Editor’s Note: The author is a London-based partner at Katten Muchin Rosenman.
What a difference a few weeks can make.
In the aftermath of the UK’s shock decision to leave the European Union, urgent questions have been raised about the nature of the UK’s future relationship with the EU, in particular whether it will retain the same privileged access to the EU single market in financial services that it enjoys today.
The initial verbal skirmishes between European and UK politicians suggest that the UK’s continued access to the EU single market will be linked to the UK’s compliance with EU rules on free movement of persons, which is deeply unpopular with pro-Brexit campaigners and the 52 percent of UK voters who chose leave.
Given the likely trade-offs between these two policies, the ultimate terms of the UK’s exit from the EU will almost certainly be influenced by diplomatic bargaining as much or more than by strictly commercial or economic concerns.
To put it another way, a result that maximizes both sides’ economic interests is not necessarily preordained. This point has been brought home most starkly by recent proposals by European politicians to transfer clearing of euro-denominated derivatives away from London and inside the Eurozone; notwithstanding any political appeal this may have for domestic voters in the Eurozone, implementing such a move is widely expected to interfere with netting and raise costs for the cleared derivatives industry.
In light of the ongoing political and legal uncertainty, financial market participants ought to begin to consider the impact of Brexit on their business activities in the UK and in the EU more generally.
At the heart of the matter is the so-called “passport”, which refers to the principle that a financial market participant authorized to conduct certain financial activities in one EU member state is generally free — subject to certain notification and other requirements — to conduct such activities without hindrance in other EU member states.
So, for example, a UK-based broker authorized by the UK Financial Conduct Authority can intermediate trading activities for clients located not just in the UK but in other EU member states.
Notably, non-EU financial firms with appropriately-regulated establishments in an EU member state also benefit from this “passport”, and the UK has been particularly successful in attracting international firms, including many US and Asian banks, to London in order to establish a foothold in the EU to access the European financial services market. Clearly, the continued availability of the “passport” is important not just to UK firms but also to the universe of international firms that have relied on London as their gateway to Europe.
The nature and extent of any post-Brexit “passport” for UK-based firms will depend in large part on which model of relationship is agreed on between the UK and the EU. For the moment, there are a handful of principal models under consideration, which can be generally grouped in to the following: the “Norwegian model”, the “Swiss/Canadian model” and the WTO model.
The so-called “Norwegian model” would require the UK to join the European Economic Area (EEA), a grouping that includes all EU member states as well as Iceland, Liechtenstein and Norway.
In this scenario, the UK would retain its existing access to the EU single market — including the coveted passporting arrangements — and represents the least disruptive option compared to the UK’s current position. However, EEA membership also requires the UK to observe the EU’s rules requiring free movement of persons, which as noted above is politically very unpopular; the UK would also be required to make regular contributions to the EU budget. EEA members are also required to comply with a vast amount of EU legislation without any formal voice in the adoption of such legislation.
The EEA can be said to represent significant substantive continuity in terms of the EU legal obligations imposed on the UK while at the same time removing the UK from any formal decision-making authority in respect of such obligations. Therefore, despite the clear benefits to financial market participants, there may be limited political appetite by the UK government or the UK electorate to pursue the EEA model.
Under the “Swiss model”, the UK would negotiate an extensive set of bilateral agreements with a number of EU member states. There is an inherent flexibility in this approach, meaning that the UK may be able to obtain some terms limiting free movement of persons; however, this would almost certainly come at the cost of passporting arrangements that grant full access to the EU financial services market. The UK would also likely have to make contributions to the EU budget.
The complexity of the Swiss negotiations appears to have limited the EU’s desire to repeat this approach with other countries.
A variation on the Swiss model is the “Canadian model”, which is where a third country negotiates a free trade agreement with the EU itself. The key drawback of this approach is the time involved: the Canada-EU negotiations took seven years to finalize, meaning that the UK could face a significant period of time where it faces tariffs and other barriers to EU trade while the negotiations are taking place. It is also expected that any free trade agreement between the UK and the EU would contain the quid pro quo of access to the single market in exchange for free movement of persons.
Finally, the UK could determine not to pursue any special trading relationship with the EU and instead rely on its membership of the World Trade Organization.
This approach would ensure that the UK is not required to contribute to the EU budget or comply with the EU’s rules on free movement of persons, and the UK would benefit from certain caps on tariffs and non-tariff barriers to trade. However, under this model there would be no passporting rights of any kind, and the limits on trade barriers do not apply to services, meaning that this model could imply the imposition of the strictest limits on the UK’s access to the EU financial services market.
