How UK financial services can continue to thrive after Brexit

How UK financial services can continue to thrive after Brexit

Barnabas Reynolds is a partner at Shearman & Sterling and the author of A Blueprint for Brexit: The Future of Global Financial Services and Markets in the UK, published recently by Politeia.

Following Brexit, government ministers and industry players need to determine how the UK can retain and enhance its position globally and facing the EU. London is one of the world’s leading centres for financial services, matched only by New York. If pursued effectively, Brexit gives the UK the opportunity to excel further, leaving behind ill-focused and unnecessarily burdensome EU regulation.

Approximately 20% of the City’s business concerns the delivery of cross-border financial services into the EU. It is a therefore a priority for the UK to retain both the ability to deliver these services, and to offer a full range of products to EU-based counterparties and customers. The passporting system has provided such access, and some advocate its continuation post-Brexit.

Yet this position is misguided. Passporting facilitates the provision of cross-border services from the City to the EU without licensing and regulation, and prevents the costs and barriers associated with duplicative regulation. However, this is not the full picture.

This view fails to consider the crucial fact that passporting has come at a huge cost to the UK. Its continuation, or a bilateral EU-UK deal to replace it, would undermine the cost-saving opportunity provided by Brexit. Passporting requires the UK to implement ill-focused and process-driven EU regulation. 20% of the City’s business is not enough to justify the blanket application of such EU regulation across the breadth of the City’s global activities.

Additionally, the UK will lose its power to influence EU law. Without the UK’s rational input, the EU is likely to move towards more protectionist and process-driven legislation. Such legislation could require the UK to make additional concessions to the EU. For example, the UK may have to accept the ECJ’s ‘harmonised interpretations’ or perhaps accept the free movement of persons, which would be politically controversial following the referendum result.

Two attractive alternative options exist: an “enhanced equivalence” model and a financial centre model. Both would facilitate the UK’s access to EU markets but would allow the UK to avoid the issues outlined above.

The Enhanced Equivalence Model would allow the UK to access the single market through the EU’s pre-existing “equivalence” regimes. Third countries (which is what the UK will be following Brexit) may access the single market under “equivalence” regimes based on a determination that their domestic rules are comparable, or “equivalent”, to the EU’s in the same area. In return, the UK would grant EU institutions the reciprocal ability to establish UK branches or trade in the UK under predominantly EU rules. This is a major benefit. The UK would not be required to implement EU legislation, only maintain equivalent domestic rules. This regime would give the UK some freedom to create its own laws as it requires equivalent, not identical laws. The US, Singapore, Mexico and others have achieved equivalence on the basis of such legislation.  Therefore, it should be relatively straightforward for the UK to redraft its domestic laws to comply with international standards whilst also ensuring these laws are deemed “equivalent” under EU legislation.

An overarching procedural bilateral deal could be used in conjunction with the equivalence regime to provide the UK’s financial services sector with an additional layer of certainty and stability. This agreement could cover notice periods for the determination and removal of equivalence, the introduction of a dispute resolution mechanism and the de-politicisation of equivalence determinations.

Politically this approach would conform to the referendum result as the UK would regain its sovereignty by no longer being bound by the EU’s membership obligations, particularly the four freedoms.  Further, the UK could, before its withdrawal from the EU, drive an initiative to close gaps identified in the existing equivalence regimes.

This is a more attractive option than a grand bilateral deal. The enactment of EU legislation requires the approval of a qualified majority, of which the UK could form part. The two-way procedural deal could be struck on the basis of a qualified majority vote at EU level as well. The conclusion of a grand bilateral deal would require the unanimous agreement of EU member states.

Despite its merits, the equivalence model should not be pursued blindly. Ultimately, the EU has discretion to grant equivalence, and may in practice turn the UK into a “rule-taker” by requiring it to maintain essentially identical rules to the EU. This should not be accepted. It undermines both the referendum mandate and the potential opportunities that Brexit could afford the City.

If the EU maintains such an uncompromising and unproductive stance, the UK should be willing to detach itself from any existing EU regime, and instead opt for a “Financial Centre Model”. Then, the UK would have the freedom to legislate in accordance with global standards without any limits from the EU’s restrictive, process-driven policies. Additionally, the Financial Centre Model could bring increased business and liquidity to the City by eliminating the inherent uncertainty caused by the ever-increasing scope of EU regulation. This model gives the UK the opportunity to create a market-friendly regulatory framework, a framework that allows business from all over the world to thrive on clean and free markets that protect consumers and effectively manage systemic risk. If achieved, this model could attract business away from the EU and other jurisdictions, such as New York. EU customers and counterparties would come to London for their financial services, as they have for centuries.

The two-year negotiation period prescribed by Article 50 provides enough time for the effective development of both the Enhanced Equivalence Model and the Financial Centre Model. The UK government must act quickly to demonstrate the feasibility of the Financial Centre Model, to demonstrate the UK’s commitment to promoting the sector (and reassure any UK financial institutions considering relocation that such a move is unnecessary) and to allow it accurately to assess the value of pursuing the Enhanced Equivalence Model.

Both models afford most of the UK’s financial sector the opportunity to provide uninterrupted services across Europe and the world. Brexit provides the UK with the unique opportunity to build on its advantages of language, law, time-zone, talent pool and established financial ecosystem. If done correctly, Brexit will allow the UK to create an enhanced and highly competitive environment for the City.