November 9: the day the Brexodus started?

The UK Treasury’s equivalence verdict is a positive gesture, but could backfire if not reciprocated

As the hard deadline of December 31 – the end of the Brexit transition period – looms, negotiations between the European Union and UK have been stuttering. The UK chancellor of the exchequer Rishi Sunak has now taken a bold step into this unpredictable situation, in a bid to create greater certainty. But his decisive action is also a gamble, with the future of the UK’s financial markets at stake.

Sunak announced on November 9 that the UK will grant equivalence under several regulations for firms in the European Economic Area (EEA: the EU plus Norway, Liechtenstein and Iceland). This move resolves a number of problems that were potentially facing both EU firms, and the EU subsidiaries of UK firms, in attempting to trade with UK counterparties from January 2021.

With equivalence granted under the UK Capital Requirements Regulation, UK banks will not face increased capital on exposures to EEA counterparties. And EEA clearing houses can apply for permission to clear trades for UK firms permanently – by contrast with the 18-month temporary equivalence that the EU has so far provided.

Thanks to equivalence granted under the UK onshored version of the European Market Infrastructure Regulation, the EEA subsidiaries of UK firms will not be obliged to clear over-the-counter intragroup derivatives trades. Those trades will also be exempt from capital requirements for credit valuation adjustment risk.

These and other moves contained in the November 9 statement have all been welcomed by the financial services sector on both sides of the Channel as an effort to smooth the end of the Brexit transition period, and to improve the mood music in the negotiations.

But there are no guarantees the EU will reciprocate. From the very start of the Brexit process, EU leaders have viewed the UK’s departure as a negative for the bloc. One of the few positives they hope to draw from it is the opportunity to strengthen the financial services sector of the EU27 by attracting lucrative business away from London. That creates a disincentive to be particularly generous in helping the UK continue as some kind of offshore financial centre for the EU.

Already, the EU has made clear that it cannot yet grant full equivalence under the second Markets in Financial Instruments Directive, because the legislative framework will not be complete by December 31 in any case. And early drafts of possible new regulations for fund managers point in the opposite direction – toward a clampdown designed to make it harder for EU firms to outsource activity to third countries such as the UK.

If Sunak’s unilateral move still proves to be unilateral on January 1 next year, it may begin to look rather less positive for the City of London – and for the coffers of the UK government. The Treasury granting equivalence to EEA firms and subsidiaries makes it easier to handle UK clients from the EU27, but for now that certainty works only in one direction. As long as there is no clarity on whether or how UK firms will be able to handle EU clients, the temptation will be to concentrate European wholesale business in the EU27, at London’s expense.

November 9 may yet be remembered in the financial services sector as the day the UK green-lit Brexit relocation to the EU.