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Brexit refresh: Aiming for equivalence

Financial institutions look for UK government to reach an equivalence deal

On March 29, 2019, the United Kingdom's (UK) membership in the European Union (EU) will officially end, although experts are somewhat optimistic that a transitional arrangement or implementation period may be formalized.1 If so, UK and EU negotiators will have an additional two years to finalize a trade deal, and possibly avert a ‘hard Brexit’; an outcome which will provide some assurance to financial institutions.

Key insights

  • Equivalence is a tenuous concept open to sudden change and legal uncertainties
  • Mutual recognition is preferred within financial services as it creates a comprehensive framework around market access
  • Mutual recognition, while desired in the UK, has found few backers inside the EU, which seems more content striking a Canada-style free trade deal that excludes financial services

Following the Brexit vote, a number of lobby groups representing financial services, including TheCityUK, urged the UK government to consider the option of remaining in the Single Market to preserve access to the EU.2 Lobbyists have since rolled back on that demand as the government is unprepared to accept freedom of movement provisions or be subject to decisions passed down by the European Court of Justice (ECJ), two key criteria for Single Market membership.3

With retention of Single Market membership untenable, financial institutions increasingly explored the possibility of setting up subsidiaries inside the EU in order to retain their passporting benefits,4 which would entail additional legal considerations and capital requirements. As a result, lobbyists recommend the government pursue a policy of either equivalence or mutual recognition with the EU.

Equivalence: a fine balance

The equivalence approach is when one jurisdiction recognizes another country's market practices and regulatory regime5 as having broadly comparable standards to its own in order to help facilitate cross-border trading.6 The UK has and will continue to transpose EU law into its domestic legislation until March 2019. Nonetheless, equivalence is not definitive and could be vetoed by the EU should negotiations turn acrimonious.

The chief benefit of equivalence is that it would not oblige the UK to replicate EU law exactly but to ensure similar standards.However, equivalence, if not fully defined, could result in the UK being required to adopt EU rules it does not necessarily endorse in order to maintain equivalence, as noted by Mark Carney, governor of the Bank of England.8

Equivalence is not definitive and could be vetoed by the EU

A report by the House of Lords concurred: “An agreement based merely on the EU's present 'equivalence' framework would not be a reliable long-term basis for either the UK or the EU. Any form of alignment that renders the UK a de facto rule taker would not be acceptable, given that future EU regulation may not be appropriate to the needs of the UK economy."9

Equivalence has other constraints. Ratifying equivalence agreements can take a prohibitively long time. For example, it took several years of negotiations before the US Commodity Futures Trading Commission (CFTC) and European Commission (EC) found common ground on Central Counterparty Clearing House equivalence.10 Such delays can lead to instability and uncertainty.

Furthermore, the equivalence model can be arbitrarily abrogated by the EC at any point and with the provision of only 30 days' notice.11 “Revocation may generally occur if the EC no longer considers the third country's legal system to be equivalent to that of the EU following changes in that third country's regulatory and/or supervisory framework," read a report by the European Parliament. Given the systemic importance of the financial services industry in the UK, equivalence that can be removed on short notice has limited appeal.

Mutual recognition: an unrealistic outcome?

There have been proponents calling for the UK to adopt a policy of mutual recognition with the EU. In September 2017, the International Regulatory Strategy Group (IRSG) produced a report in conjunction with international law firm Hogan Lovells advocating a Free Trade Agreement, “introducing a joint dispute resolution body and mechanisms for mutual market access when financial services passporting rights … are lost after Brexit".12

While obtaining consensus on Brexit is challenging, the prospects for a mutual recognition proposal are also unclear

The report added that the premise of mutual recognition would be based on regulatory alignment between the UK and EU, thereby allowing UK financial and professional services firm to operate inside the EU without restriction and vice versa.13 The government subsequently announced in February 2018 that it supported the concept of mutual recognition, sanctioning a number of the recommendations made by the IRSG.14

While obtaining consensus on Brexit is challenging, the prospects for a mutual recognition proposal are also unclear, particularly since a UK government proposal has already been rejected by the EU, which described it as a “pick and mix" approach.15  In addition, it has been reported that senior financial executives in the UK no longer believe that mutual recognition is a realistic outcome of the ongoing Brexit negotiations. A government document on its EU proposals for a financial services deal published in May 2018 also failed to mention mutual recognition.16 The EU added that while it was keen to find accord on a tariff- and quota-free deal for trade, services could only be included with restrictions,17 a position that resembles the bloc's recent trade agreement with Canada.

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