liberalisation of financial services were limited to a general obligation of market access that would be fully subject to the PCO. The UK will be looking for a more ambitious EU-UK FTA in this area. This would increase the likelihood that those provisions would fall under ‘shared’ competence between the EU and Member States. It follows that some key elements of that FTA would therefore need to be ratified unanimously by all EU Member States and their 38 national and regional parliaments. Aside from the obvious time delays, an agreement under those circumstances is far from assured. The question may become – where is Brexit’s Wallonia?
What are the options for financial services?
Given the above, several options for the financial services sector may emerge from the Brexit negotiations, though some are more likely or realistic than others.
An ambitious FTA mutually aligning the scope of the PCO
Several trade associations representing the UK-based financial sector have publicly backed the idea of a mutual recognition agreement as part of a wider FTA. To provide sufficient predictability for firms, so avoiding one of the drawbacks of the equivalence regime (see below), this agreement would need to ensure the continuous alignment of frameworks between both sides and would need a transparent, effective and rapid dispute resolution mechanism. This would limit the discretion each side has in applying the PCO.
Such an agreement would undoubtedly deal with consumer and investor protection (Article 169 TFEU) and investor-state dispute resolution, both of which are deemed mixed competences between the EU and Member States and require national ratification. The political consensus in the EU corridors of power is that not enough time is left before March 2019 to agree and ratify any (transitional) agreement which covers mixed competences.
Additionally, there is no guarantee that the EU and UK would agree on the scope of measures to be assessed in the context of mutual recognition. Whereas the UK might want a narrow scope looking only at financial services regulation, the EU may be keen on a wider scope including taxation and competition/state aid elements.
Therefore, we do not rate this option as realistic in the near future. Moreover, the fact that no FTA in the world currently contains such a far-reaching financial services chapter may dampen optimism.
Existing tool: equivalence
Equivalence’ is a unilateral EU tool, foreseen in several existing pieces of legislation, to grant market access to firms established in certain third countries. Since the possibility for the European Commission to deem third countries equivalent is already foreseen, taking an equivalence decision is not necessarily perceived as making a new market access concession to a third country but rather as a unilateral EU action. Member States are less likely to argue that this would involve a mixed competence.
The adoption of equivalence decisions where foreseen should be relatively straightforward as the UK will have implemented and be applying the existing EU directives and regulations. Equivalence is, however, deemed unpredictable as certain decisions have proven to be politically motivated and decisions may be withdrawn within a short timeframe.
Equivalence is currently being reviewed with the aim of giving the EU a better set of unilateral tools to regulate market access. The legislative proposal on the review of the European Supervisory Agencies (ESMA, EIOPA, EBA)3 published on 20th of September gives a more important role to the ESAs and the proposal to review EMIR in the context of third country CCPs may bring changes to the functioning of equivalence. It may also introduce various shades of equivalence, rather than the binary option of full or no equivalence.
Assuming no overall breakdown in the negotiations between the EU and UK, we rate this as the most likely outcome.
Transition by default – EEA style arrangement?
Although discarded early on by the UK as it meant staying in and paying into the single market, being subject to the judicial review of supranational courts and involved very little ability to shape the rules, a transitional arrangement that would replicate the European Economic Area (EEA) is rapidly becoming the only scenario which would avoid a cliff-edge. Some pro-Brexit politicians argue this falls far short of delivering Brexit.
For firms, it would have the advantage that the UK would abide by the existing EU rules but would equally be entitled to the rights these rules confer, such as the much-used regulatory passport. One important drawback would be that any new rules would be agreed without the UK being present at the negotiating table. UK-based firms would have a more challenging time in making their voice heard with EU policymakers.
An EEA-style transitional arrangement may at this stage be the least disruptive transition possible. However, it is unclear whether those in the UK government supporting this arrangement will prevail in the internal power struggle. Also, this will only become a realistic option if ‘sufficient progress’ is reached in the Brexit negotiations (e.g. on the financial settlement) between the EU and UK. While the UK government has recently sought to strike a more conciliatory tone on the financial settlement, it is still unclear whether any agreement can be reached that facilitates a transitional arrangement.
By a ‘deep and comprehensive’ EU-UK FTA, we assume that the UK Government – in the case of financial services – is seeking an agreement that would restrict the ability of each side to use the PCO for divergent financial regulation.
To achieve an effective regime, the EU-UK FTA must address issues of investor protection as well as put in place an appropriate dispute resolution mechanism – both mixed competences between the EU and Member States. This will require a lengthy ratification process. But as we approach March 2019 and – with no decisive progress on the financial settlement between the UK and EU in sight – this option will not offer a practical solution to firms. Equally, the option of an EEA-style transition arrangement will require an agreement on the financial settlement. Therefore, the options of – pre-emptively – seeking equivalence under existing pieces of EU legislation may be the most realistic solution to avoid a cliff-edge scenario. While this is not ideal, it may be the most realistic alternative in the present circumstances.
As negotiations continue and there is no sign of a mutual recognition mechanism or equivalence decisions, firms are or will take decisions on adapting their business structure to ensure market access beyond March 2019. In that context, future EU legislation and guidance by European supervisors such as the ECB/SSM and ESMA on delegation, outsourcing and risk-transfer arrangements between EU regulated entities and third countries are probably as important as the final outcome of the negotiations.
Ultimately, if firms are forced to adapt their business structure, they will make these resilient to the worst possible outcome of Brexit. Once this has happened, the financial services industry may no longer be the most important priority for negotiators on either side in future FTA negotiations.
1 WTO, General Agreement on Trade in Services – Annex on Financial Services 2 Court of Justice of the European Union, Opinion 2/15 – 16 May 2017 3 European Commission, Proposal on the review of the European Supervisory Agencies, 20th September