Dr Cleo Davies – Senior Research Associate at the University of East Anglia
On the 29th April 2021, the Financial Services Bill received royal assent. Touted as a milestone for financial services by the UK government, John Glen, Economic Secretary to the Treasury who guided the Bill through Parliament, declared “For the first time in decades, the UK has full control of its own financial services regulation”. In many ways, this is a puzzling declaration. First because regulation of the financial services sector has evolved tremendously over the past decades and is very much a mix of international, European and domestic rules and principles, that emerged first in the context of globalisation and then as a response to the Global Financial crisis in 2008. Secondly, because the UK was such a huge influence in this area as a member state and reaped substantial economic and reputational gains from the regulatory regime it largely help create. Thirdly, because it is counter-intuitive that a Conservative Party politician should choose to focus narrowly on ‘regulation’ of the financial services sector. However, the declaration does reflect the Johnson government’s priorities in the future relationship with the EU: full control of regulation even at the expense of its economic interests. Indeed, the UK financial services sector has ended up with something very close to a no deal scenario.
A no deal scenario for financial services
The EU-UK Trade and Cooperation Agreement (TCA) does not include financial services. The political Declaration adopted in October 2019 by the EU and Johnson’s government stated that both parties should endeavour to complete equivalence assessments before the end of June 2020. Equivalence is the EU’s instrument that gives third countries access to the single market in financial services. The UK’s negotiating position, published in February 2020, included equivalence and its governance in the trade agreement. The EU’s position, on the other hand, insisted on unilateralism and that equivalence would not be part of the trade agreement.
Equivalence assessments were not completed by June 2020. As the end of transition period came closer, both parties took unilateral decisions to ensure continued trading in certain areas of financial services. In November 2020, the UK granted equivalence to the EU in 17 different areas of financial services. The EU granted the UK time-limited equivalence in two important area of derivatives trading (eighteen months for UK central clearing counterparties, and six months for central securities depositaries).
But financial services were conspicuously absent from any of the media and political focus in the months leading up to the end of the transition period on the 31st December 2020. The Bank of England and the industry were quiet, leaving the negotiation teams to their work. The UK did seek to introduce some aspects of financial services in the trade deal in the last few days of the negotiation but to no avail. The only specific reference to financial services came in the form of a short Joint Declaration published alongside the TCA, in which the parties commit to a Memorandum of Understanding by March 2021 on regulatory cooperation. The Joint Declaration included a non-committal formulation, to ‘discuss, inter alia, how to move forward on equivalence’.
In effect, this left the industry close to a no deal scenario. The sector, though, was well prepared. From a business perspective, it had adapted to the eventuality of losing automatic access to the single market (passporting) with firms developing contingency plans, relocating staff to, and setting up offices in EU member states. From a financial stability perspective, a combination of unilateral measures and ongoing cooperation between the UK and the EU regulators ensured there was no disruption on the 1st January 2021.
The waning star of the City of London?
In the first few weeks of 2021, financial services were back in the public debate. Reports emerged on the loss of business from London to Amsterdam. There was renewed emphasis on the need to secure equivalence for the City of London – in 2019 financial services are the second UK’s largest export services sector to the EU so loosing access to the single market incurs a loss revenue and of economic competiveness. In early 2021, the Governor of the Bank of England, Andrew Bailey, openly voiced criticism of the EU’s reticence to reciprocate the same level of equivalence that the UK had granted the EU.
In theory, equivalence provides the same access as passporting in so far as there is no need for businesses to comply with two regulatory and supervisory regimes. But the scope and legal basis is different. The EU grants equivalence only on specific aspects with no third country benefitting from equivalences that cover the entirety of what passporting provides for (full overview). Crucially, equivalence is granted by the European Commission on a unilateral basis and can be revoked anytime and at short notice without any means for appeal. In effect, it puts the UK at the mercy of the Commission for its access to the single market in financial services.
Despite the talk in early 2021, it became clear very quickly that equivalence would not be granted anytime soon. Instead, the EU granted equivalence to the US central counterparties (CCPs) supervisory regime potentially exposing London to competition it did not have previously, and started to voice its intention to onshore certain activities, i.e. have these carried out inside the EU and the Eurozone instead of out of London. By the end of March 2021, a Memorandum of Understanding was agreed, but focused entirely on cooperation between supervisory authorities not on the trade dimension.
It remains puzzling that UK negotiators did not foresee the EU taking this approach on equivalence. The ECB’s preference for having certain financial services activities carried out under its jurisdiction (location policy) is longstanding, as emphasised by Andrew Bailey when he spoke to the House of Commons Committee in February 2021. As recently as 2015, the UK had won an EU court case against the ECB on its location policy. Alternatively, the UK may have foreseen this outcome, but it was not able to secure any concessions because of the asymmetry in the bargaining power between the two parties – it was in the EU’s interest to tackle financial services independently of the broader trade agreement and to keep equivalence as a unilateral tool. Whether out of design, the UK de facto ended up prioritising regulatory autonomy over its economic interests.
The current legal and business landscape defining the relationship is unlikely to shift in any substantial manner in the near future. At least, this means stability and some degree of certainty for the sector. But gradually, the consequences of the loss of access to the single market for the City of London will unfold as it has become clear that third country status is the new regime and there will be no preferential treatment for the UK in granting equivalence. The UK may no longer be an EU rule taker, but that also means it no longer plays a role in shaping the rules that govern the EU. This was the logical consequence of becoming a third country.
What next for the UK and the EU?
Financial services regulation fulfils two dimensions: a regulatory environment that ensures competitiveness and attractiveness of the financial services sector; and the rules that make it sound and protect investors and consumers (prudential rules). The UK is still in the process of developing its post-Brexit regulatory approach after having largely shaped a balance that worked for its industry and regulators when it was a member of the EU. Though the UK has vouched to maintain high prudential standards, it will have to find a competitive advantage to compensate for the loss of automatic access to the single market. However where and how is not yet clear. The financial Services Act ensures that the UK maintains high standards of prudential rules, but it does not say much about how financial services will be contributing to UK economic growth going forward. Moreover, many of the rules originate at international level. The UK will seek to maintain its strong voice in international bodies. In turn, this may limit the potential for major deregulatory agendas.
As for the EU, the Brexit in financial services is not necessarily good news. The EU benefited from the services provided out of the City of London with the UK as a member state, as well as from the expertise of UK regulators. Now, its largest financial centre is outside its jurisdiction. Furthermore, the picture that is emerging is one of fragmentation across the EU with no clear financial centre inside the EU-27 after Brexit. In freezing London out, everyone may end up losing out to New York.
Finally, regulators in the UK (the Bank of England and the Financial Conduct Authority) and, in a more diffuse way, the ECB in the EU-27 have gained power. The degree to which the ECB in the EU, and the regulators in the UK, emerge as strong policy drivers could raise broader issues of accountability.