The appointment of Michel Barnier – former European commissioner for the internal market, and post-crisis financial regulation supremo – to lead the European Commission’s Brexit negotiating team, reflects the importance of this topic in talks between the UK and its erstwhile European Union partners. While UK access to EU markets has been much discussed, the UK’s role in facilitating EU financial regulation has perhaps been overlooked. Given the dominance of London in EU financial markets, the local regulators – the Bank of England and Financial Conduct Authority (FCA) – provide the lion’s share of market data to the European supervisory agencies (ESAs).
Nowhere is this more vital than in the second Markets in Financial Instruments Directive (Mifid II) and accompanying regulation (Mifir), which enter into force in January 2018. This vast set of rules will govern everything from plain vanilla equity trading to exotic commodity derivatives, with every category of liquidity characteristics in between. The rules dictate pre- and post-trade transparency and trading obligations on both instruments and types of market participant, all calibrated according to the size of the total European market for a given instrument.
If the UK leaves the Mifid-regulated market altogether, the market size will be fundamentally altered and many of the calibrations will be rendered irrelevant. Absent a specific arrangement between the UK authorities and the ESAs, EU regulators will be in the dark about much of the activity carried out by entities they oversee.
This creates the outline of a potential compromise. The UK wants equivalence for its financial institutions at the very least, and lobby group TheCityUK has called for some form of bespoke passporting arrangements that would leave London firms free to transact with European clients. The EU would doubtless prefer its decade-long Mifid project to not be derailed a year or so after it enters into force. Passporting in return for full regulatory co-operation and data-sharing seems an ideal compromise.
But as one market participant puts it: “Everyone knows what the best solution looks like. The thing is, politics tend to get in the way.”
The most recent political noise from both sides of the Channel is unsettling. Spurred on by talk of the new US administration rolling back the Dodd-Frank Act, some UK politicians have suggested similar deregulation after Brexit. One expert at a London trading venue warns sternly against this approach.
“We are all in it together. If the UK wants to interact with Europe, we need equivalence, and we will not get it if we make politicians’ lives harder in Brussels. The FCA was a strong supporter of a lot of the initiatives in the Mifid negotiations, and it is still a very difficult political message to say financial services in the UK have been cleaned up. This idea the City is suddenly going to move to a deregulated design, the idea the UK could become almost a 52nd state [of the US], is a bit of a joke,” says the expert.
Meanwhile, both the European Commission and the European Securities and Markets Authority (Esma) recently weighed in with discussions on how the equivalence process – key for allowing UK and EU counterparts to face each other post-Brexit – should evolve. The Commission’s paper noted ominously: “As a rule, ‘high-impact’ third countries for which an equivalence decision may be used intensively by market operators and any shortcomings in the analysis underpinning the decision may significantly jeopardise financial stability or market integrity in the EU will feature a higher number of risks which the Commission will need to address in its assessment of the equivalence criteria and in the exercise of its discretion.” The UK would surely fall into that high-impact category.
Esma’s chairman, Steven Maijoor, cast the EU in a recent speech as “an island of third-country reliance in a world that has mostly opted for individual registration”. He suggests ESAs should reduce their deference to foreign home regulators and build more direct supervisory powers of third-country entities operating in the EU.
Ironically, this implies Europe is moving in a more restrictive direction at a time when the US Commodity Futures Trading Commission has a new acting head who is arguing for greater recognition of foreign regulation. In a speech in January 2017, Christopher Giancarlo called for regulators to “set limits on the cross-border application of swaps rules to achieve the ends of market reform in a spirit of co-operation and deference”.
That line may embolden those in the UK calling for a total realignment of post-Brexit financial regulation away from a more confrontational EU equivalence regime and towards a more accommodating US. But for market participants, the minimum possible fragmentation remains the best solution.