Passporting – Key issues for the UK’s financial sector

One of the key issues for the UK’s strong financial sector concerned about Brexit is that of passporting – the rights which enable firms here to offer their services in the EU and EEA because of the regulatory framework here. Nicolas Groffman, Head of International, looks at some of the questions facing the sector as Brexit looms.

How do passporting rights work?

• A UK financial institution can offer its services under an ‘establishment’ passport, which requires it to establish a branch in the relevant country, or do so without setting up a branch, under a ‘services’ passport.
• The debate about the significance of passporting rights stems from the importance of the financial services sector to the UK’s economy. Around 10 per cent of the UK’s exports are financial services, and around one third of those are to the EU. Given that around half of the UK’s financial services output is exported, the significance of any unhelpful adjustment to the existing model should not be downplayed, although we should avoid the implication that the exporting of financial services to the EU would simply cease if passporting rights were lost. It is also important to point out that the export of financial services is only partly carried out under the passporting arrangements.

Considering that passporting rights are part of the EEA, what options are available to the UK in the case of a hard Brexit?

Option 1 – remaining in the EEA

• Even the term “hard Brexit” isn’t completely clear as passporting rights are part of an EEA agreement, not an EU agreement. This is the so called ‘Norway Option’ whereby the UK joins the EEA and operates outside the common agricultural policy and fisheries policies; however, this would entail the UK still having to contribute almost as much to the EU budget, retaining free movement of people and enacting EU regulations without having any say in how they are decided. This seems almost impossible.

Option 2 – bilateral agreement

• If the UK leaves the EU and retains no EEA membership, it would still be possible to set up bilateral agreements for passporting. The other option would be an end to passporting.
• The UK is the world’s foremost provider of financial services and it is unlikely that the EU would reject its services. It is likely however that the arrangement would not allow for ‘services’ passports – in other words, UK institutions would be required to set up branches in the countries where they wish to do business. It is also possible that some forms of services will not be passported.
• The type of agreement reached is likely to depend on whether Europe’s own financial institutions are allowed to argue their case. While European businesses in general benefit from UK financial institutions and would suffer if passporting rights were diminished, Europe’s banks might spot an opportunity to develop their business at the UK’s expense and push for reduced rights.

Option 3 – no agreement of any sort

• It is impossible to say what the impact of this would be. If the UK leaves the EU with or without a trade agreement but with no agreement to allow passporting, then access to EU financial services markets would have to be negotiated on an individual basis. It would be hard to say how long this process would take and what the outcome would be as this would cause significant uncertainty within the City.
• One likely outcome would be depending on ‘equivalence’ provisions, allowing third-country financial firms access to the EU if their home country’s regulatory regime is deemed ‘equivalent’. Equivalence provisions are found in regulations such as those governing clearing houses and securities trading, but many financial sectors are not covered.

Could the UK secure a series of bilateral agreements, as in the case of Switzerland? What are the chances of success in this regard?

• Switzerland, despite not being an EEA state, has negotiated limited passporting rights. To operate under these rights the Swiss must adopt equivalent regulations to those in the EEA. If the regulations change then they must act swiftly to adapt their own regulations. The result of this is that the Swiss can be left out in the cold, with their banks unable to operate in the EU, until they adopt amendments to EU law.
• Success in this regard would be limited to what can be negotiated with the EU on the UK’s departure. Both the governor of the Bank of France and the president of the Bundesbank have indicated that in their view, the UK should not be allowed to continue using passporting rights after Brexit unless it becomes a member of the EEA under the Norway option.

What are benefits and risks to this scenario? Do bilateral agreements, for example, limit the provision of financial services?

• There is a risk that the UK government will be unable to legislate swiftly enough to maintain UK equivalence with EU regulations, and that the EU will use this as an excuse to bar the UK. Yet at the same time Canadian banks are allowed to operate in the EU, despite having arguably less ‘equivalence’ than UK banks, so the EU would risk looking foolish and losing credibility if it took this hardline approach.
• There are some potential differences which could be cited as reasons for not accepting ‘equivalence’ – eg the EU currently caps bonuses paid out to bankers; if the UK sought to raise this cap, they would fall foul of the EU regulations, possibly causing any passporting rights to be rescinded.

Could the UK rely on third-country equivalence provisions under existing EU legislation?

• Whilst passporting is a useful tool, losing it will not signify the end of cross-border banking for the City. Moody’s have recently announced that the ‘impact of losing passporting rights under EU law would be manageable for rated banks’. They do not consider it likely that the UK will lose all its passporting rights and instead look towards the incoming rights within the MiFIR regulations and MIFID 2 EU directive.
• Under MiFIR, the UK may be deemed a ‘third country’ to the EU and thereby provide firms with an alternative means of accessing the single market. In order to be eligible for third country rights under MiFIR, a firm must be regulated and supervised in its home country by the relevant authority, for instance the FCA, and they must receive a positive equivalence determination from the European Securities and Markets Authority (ESMA) that the legal and supervisory facilities of the third country are equivalent to those required under MiFID II. Cooperation agreements must also be in place covering methods for exchange of information and for notifying breaches of the regulation to ESMA. Once the above has occurred, the firm must the register with ESMA.
• The FCA has confirmed that financial regulations from the EU will remain applicable until any changes are made by the UK government.

How should a new arrangement be implemented? Would a transitional period be required?

• This could provide a smooth transition out of the EU, however, it relies upon a European Commission judgment, which is a political decision over which the UK will no longer have a say. The process under MiFID II can also take up to 210 working days (30 working days for ESMA to confirm that the application is complete, followed by a further 180 working days to determine whether the registration should be granted) the process of which may not be enacted until the UK has left the EU.

What if the UK and the EU reach no agreement? How would this impact the UK’s financial services industry?

• The UK’s position as recently voiced by the Prime Minister appears to lean towards a hard Brexit. If the UK failed to reach any agreement with the EU, then the City would face challenges in Europe until other negotiations are concluded. There has already been some suggestion by the chief of the British Bankers Association, Anthony Browne, that banks will move some of their operations out of the UK. The French Finance Minister has also reportedly made moves to entice American banks to move operations to Paris. So far however the moves are relatively small.
• A more blunt calculation may simply be that the banks do not have a great deal of choice. No European city is as globalised as London, and while UK-based banks may have been using Brexit as leverage for concessions from the government, the UK government may believe they are bluffing and that the UK’s prime role as a trader for Asia, the US and the wider world is fixed, with or without Brexit.

How do these issues differ for different types of financial services providers (eg investment firms, credit institutions, asset managers, insurance companies)?

• Under Solvency II, insurance and reinsurance companies could operate within the EU under equivalence provisions. In some areas the UK is judged ‘super-equivalent’ for Solvency II and this is unlikely to change post-Brexit so it should be in a position to achieve equivalence under Solvency II.