A Brexit financial services deal and the 12 tasks of Hammond

In a speech on March 7, UK chancellor of the exchequer Philip Hammond told European Union negotiators what they already know: he is very much hoping Brexit will not damage the City of London.

His solution is to base UK-EU financial services trade on “mutual recognition and reciprocal regulatory equivalence” propped up with safeguards such as “dispute resolution mechanisms”, rather than on the EU’s established equivalence regime with third countries.

The template already exists: last year a cross-sector City lobby, called the International Regulatory Strategy Group, proposed a deal that would allow continued access to financial services in the EU and UK for both sides, based on comprehensive recognition of each other’s entire regulatory regimes. If the mutual access is to be withdrawn at any point, market participants should be consulted on how long it would take them to adapt to loss of access, and the notice period should be set accordingly. This differs from current EU equivalence deals, which are negotiated separately for each set of regulations and can be revoked at a month’s notice.

The arrangement would be mutually beneficial, its advocates claim. London would keep its status as the dominant financial centre in Europe, and the EU would keep an integrated hub that would help its capital markets union project, designed to stimulate market-based finance as an alternative to Europe’s heavy dependence on bank funding.

But while Hammond may not quite face the 12 labours of Hercules, there are certainly a number of sizeable obstacles he will need to overcome.

Financial services cannot be in a free trade agreement for many reasons: for reasons of stability, for the sake of supervision

Bruno Le Maire, French finance minister

The first, mentioned by French finance minister Bruno Le Maire in a radio interview on March 6, is the EU’s preference for equivalence agreements, of the kind the bloc has with the US and Asian countries. “I think this is the best solution for financial services,” he said, explaining that “financial services cannot be in a free trade agreement for many reasons: for reasons of stability, for the sake of supervision”. In other words, after Brexit, the EU would not be happy to cede supervision of London-based activities to which its financial firms have heavy exposures.

The next day, European Council president Donald Tusk outlined his draft guidelines for post-Brexit relations with the UK that didn’t even mention financial services. He did say the EU should aim for a free trade agreement that should include services but “the EU cannot agree to grant the UK the rights of Norway with the obligations of Canada”. This is as strong a hint as any that Britain cannot hope to retain exactly the same access to the single market as now once its membership ends and, with it, a member’s responsibilities such as implementing EU laws and contributing to the EU budget.   

Hammond rightly pointed out that the EU had explored closer partnerships in financial services in the past, for example in trade talks with the US. In some cases, foreign firms benefiting from equivalence deals are already allowed substituted compliance, where the EU essentially trusts the home jurisdiction to supervise them adequately.

But EU thinking on this is evolving, and not necessarily in a direction that is helpful for the UK. EU regulators are increasingly complaining that equivalence deals with the US are something of a one-way street because only the EU implements substituted compliance in practice. US firms are able to operate in the EU without dual registration, but many EU firms are caught by US registration requirements and subject to local supervision.

Accelerated by Brexit, this debate has prompted proposals to give European supervisory agencies greater powers over foreign entities active in the EU. And equally important, EU lawmakers are leaning towards varying the degree of supervision based on the significance of EU firms’ exposures to third-country institutions – such as clearing houses or stock exchanges. If this logic is followed on Brexit, UK institutions, which currently play a huge role in European financial markets, will be subject to stricter EU treatment than firms in other markets.

Risks and benefits

The second major obstacle is that the EU will probably take issue with the dispute resolution mechanism proposed by the UK lobby group as part of its mutual recognition and access plan. The body would be able to rule whether or not one party’s regulatory system has diverged from the other and, if so, whether the divergence is too great for mutual market access to continue. The simple truth is the EU is highly unlikely to delegate to a third party decisions that are key to maintaining a level playing field between the two financial sectors.

For example, if the UK deregulated, the EU objected, but the dispute resolution body sided with the UK, the EU would be left with the invidious choice of either converging with UK standards or keeping its own rules but placing its firms at a competitive disadvantage.

The EU is likely to conclude that maintaining the status quo in financial services is not worth the risk of adverse rulings that curb its policy-making independence. In contrast, Britain would be happier to take such risk, given the pay-off of a seamless access to the huge European market.  

A third – and related – obstacle to Hammond’s solution is perhaps the most profound: commercial incentives. EU countries see very few benefits from Brexit but one of the few they do see is the opportunity to prise part of the lucrative financial sector away from London, together with associated businesses such as professional services and technology. And the prospect of this prize is likely to outweigh the advantages to the EU from having a single, integrated financial hub in London.

That makes selling Hammond’s plan in Brussels a truly Herculean task.