Brexit Trigger Highlights Equivalency Hurdles

Shanny Basar

Law firm Ashurst warned that the UK will face hurdles and pitfalls in the equivalency regime for financial services as the government said it will trigger leaving the European Union next week.

On March 29 the British government is due to trigger Article 50, informing the European Union of its intention to leave the bloc. The UK and EU then have two years to negotiate the terms of departure, such as how UK financial firms can access  EU markets and vice versa. UK financial services are likely to lose the “passport” which allows firms in an EU member state to sell services across the bloc without obtaining a separate regulatory approval from each country. Passporting procedures depend on both the specific directive and the kind of passport being requested.

There are 23,532 passports into the UK from another EU states and 336,421 outbound from the UK according to letter from the Financial Conduct Authority to the UK parliament last August.

It is possible for firms outside the EU to be given permission to operate in the region, if they are deemed to be authorised in a country with equivalent regulatory standards by the European Commission, or in some cases, member states or their national regulators.

Last month the European Commission published a report giving an overview of third country provisions in EU financial services legislation, including the equivalence framework.

Ashurst said in a note last week that equivalence for financial services serves primarily prudential regulatory purposes and only enhance the possibilities of doing business in the EU in a few areas. In addition, some EU legislation does not provide for equivalence, for example Ucits for funds, payment services and the Bank Recovery and Resolution Directive.

“The primary beneficiaries of equivalence decisions are therefore EU market participants, in particular where equivalence relates to the treatment of exposures to non-EU countries or cross-border activities that are subject to third country rules and supervision,” added Ashurst.

The Commission also noted that that there are sometimes additional considerations in relation to equivalence decisions. Ashurst gave the example of the Alternative Investment Fund Managers Directive (AIFMD) which requires European regulators to take into consideration whether EU entities encounter difficulties when seeking establishment in third countries.

“The Commission made it very clear in the report that an equivalence regime does not confer a right on third countries to receive a positive determination, or even to be assessed. A more pointed message, there never was,” added Ashurst. “As a unilateral and discretionary act, an equivalence decision may be amended, revoked and also reinstated (if all necessary conditions are deemed to be met.”

Ashurst said the European Commission has adopted 212 equivalence decisions – Japan has the largest number at 17,  followed by the US and Canada with 16 each. The law firm added: “The European Commission’s publication of its working paper is a timely reminder to the UK of the hurdles and pitfalls of the equivalency regime.”

Consultancy Oliver Wyman and Morgan Stanley Research last week said in a report, The World Turned Upside Down, that initial hopes for the maintenance of “passporting” have faded, while there are concerns over the coverage and stability of the current equivalence provisions.

“A favorable outcome here would minimise change required, limiting the costs,” added the report. “This would likely rest on enhanced equivalence agreements between jurisdictions.”

The study continued that the most pressing challenge for wholesale banks in Europe is the possibility of a material worsening of the economics after Brexit.

“On one level, the scale of the impact is often overplayed,” said the report. “Much of the wholesale banking activity in the UK today is with other financial institutions – notably asset managers and hedge funds – and they have not indicated an intention to move from the UK.”

The study said the immediate focus for banks therefore is on the businesses that serve EU clients cross-border from the UK. These businesses are likely to require a level of new onshore distribution capability and there is also a risk that some EU product traded in the UK is forced onshore. For example, restrictions on Euro swap clearing could require banks to locate swap trading desks within the EU.

“Together these represent 35% to 40% of Emea wholesale banks revenues,” said the study. “We expect bank management teams to take action to minimize the scope of operations moved out of London and further reduce the impact.”

International banks are concerned about the regulatory treatment of back-to-back booking models and inter-affiliate exposures which would allow them to maintain their core trading infrastructure and risk management in London, with distribution only in the EU. Regulators could push back on this model, requiring the banks to duplicate infrastructure in the EU and likely create trapped capital and funding, which would increase costs and increase capital requirements.

Asset managers also face disruption from Brexit but Oliver Wyman and Morgan Stanley expect only limited operational upheaval.

“Distribution of funds to EU clients could be restricted, but this is a relatively small part of the value chain outside of Ucits funds, and many funds are not domiciled in the UK currently anyway,” said the study. “Crucial for asset managers will be the ability to continue to delegate portfolio management to the location of their choice. We do not expect to see large movements out of the UK.”

However, the report acknowledged that in a more severe outcome some of the £1.2 trillion of assets currently managed in the UK on behalf of EU clients could be at risk.

Last December the UK House of Lords published a report on Brexit and financial services highlighting the importance of agreeing a transitional period , so that a ‘cliff edge’ was avoided, both at the moment of withdrawal following the Article 50 process and during the negotiations. The Committee also noted that the wider EU economy relied on the financial services currently provided in the UK, which might not be easily replicated elsewhere in the EU, and therefore it would be in the EU’s interests to preserve access to its market for UK-based firms. The report was also debated in the House of Lords last month.

The House of Lords said: “We endorse the government’s work in analysing the difference between the opportunities afforded by passporting and third-country equivalence. The priority should be to establish at an early stage the extent of the lacunae in the regimes, the likely restructuring that will have to be undertaken by businesses to adapt to changed circumstances, and the consequent effects of such adaptations on the financial services sector and the wider UK economy.”

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