On Monday, 19 March 2018, the UK and the EU came to an agreement regarding a 21 months transition period. This weekend, an EU summit is due to formally approve the latest evolution of negotiations and set the tone for the EU. This article highlights what you must know on the issue.

One year ago Theresa May triggered article 50 of the Lisbon Treaty. The British prime minister, sitting in front of the Union Jack, officially opened two years of negotiations with the EU.  In the letter she sent to Donald Tusk, Theresa May ambitioned “a deep and special partnership” with the EU and proposed key principles to guide Britain in negotiations.

One year later and half way through the negotiations period, nothing has been officially agreed and parties diverge on many key issues including customs union, market access and regulatory oversight.

After losing months endorsing an expensive Hard Brexit solution, Theresa May changed her tone in early March 2018. She adopted a more realistic approach to negotiations, acknowledging that the UK would have to make some trade-offs to strike a deal with the EU.

In the EU, Michel Barnier has adopted a clear position. Firstly, the UK will not be offered a more generous treatment than existing agreements between the EU and other countries. Secondly, the agreement will leave no room for a “pick and choose” approach, where the UK would be able to access the Single Market without accepting all of its four freedoms, or where the UK would secure a sector by sector deal.

Incompatible Positions

Negotiations are now entering their final phase. Parties have one year to shape a Brexit deal, or they risk creating an economic shock, which could break the current European recovery. On March 29, 2019, the UK will officially leave the EU and enter into a transition period. This transition period has been designed to allow sufficient time for businesses to adjust.  It will last until December 31, 2020, maintaining the UK access to the single market. The EU-UK relationship will then be guided by the Brexit deal that could have been agreed on during the negotiations.

Scenarios:

While the ultimate shape of the Brexit deal is still unknown, most studies show that the four following scenarios are the most credible:

A comprehensive Free Trade Agreement:

Negotiations are likely to lead to a Free Trade Agreement. The question is how inclusive will it be? The economics at stake are clear. The EU is a net exporter of goods to the UK, therefore a deal on goods is in the EU interest. The situation is different in services, and in particular in financial services, where the UK is a net exporter to the EU.

An FTA including goods and services could drastically limit the economic impact of Brexit. Logically it appears to be the UK’s favorite solution. In her latest speech, Theresa May highlighted her preference for an FTA which would include services. She acknowledged that the passport would be lost, but reinforced her conviction that an ambitious deal was possible. Unfortunately, it is clear that the EU is not keen to extend any potential FTA to financial services (for political, financial and regulatory reasons). Besides, current agreements in place with Switzerland or Canada do not extend anywhere near the EEA passport in financial services, making it difficult for the EU to justify granting a better deal to the UK. Finally, defining a new FTA takes years (CETA took 9 years to negotiate) and the EU is unlikely to get its hand forced.

This scenario has a medium probability to happen. It would ensure a smooth transition but it seems too ambitious to be finalized in one year, and carries a dangerous political message for the EU. Including services in an FTA could go against the single market integrity.

Equivalence:

A possible way of preserving many aspects of the current financial services organization would be to use the equivalence clauses included in several EU regulations. Concretely, the European Commission could deem UK regulatory and supervisory framework as equivalent to EU regimes. It makes sense as the UK is currently respecting all EU regulations, and offers to keep doing so in the future.

Several activities are operated under regulations which include equivalence clauses (see below). For these activities, if equivalences were to be granted, the impact of Brexit would be limited and firms based in the UK would keep doing business without being forced to relocate most of their operations.

Nevertheless not all activities are covered by regulations including equivalence clauses. For those activities, relocation to the EU will be necessary.

Besides, using equivalences for such a large and systemic actor as London raises concerns from supervisory and political point of views. We can imagine that in a situation of crisis, the UK government may prioritize its own interests/taxpayers over the EU ones. This rationale has already been used in an argument made by the ECB pushing for the relocation of clearing activities within the EU and under its direct supervision. From a political point of view, deeming UK activities equivalent could also lead to further attacks on the single market integrity.

Finally, this would make the UK a “rules taker” in financial services, a position which has so far been refused by the UK negotiations team. The EC would indeed retain the possibility to withdraw equivalences at any time with only one month of notice.

Overall, this scenario has a high probability. It helps the UK to limit the cost of Brexit and allows the UE to have a clear/fair political message around the treatment of the UK. It wouldn’t be a surprise to see the equivalence regime being redefined in order to use it as a deal baseline.

Financial Services Regulations & Equivalences

Source: European Parliament

EEA:

The UK secures an EEA membership and adopts a position similar to Norway. This scenario has the smallest impact of all, as passporting is preserved. Unfortunately it goes against many of the core ideas behind Brexit. It actually prevents the UK to regain its sovereignty.

This scenario has a low probability but still makes it into the list due to its low cost.

No Deal:

If no deal can be found in time, EU-UK relations will fall back on World Trade Organization trade rules. A recent study by Wyman estimates that the return to WTO terms of trade would cost EU27 exporters around £31bn and UK exporters around £27bn. For financial services in particular, this is the worst solution. Institutions based in the UK wishing to deal with EU clients would have to set up subsidiaries in the EU. The situation will be easier for EU based firms who would still be able to deal with UK clients.

This scenario has actually a low probability. If both parties were to stand by their current red lines, no deal would be found. But because this scenario is very expensive for both sides, it is unlikely to happen.

Focus on financial services:

In the FTA and EEA scenarios, the impact would be relatively contained for most financial services activities.

In the Equivalence or No Deal scenarios, the situation is different. The chart below highlights the macro impacts on financial services activities:

(*)Reverse solicitation: In the context of MiFID II, where a client requests services on its own initiative, there is no requirement for a third-country provider to set up a branch or be authorized by ESMA. In the context of AIFMD, professional investors established in the EU can invest in AIFs on their own initiative, irrespective of the AIFM/AIF location. Reverse solicitation can be seen as a way to access the single market for third countries. In reality, is it limited as third country firms are not allowed to market their services to EU clients.

The conclusion of the European Summit this weekend will lead to a refined version of the EU’s proposal. Eventually, both sides will have to make concessions, accept higher costs of operations and a lower fluidity in trade. The EU has the calendar on its side, as a no deal Brexit will be easier to digest for the bloc than for the UK. For financial services, a balance remains to be found between political motivations and economical arguments. The final result of the negotiations is unpredictable, but it will probably force the European financial industry and its ecosystem to change quickly and significantly.

Sources:

European Parliament: implications of Brexit on EU financial services

European Commission: Brexit preparedness: Notices

Theresa May speech. 02.03.2018

ISDA DerivatiViews: derivatives contracts will not be VOID post-Brexit 

Institut Louis Bachelier: the impacts of Brexit on the European financial services ecosystem

Letter from the Financial Conduct Authority to Committee Chair regarding passports

Oliver Wyman red tape cost of Brexit report

European Parliament : understanding equivalence and the single passport in financial services Third-country access to the single market

European Commission : press statement by M. Barnier following the latest round of Article 50 negotiations