Barnabas Reynolds is head of the global financial institutions and financial advisory practice at Shearman & Sterling LLP. He is the author of A Template for Enhanced Equivalence: creating a lasting relationship in financial services between the EU and the UK.
Now that the Brexit negotiations have turned to the possible shape of a financial services deal, we should understand what a good result would look like and why. A mutually advantageous deal would allow both the UK and EU financial sectors to trade freely and flourish. It would permit EU customers the cheapest access to capital.
Most people in the sector want a mutual access arrangement for financial services which replicates what happens now – whereby UK-based firms operate across the EU supervised solely in the UK under pan-EU regulations, and EU-27 firms operate in the UK whilst being solely supervised in their home state. After Brexit, firms located in the UK want to be solely supervised here under UK regulation, but to service clients across the EU without being supervised or regulated in the EU. EU firms want to be supervised solely in the EU under EU regulation whilst conducting business in the UK’s global markets.
In order to achieve these aims, some form of agreement must be reached on how similar the relevant financial services laws and regulations in the UK and EU need to be. Otherwise neither party will be satisfied that providers from the other party are operating safely in their markets. This is the main concern to navigate, since the EU Treaty provides for free movement of capital to and from so-called third countries, which is what the UK will be after Brexit. It does not seek to disadvantage EU customers by cutting off their access to competitively priced products, and indeed EU businesses themselves wish to compete in the global markets.
And if a deal is to succeed, it must be flexible so that both parties can adapt their rules and supervisory approaches to contend with the global markets hosted in the UK and the smaller, more domestic markets of the EU-27. Rule-taking by the UK from the EU, or micro-management by some oversight committee, would be destined to fail. Each would insert massive systemic risk into the UK’s global financial markets. Those markets can only be regulated safely by tailored regulation and dynamic, on-the-ground supervision. Laws and regulations need to fit properly into the common law framework that exists here.
Various words have been used to define the sort of relationship the UK’s regulations should have with the EU’s after Brexit – ‘equivalence’, ‘divergence’ and ‘alignment’ being the favourites. The UK-EU Phase 1 non-binding draft Brexit withdrawal agreement uses the term ‘alignment’. The International Regulatory Strategy Group suggests that a new concept of ‘divergence’ should be provided for, and any ‘material differences’ between UK and EU law avoided. My own analysis proposes ‘equivalence’, and outlines detailed draft EU and UK legislation and a model UK-EU agreement based on enhancements to the existing EU notion of ‘equivalence’.
None of the terms on its own achieves what is required, for each can be used to demand vastly differing levels of compatibility in law. Ships can be ‘aligned’ on opposite sides of the ocean. ‘Equivalent’ and ‘divergent’ provide scant guidance on how far apart either side’s rules may be. And the IRSG’s materiality concept adds little: material to whom? In what way? Materiality is notoriously slippery to define in law. The fact is that without additional delimiters none of these ideas, on its own, would be acceptable.
There is much to be said for the EU equivalence concept as a starting point because it is in use by the EU already, including for the US, Mexico and Singapore. In the form in which it exists now, it does not bring with it any attempt at EU control of UK law or policy, or restrictions on the UK’s need to be competitive, any more than the EU seeks to control those matters for the US or other sovereigns. It merely seeks to measure the similarity of the UK’s regime to that of the EU in the respects that matter.
To this end, it is defined with a vital in-built limitation. It requires equivalent ‘outcomes’ to be achieved. These outcomes are higher level than the minutiae of detailed regulation. This approach fits well with the lead that the UK takes in setting and complying with international standards in financial services regulation, to which the outcomes should sensibly look. But there are shortcomings in the definition, and mechanics surrounding the equivalence concept which it would benefit both parties to fix. This is where my draft legislation and bilateral agreement come in.
First, the markets wish to have predictability of access. In order to provide for that, there will need to be a two-way, binding agreement between the UK and EU over equivalence. Commitments will need to be made to recognise each other’s jurisdictional arrangements as equivalent from the day of Brexit. These must last indefinitely until some objective change occurs which means the parties’ rules are no longer equivalent.
Second, there needs to be more specificity as to what is meant by equivalence. Pinning it to outcomes seems sensible. Indeed, it is hard to identify other delimiting concepts that would work for the financial markets. However, it should be made clearer how the outcomes are to be defined by reference to high level international standards where those exist. In the context of regulatory capital, the Basel rules provide such a set of standards, for instance. Also, in many areas, no international standards currently present themselves. The UK should play a strong role in rectifying that fact. Pending such a development it will be necessary for the short to medium term for officials from the UK and EU to agree the set of outcomes that are required for mutual access.
This process could of course become very political. If one party sought to use the process to render the other a rule-taker, interminable disputes could result. Ongoing goodwill will be required. Given the long history of official collaboration, it is reasonable to believe that will be achievable here.
Two additional concepts should be borne in mind. In the wholesale markets, the rules of one party should not cause unnecessary systemic risk to the other, bearing in mind nevertheless the need to recognise that each other’s regulators operate in good faith and under equivalent rules. In the retail markets, the parties should seek to observe each other’s consumer protection regimes. Both ideas are reflected in the draft legislation.
In addition, any system should be flexible enough to permit the other party to select the areas in which it seeks equivalence, not bothering with access arrangements where agreement on outcomes cannot be reached. The lack of equivalence in a particular area should not prejudice the entire arrangement.
Whichever way the task is addressed, it is important we focus on the concepts that are truly defining. The more the wording abstracts the compatibility test away from line-by-line comparisons in favour of the achievement of objective high level outcomes, the more robust any agreement will be. Success will only arise from clarity of thinking up front as to what is desired and why.