Brexit and UK-Based Financial Services

The fundamental issues concerning Brexit and financial services relate to continued access in some form to the Single Market. While there were some discordant voices during the referendum campaign, the dominant view of Britain's financial services industry supported remaining in the EU, in order to have access to financial business throughout the Union. In light of the Brexit vote, the initial general preference was to retain membership of the Single Market, or more specifically to keep so-called "passporting rights" which allow companies based in the UK to provide financial services throughout the EU. For the Government, this of course raised the conundrum of what concessions Britain would have to make to retain such access to the Single Market, once the UK leaves the EU. In particular, these concessions would have involved accepting the four freedoms of the Single Market, and hence continued labour mobility within the Market (i.e. European immigration), and acceptance of EU law.

The likelihood that Government policy would take a different course was, however, already set out clearly by Theresa May in her speech at the Conservative party conference in October 2016, when she clearly stated that her government would take back control over Britain's borders and end the primacy of ECJ law in the UK. With her speech in January 2017 and the subsequent White Paper, these two policy priorities have been very clearly set out, and Britain will therefore leave the Single Market.

Issues concerning the loss of "passporting" rights

Other things being equal, British-based financial service companies will therefore lose access to the Single Market and the so-called passporting rights. This assumes of course that there is no special or bespoke deal allowing UK financial services to remain in the Single Market. Both the May speech and the White Paper in January 2017 hold out hope for sectoral agreements, as part of a bespoke deal. And as we shall see below, the rest of the EU does indeed have some interest in such a sectoral arrangement for finance. It is therefore not entirely impossible that UK-based financial services will in some way remain within the Single Market, under a sectoral bespoke deal. But at present (February 2017), such continued Single Market access and hence passporting seem like a long bet. In particular, continued membership of the banking and finance sector of the Single Market would mean Britain accepting EU laws and regulations (in finance and related commercial activities), without having any say in how they are made. Alternatively, Britain would still have a direct voice in the shaping of EU financial regulation, even though it has left the Union. These possibilities seem politically highly unlikely and technically complex. But so do the alternatives.

Proponents of leaving the Single Market, or what used to be called "hard Brexit", tend to argue that "passporting" is actually not that important and other business can be generated elsewhere (for example, London can expand its lead role in Islamic banking). However, as with everything else concerning Brexit, the issue of passporting is highly complex. According to the Financial Conduct Authority (the main independent public authority regulating finance, responsible to government and Parliament), there were 5,476 UK-based firms which benefitted from some type of passporting rights to carry out business in other EU countries, in mid-2016. Similarly, there were 8,008 companies based in other EU countries which operate in the UK, on the basis of passporting rights too. But, given the variety of different activities which any one company may carry out, and which may fall under different European regulations, the total number of "outbound" passports held by UK-based companies was 336,421. By contrast, the total number of "inbound" passports (held by firms based elsewhere in the EU and operating in the UK) was only 23,532. The loss of passporting rights could therefore have consequences for very many businesses.

That said, passporting is not equally important to the main activities undertaken by financial services in the UK. According to the organisation Open Europe (drawing on work by Olivier Wyman Research, a management consultancy), it is above all banking which benefits from passporting, contributing to one fifth of UK-based banking revenues (between £23 billion to £27 billion). Such passporting involves two pieces of EU legislation in particular: the Capital Requirements Directive IV (CRD IV) which relates to retail and wholesale banking (i.e. deposit taking and lending between financial institutions and large entities); and the Markets in Financial Instruments Directive 2 (MiFID II) for investment banking. As CRD IV legislation does not allow for "equivalence" (see below) or meaningful third party access, UK-based banks (such as London-based US wholesale banking establishments) may experience dislocations in their business, if no agreement is reached between the UK and the EU to preserve passporting. More specifically, Sir Charles Bean (formerly Deputy Governor of the Bank of England and currently Professor of Economics at the London School of Economics) also recently stated to the House of Lords European Union Committee that where wholesale financial services need to connect with retail consumers, then the loss of passporting would necessitate setting up subsidiaries in other European countries. This in turn could entail considerable costs, in terms of opening offices, and providing capital for such independent subsidiaries.

For asset management activities, however, the situation seems to be different. The key EU directives (UCITS and AIFMD) provide passporting possibilities for funds to be marketed throughout the EU, while operating from a single base. In practice, however, there are several technical barriers to such operations, including: supervisory and legal fees, along with national variations in the definition of 'marketing'. It is therefore difficult in any case for small and medium-sized asset managers to operate across the Union, while larger funds often have local subsidiaries. At the same time, the UCITS and AIFMD directives allow for some portfolio management functions to take place outside the EU, from which UK-based firms could then still benefit after Brexit. As a result, it is estimated that only 7% of total assets managed in the UK are under direct threat from the loss of passporting rights.

The situation is different again concerning insurance services, which on the whole depend less on European markets: it is estimated that 28% of insurance service exports went to the EU in 2015 (compared to 44% for other financial services). This follows from the way insurance continues to be a nationally-based activity, with international companies operating through local subsidiaries, rather than foreign branches. Lloyd's of London, in contrast, operates differently, as an international market, and EU regulations do allow pools of underwriters at Lloyd's to provide insurance throughout the Union. But such work only accounts for 11% of the market's gross written premium, so it is possible that only as little as £800 million is directly reliant on passporting.

In short, the loss of passporting rights would surely have quite a significant impact on banks and their business throughout the European Union. But the effects in other financial activities could be much lower. That said, in its report on Brexit: financial services, published in December 2016, the House of Lords Committee on the European Union noted that, "some firms do not themselves appear to be aware of their reliance on the current passporting arrangements", and called for cooperation between firms, the Government and regulators to examine such reliance.

The prospects of "equivalence"

As UK financial institutions are now most likely to lose passporting rights, attention is shifting to the possibility of operating within the European market, on the basis of socalled regulatory "equivalence". This is a fairly new, open-access regime introduced into EU law in the wake of the financial crisis. It gives access to third-country firms to operate in member states of the European Economic Area (essentially made up of the EU and former EFTA countries like Norway and Iceland), when regulation in their nonEuropean home countries is seen by the EU to have a broadly-equivalent regulatory regime. Such "equivalence" recognition, would allow UK-based financial institutions to operate in the cross border provision of investment services to wholesale clients or counterparties (under MiFID II). London could also remain a venue for trading European shares and so-called over-the-counter (OTC) derivatives: i.e. derivatives on financial assets which are directly traded between parties, and are not carried out through central counterparty clearing houses (CCPs: see below). Other activities that may also be covered by equivalence provisions include: the establishment of CCPs; the marketing of Alternative Investment Funds; and Reinsurance activities.

Yet, European equivalence regulations so far do not extend to banking services such as lending and deposit-taking (under CRD IV), and retail asset management (under UCITS). UK-based fund managers would not therefore be able to market UCITS funds, and would instead need to operate under more complex EU regulation.

In the case that equivalence regulation becomes the cornerstone of future business relations between UK-based financial institutions and the European Union, then much will depend on the evolution of such regulations. If things work out well for the UK, exiting the EU could mean that British-based institutions will be able to develop new activities, while remaining within equivalence-accepted regulation, perhaps as part of within the framework of broader international regulatory mechanisms set up after the financial crisis, under the auspices of the G20. By contrast, it is also possible that future financial regulation in the UK and the EU may diverge, given Britain's clear historical preference for liberalized finance and the more regulatory aspirations of some key European countries (such as Germany and France). In this case, the sale of financial services into Europe by UK-based institutions may well become more difficult and/or costly over time. Much will depend on the kind of overall relationship which the UK will have with the EU in the future.