What will happen to British financial services after Brexit? Amid rows over fishing, car manufacturing, and agriculture, financial services have rather faded from public view. Yet from this December, regardless of whether or not the UK and EU reach a deal, the UK will regain control of the ability to regulate the City.
In a speech last week, Rishi Sunak outlined a number of areas where he intended UK and EU regulations to diverge. As access to EU markets is based on declarations by either side that diverging regulations are “equivalent” – that is, good enough in their effects without the need for full alignment – this is perfectly compatible with the parties reaching a deal in other areas.
The UK has been asking for a new kind of mutually agreed “permanent equivalence”, but Europe would be mad to agree to it. Equivalence with Europe is more likely to be arranged in the usual way: situationally, at the complete discretion of the Commission.
The great positive of equivalence declarations is that they allow two regulatory systems to differ slightly, while maintaining mutual access. The downside for the UK is that the need for equivalence to be granted gives the Commission huge leverage over the City, which it will delight in using.
Brussels has recently given European Supervisory Authorities the power continually to monitor recipients of equivalence declarations to check just how “equivalent” they still are. Only last year, the EU let a declaration with Switzerland expire after the Swiss parliament failed to ratify a trade agreement. The downside of equivalence for Europe is that it might work. Or, as the European Capital Markets Institute puts it, “equivalence disincentivises UK financial institutions to relocate in the EU”.
Since at this moment the UK and EU share the same regulations, equivalence isn’t a problem, but neither British nor European financial regulation is going to stand still. The current regulatory landscape in financial markets is dominated by a vast piece of legislation called Mifid II.
Mifid II isn’t perfect, but it has increased transparency and has helped market efficiency. It is also that most beautiful of things, a European regulation that doesn’t really undermine national sovereignty, and in some ways actually strengthens it. Mifid II was led by the British, both via the Financial Conduct Authority and British employees in Brussels.
As the British leave, and take their opinions with them, the Commission is coming under pressure to reform Mifid II, as they lead the move towards a European Capital Markets Union. The Commission and ESMA, the European regulator, are being assailed from all sides by eloquent national regulators and lobbyists, seeking personally beneficial regulatory changes in the name of European unity and “end investors”.
Though there are exceptions, resisting national or corporate pressure is not a great strength of European regulators. Systematic Internalisers (SIs) are an example. SIs were first created by Mifid I (the predecessor to the current rulebook), and allow banks and private companies essentially to run their own mini-exchanges. They work alongside another form of exchange called a “dark pool” to allow firms to trade as efficiently as possible. The London Stock Exchange recognised the way the wind was blowing some time ago and bought its own dark pool, Turquoise, which is now a market leader. Deutche Bourse and Euronext didn’t, and where the two European exchanges go, the German and French regulators follow.
Dark pools and SIs are also currently being reviewed by ESMA, which has raised the possibility of increasing their reporting requirements and limiting the types of order they can process to large-in-scale only.
In recent years, the British have tended to understand better than their European counterparts that the purpose of financial regulation is not to protect the market as it is, but to allow it to evolve and improve in a way that is fair to all participants. One of Mifid II’s major achievements was to force banks to charge separately for investment research, and to require asset managers to decide whether to pay for it themselves or pass the cost on separately to clients.
“Research unbundling”, as it is known, was advocated strongly by the British FCA to increase transparency in financial services. Now the Commission is proposing to let banks provide research on small companies for free to boost the economic recovery from coronavirus. Which it won’t, mostly because the whole concept of written company-focused research is becoming out of date anyway.
However, European regulators, particularly the French AMF, who were never huge fans of the requirement in the first place, have been persuaded the change will boost growth and support traditional research providers. So here we are.
Whenever the Commission brings in a rule change, the UK could just sigh and copy it. The Chancellor’s speech makes clear that Britain likely to move in the opposite direction. The process of transferring European legislation into UK law has significantly increased the role of British politicians in financial regulation.
The Chancellor’s speech indicates that he is not going to let the opportunity go to waste. Sunak referenced insurance capital requirements, and an extremely complicated rule that would have forced transactions that didn’t settle quickly to fail, as areas where the UK would seek to diverge from Europe. Neither regulation was passed with the interests of Britain in mind. At best, this heralds a world where the UK and EU have competing, but generally “equivalent” regulatory structures. If the experiences of financial regulation over the last few years are anything to go by, this is a world in which the UK could expect to do extremely well. And that, for the EU, is the problem.
A French source indicates an important truth about the European Commission: it is under structural pressure to change things, since every change made on a pan-European level strengthens the European project. Practically, a European Capital Markets Union will be difficult to achieve if the centre of European capital is outside of the EU’s regulatory orbit.
The UK has with two options, one deeply unpalatable, the other extremely risky: accept poorly thought through regulatory changes it doesn’t like, designed specifically to harm its own interests, or ignore them and risk Europe panicking and revoking market access.
We can now be fairly certain what the government’s decision is, and it is hard to argue that it isn’t the right one. But regulatory competition and regulatory equivalence are unlikely to co-exist happily.