Brexit - What could improved equivalence look like?
31 August 2018
The UK Government has now confirmed that, rather than pursue a model of mutual recognition to allow market access for financial services firms post-Brexit, it will seek improvements to the EU’s existing equivalence model. At this stage we don’t know whether the EU-27 will accept the UK’s proposals. But with such limited time available to reach an agreement now is the time for serious thought on how the equivalence regime could be made to work.
So how could the EU’s current approach to equivalence be improved upon? And what would need to be done by the EU to do so?
At the point the UK leaves the EU it will have identical standards to the EU in most areas of financial services regulation. The UK has been a very active participant in helping shape EU regulation as well as many of the international standards that underpin them. The Financial Policy Committee has also made clear its view that the UK’s regulatory standards post-Brexit will need to be at least as robust as those currently in force, and the UK has a track record of going further than minimum EU standards in many areas. All this means that, objectively, the UK should be very well placed to be deemed to be equivalent post-Brexit.
To preserve the benefits of free trade in financial services between the UK and EU, an equivalence regime allowing market access would need to be extended to a wider set of sectors and activities. The EU’s current approach to equivalence is patchwork and varies by pieces of legislation. Under MiFID and EMIR, investment services and clearing can be provided by third country firms, subject to them meeting a number of criteria, including being located in a jurisdiction deemed to be equivalent by the European Commission (EC). But for banking, insurance and reinsurance (governed by CRR and Solvency 2 respectively) a similar framework does not exist. There is no equivalence regime in UCITS (the regulation which covers retails funds), but under AIFMD (which covers professional clients) there is.
One approach would be to introduce an equivalence regime that covers all activities. This would allow UK firms to provide the full suite of financial services to clients in the EU. But politically this would be extremely difficult. The range of EU legislation which would need to be covered to create a regime fit to govern the depth of the UK/ EU relationship would be significant and would have to be analysed in detail to avoid the risk of inadvertent omissions or key dependencies. At a minimum though, the equivalence regime would need to be extended to cover lending , deposit taking (CRR) and insurance activities (Solvency II, IDD), payments (PSD 2), UCITS funds and to extend the equivalence regime in MiFID from credit institution and investment firms to regulated markets. As the regulation of FinTech firms develops it will also be important to include suitable equivalence provisions for this area.
It may be that a distinction is made between retail activities (where regulators risk appetite is generally lower) and wholesale and commercial activities, which are generally more cross-border in nature. For example, under MiFID, services to retail customers are not included in the equivalence framework. Even in the UK the regulators make a distinction between retail and wholesale activities, for example in the PRA’s risk appetite for branches.
Current EU equivalence regimes do not provide sufficient certainty for firms to plan on a long term basis. Under MiFID in certain circumstances, equivalence can be revoked at 30 days’ notice. And the recent decision by the EC to grant Switzerland’s stock exchange equivalence under MiFID for only one year shows that the process can, at times, be unpredictable. How could greater certainty be provided? First, equivalence should only be revoked in specific, defined circumstances such as a deliberate divergence of regulatory standards. In future, the UK and EU may choose to diverge on regulatory standards. If this occurs, adequate notice that equivalence was to be revoked (at least a year) would also be required to avoid disruption and financial instability. The EC is already proposing that the European Supervisory Authorities be given a greater role in equivalence assessments. The ESAs may be able to apply a more technocratic assessment of equivalence than the EC, with a focus on regulatory outcomes rather than line by line equivalence.
There are many in the EU-27 who would like to see the EU’s approach to equivalence overhauled, regardless of Brexit. The European Parliament recently voted on a report calling for more predictability and transparency in the way equivalence decisions are made in the EU. Other large third countries, such as the US are also watching the EU’s equivalence debate closely.
But, assuming the EU would be prepared to amend its approach to equivalence, how would it be done? And how long would it take to change? One way would be for the EC to propose an amending Directive which would insert a consistent approach to equivalence in each of the sectoral pieces of legislation. The EC used a similar procedure when the European Supervisory Authorities were established, adopting a so called ‘Omnibus Directive’ which amended various pieces of financial services legislation to reflect the new roles of the ESAs.
Could this be done in the period prior to at the end of the 2020? Experience suggests this would be difficult. Large, politically sensitive negotiations in the EU tend to take several years. There may be other legal mechanisms to make amendments over a shorter time period if there were the political will to do so. But there is a clear risk that an improved equivalence regime will not be in place by the end of 2020 (the end of the transitional period) even if both the UK and EU are in agreement. If this were the case then those sectors where there is currently no equivalence framework in place would see market access closed, even if only temporarily.
Despite the political will to reach an agreement at this stage financial services firms preparing for Brexit should continue on the basis of no deal, as it is prudent to plan for all eventualities. But firms should follow the negotiations on financial services closely as developments may speed up in the lead up to and after the European Council in October. Firms may also wish to assess the extent to which their cross border business is covered by an existing equivalence regime and identify business lines that are not currently in scope.