In brief
Written by Senior Regulatory Counsel Michael Mathieson
It is impossible to think about the likely impact of Brexit on financial services regulation without first thinking about Brexit more broadly.
Brexit more broadly
The first point is that, while there has been a lot of attention paid to when and how the UK may start the process of leaving the EU, less attention has been paid to what happens two years later. Article 50(3) of the Lisbon Treaty says:
The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification … , unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period.
That's right – unless a deal is done within two years of service of the withdrawal notice, the UK will automatically leave the EU, unless the European Council and the UK agree otherwise. That would seem, to this bystander, to give the whip hand to the European Council in the negotiations.
The second point is that, quite apart from relations between the UK and the EU, the UK will need to negotiate free trade agreements with numerous non-EU countries. The EU currently has free trade agreements with dozens of countries. The UK will cease to get the benefit of those FTAs when it leaves the EU. That means they will all need to be renegotiated directly by the UK.
Renegotiating dozens of FTAs within two years, when you don't currently have a dedicated team of trade negotiators, would seem, to this bystander, to give the whip hand to the rest of the world in those negotiations. (The UK does not currently have its own dedicated team of trade negotiators because, as a member of the EU, trade negotiations have been, to date, the exclusive preserve of the EU. If you are a trade negotiator, chances are you will shortly be able to get a good job in London.)
The third point is that, in the words of Lord William Hague (spoken shortly before the Brexit referendum), 'There is no UK strategic plan for what we do if we leave the EU.' (On any view this is an arresting statement.) As explained by Lord Hague, that approach represented a deliberate decision by the Cameron government, so as not to give any assistance to the 'Leave' campaign. The plan – not to have a plan – does not seem to have worked well. You can watch the full, fascinating interview with Lord Hague here.
The fourth point is that there is no existing model for what a majority of the UK people seem to want. The EU single market involves approximately 500 million people and GDP of an estimated €13 trillion. Access to that market would seem, to this bystander, to be valuable (and, conversely, loss of access to it to be damaging).
Norway has access to the single market by virtue of its membership of the European Economic Area but at the price of accepting freedom of movement of people (as well as having to contribute to the EU budget and not having any say over applicable EU rules and regulations). Switzerland also has access by virtue of a creaking mass of around 100 treaties (which require constant updating) but, again, at the price of accepting freedom of movement of people.
But a majority of the UK people are no longer prepared to accept freedom of movement of people. (Lord Hague predicted a significant cost to the UK economy if material restrictions were to be placed on freedom of movement – these being costs associated with the UK experiencing full employment and needing additional labour, in other words economic costs quite separate from those associated with reduced access to the single market.)
So a new model will need to be developed. A model under which the UK will want to minimise the freedom of movement of people (at least into the UK, if not from the UK into the EU) but maximise access to the EU single market. To this bystander, it is not clear why the European Council would agree to this, particularly when its own survival would seem to depend, in part, on making it unattractive for other member states to leave.
Financial services
In his interview, Lord Hague expressed the view that Brexit 'would be damaging' for the UK's financial services sector. It is unlikely he could be accused of hyperbole.
EU financial services regulation arguably makes Australia's FSR look simplistic. Think the Markets in Financial Instruments Directive, the European Markets Infrastructure Regulation, the Alternative Investment Fund Managers Directive, the Banking Recovery and Resolution Directive and the Capital Requirements Directive. For starters.
The idea that the UK could, on leaving the EU, simply walk away from a significant amount of EU financial services regulation seems fantastical. A lot of financial services regulation, EU or not, emanates from international bodies such as the Basel Committee on Banking Supervision and the Board of the International Organization of Securities Commissions. Nations effectively lost their sovereignty in this area long ago, and at least since the September 2009 G20 Leaders Statement in relation to OTC derivatives at the Pittsburgh Summit.
It seems likely that the UK will, instead, have to incorporate vast amounts of EU financial services regulation into its domestic law, to the extent it has not already done so. However, the UK will have no say on the future direction of EU financial services regulation. It will also have to manage, as best it can, the inevitable divergence between its domestic law and EU financial services regulation over time.
But adopting the bulk of EU financial services regulation on exit would not be enough to give the UK 'passporting' rights into the EU. At its simplest, passporting means a financial institution authorised in one EU member state can provide certain services into other EU member states without needing direct authorisation in those other states (or having to set up a locally regulated entity). On exit, the UK will lose its passporting rights – unless it can somehow negotiate them into its withdrawal agreement.
Without passporting, there appear to be two paths available. One is mutual recognition. Where available, this path requires detailed equivalence testing to be performed. The process can take a long time. And it is not available in relation to all aspects of EU financial services regulation. The other path is for the relevant financial institution to set up a subsidiary in a continuing EU member state and obtain the appropriate authorisations there (thus enabling it to passport around the rest of the EU). The associated costs often include becoming subject to local capital requirements.
If mutual recognition is uncertain and time-consuming, and remembering the two-year countdown once the trigger is pulled, does a UK financial institution that wants to continue to do business in the EU effectively have to consider setting up a subsidiary inside the EU? Thankfully the answer to that question lies above my pay grade.
Conclusion
Shortly after the fall of the Berlin Wall, my modern history teacher said to a classroom filled with 15-year-old boys: 'Pay attention, you have to understand that you are living through one of the most important and interesting episodes in modern history.' He might well say the same thing now, although I suspect he would feel quite differently about the current episode.