If a model is ultimately chosen whereby the “passport” is either taken away entirely or narrowed to the point of being impractical, what then? One possibility is that, even without express passporting rights, UK-based firms may nevertheless be able to access the EU financial services market through certain third-country equivalence provisions in relevant EU financial services legislation.
For example, MiFIR provides that a “third-country” firm – which would include a post-Brexit UK firm – can obtain largely unfettered access to the wholesale European financial services markets provided that the relevant EU institution, in this case the European Commission, has recognized the legal and regulatory regime in the local jurisdiction as equivalent to the regime in the EU.
EMIR, the EU regulation for the regulation of central counterparties (CCPs) and the clearing and reporting of over-the-counter derivatives, is another example of how third-country equivalence can work: to date, the Commission has recognized the CCP regulatory regime in ten jurisdictions (Australia, Canada, Hong Kong, Japan, Mexico, South Korea, Singapore, South Africa, Switzerland and — belatedly — the United States), meaning that CCPs in each of those jurisdictions are able to offer clearing services to EU firms on terms similar to EU-based CCPs.
However, equivalence may not be the panacea it seems to be at first blush.
Despite the potentially significant economic benefits for both the UK and the EU of reaching an equivalence determination, there may be overriding political incentives for the Commission to delay, possibly indefinitely, any such decision.
There is precedent for this: the recent trans-Atlantic stalemate between US and European regulators over derivatives clearing coincided with a significant delay in the Commission recognizing US-based derivatives clearing organizations as equivalent to their European counterparts.
There is the additional drawback that EMIR, MiFID II and MiFIR do not cover all aspects of the EU financial markets, and the EU financial services legislation applicable to other aspects of the financial markets does not always provide for third-country equivalence. For example, there are no equivalence provisions in the Capital Requirements Directive, which is the EU legislation applicable to banks’ non-investment business activities.
Nor does equivalence always cover every activity governed by a particular piece of legislation: the MiFIR equivalence regime discussed above does not extend to retail investment business.
This is not to say that all is doom and gloom where neither the passport nor equivalence is available.
Managers of private investment funds may actually find Brexit to offer a comparative advantage to the UK, on the basis that the relevant European legislation, the Alternative Investment Fund Managers Directive (AIFMD), imposes significant regulatory requirements on EU-based managers of EU private funds, who then benefit from an EU-wide marketing passport in exchange.
By contrast, non-EU fund managers, which would include post-Brexit private fund managers in the UK, are subject to a lower regulatory burden under AIFMD in respect of their non-EU private funds. These managers do not yet benefit from the marketing passport, and must instead contend with the national private placement regimes in the various EU member states in which they would like to market their non-EU private funds; however, many such managers, including those in the United States, have proved adept at navigating these regimes in recent years without an appreciable impact on their business.
London could therefore position itself post-Brexit as a leading “offshore” hub for the private fund management industry.
Inevitably, a number of international firms may require either a passport or an equivalence determination to continue to provide services in the EU following Brexit and, in the absence of either, these firms will likely need to consider whether or how to restructure their businesses to minimize the impact of Brexit on their European business.
The most likely route would be for such firms to identify an appropriate EU member state, establish a branch or subsidiary, and obtain a license for that branch or subsidiary from the local regulator, in effect replicating in another EU member state the arrangements currently in place in the UK.
Several candidate cities are already making overtures to London-based firms, including Dublin, Amsterdam, Paris and Frankfurt. It remains unclear whether a single city will be the primary beneficiary of any post-Brexit exodus from London, or whether certain segments of London-based business will congregate in a given city whereas other segments may settle elsewhere. As with all things Brexit, it is still too soon to tell.
What bears repeating is the extent to which, at least at the time of writing, a commonly-accepted framework for addressing post-Brexit legal issues remains elusive. Any observer of recent legal commentary in the UK has risked whiplash as the debate veers from one position to its exact opposite just days later.
The last few weeks have shown that reasonable and persuasive legal arguments can – and have been – made on either side of fundamental constitutional issues, such as whether and how an Article 50 notice can be submitted by the UK government and, once submitted, whether the notice may be withdrawn.
Indeed, even the subject of this article — the likelihood of passporting and/or equivalence for UK-based firms post-Brexit — has engendered a host of divergent opinions by leading law firms and legal commentators.
The almost disorienting nature of the debate raises intriguing questions about the interrelationship between law and politics, and suggests that the resolution of important legal questions relies, perhaps to a greater extent than many had realized, on the existence of a settled political framework that provides essential cues to the legal commentariat, and through such cues fosters legal consensus.
In the next few days, a new political settlement will begin to emerge in the UK, most likely when the new Prime Minster takes office and forms her new cabinet. Clearer political leadership from both government and opposition parties may provide a more auspicious environment for the legal community to begin to cohere around more concrete answers to the profound questions raised by Brexit.