Divergence in The City
With the EU-UK Trade and Cooperation Agreement signed and Brexit now becoming an increasingly settled fact, the areas of potential divergence between the UK and the EU are becoming clearer. The strategy appears to be to identify those areas in which the UK already enjoys a competitive edge over its rivals and then work out how to use the UK’s new position to stretch that advantage. One key area is, of course, the financial services sector.
Some had hoped that the post-Brexit MoU reached between the EU and the UK at the end of March would bring with it an EU decision to reciprocate the UK position on equivalence, thus granting UK-based financial service firms the capacity to continue trading with EU customers as they had done before the UK left the EU.
It did not work out that way: the EU is reluctant to grant London extensive equivalence, arguing that it lacked certainty about the UK’s regulatory intentions. In the end, the creation of a Joint UK-EU Financial Regulatory Forum to discuss rulemaking for the sector, one of the few solid elements of the MoU, fell far short of the legally binding co-operation arrangements for which the UK had hoped.
The EU wishes to onshore more of its financial services currently located in London partly to reduce the stability risk of having a major part of its financial services sector located outside its borders and partly to make a reality of its capital markets vision. The EU views equivalence as the methodology by which third countries gain access to the EU: withholding equivalence effectively creates facts on the ground as financial services companies move into the EU in order to be able to continue to serve EU customers – once companies have moved into the EU, decamping back to the UK is less likely.
The UK also recognizes that – even should equivalence ultimately be granted – some of the damage already done is irreversible and is thinking about how and where the UK can stretch its competitive advantage in the sector. The first irony is that the weakness of the MoU may mean that, far from being a framework for alignment, it could become the roadmap towards managed divergence.
In response to EU concerns that the UK’s well-respected independent regulator may come under political and economic pressure to lower standards to seek competitive advantage, the FCA has stressed that its objective is to undertake a genuine cost: benefit legislative analysis. Wherever possible the UK will avoid making changes where the costs of implementation have already been incurred and seek to avoid, or at least reduce the expense of requiring companies to comply with two regulatory/ reporting regimes. Nonetheless, where the balance comes out heavily on cost, as opposed to benefit, then the Financial Conduct Authority (FCA), The Treasury and the Bank of England may take the view that Brexit offers an opportunity to rewrite the regulation concerned.
This suggests a potential wholesale re-examination of the financial services regulatory to identify areas where divergence would bring a benefit to the UK as a whole. The second irony is that such an outcome (an indirect consequence of the EU’s decision not to grant equivalence) would give substance to EU hesitation about London’s regulatory intentions.
Brexit as a Force for Change…
The UK does not view divergence or convergence as a strategic objective, but Brexit will force (or allow) The City to decide how to play to its strengths.
In a speech in March, Edwin Schooling Latter, Head of Markets Policy at the Financial Conduct Authority, indicated the UK was already looking at changing Regulations in a number of areas. He expanded on the criteria likely to be used to make that assessment during the course of his evidence to the Treasury Committee on the Future of Financial Services on 26 April. The process of on-shoring the EU’s financial services legislation would offer opportunities to remove those elements of the regulatory framework, where the “current degree of complexity is not fully justified.”
The FCA initially appears to be focused on loosening two EU Regulations – the Securities Financing Transaction Regulation (SFTR) and Central Securities Depositories Regulation (CSDR). But a review of the Markets in Financial Instruments Directive (MiFID) also appears in scope. And Nikhil Rathi, CEO of the FCA has suggested Brexit could be used to tighten individual protections in areas including making online publishers liable for the content of advertisements under the financial promotions regime and expanding compensation for victims of scams.
UK financial regulators are keen to identify how to refresh settlement arrangements to support both market liquidity and settlement efficiency. They have indicated a willingness to examine the wider capital markets framework. The UK has indicated it will be consulting on changes to MiFID II rules to assess whether the costs imposed by the rules have (or have not) achieved the benefits sought and – for example – whether potential efficiency gains could be made by improving the alignment of prospectus documentation requirements with the actual transaction undertaken.
Lord Hill’s Review of the UK financial services sector made a number of other recommendations for changes to the UK’s listing rules, including on free float, dual class share structures, and special purpose acquisition companies (SPACs). The FCA is currently considering its response to those recommendations.
The EU and the UK will have to make their MoU work and prioritise close cooperation to maintain as much alignment as possible and thus reduce disruption to those financial services companies with operations in both jurisdictions and destabilising regulatory fragmentation. The more the UK diverges to press home its competitive advantage in the sector, the harder that job will become.
As the EU and UK work out their future financial services relationship and begin to integrate their thinking on how the sector assists the energy transition, Covington’s mixed team of regulatory and public policy experts is well-placed to help clients navigate these new and potentially challenging waters.