How are legal and regulatory changes affecting the UK financial services sector in the context of the government’s ambitions for a “global Britain”? Specifically, what have been the impacts of Brexit, and what are the future prospects?
The biggest and most direct impact of Brexit has been on business conducted between the UK and the EU. The difference in the legal environments here before and after Brexit is large. Something close to a true “single market” existed before Brexit. In its place are some specific commitments to open markets and protections against discrimination (in the UK-EU Trade and Cooperation Agreement) and a structure for ongoing discussion (the Memorandum of Understanding on cooperation).
Unsurprisingly, this has had a substantial effect on the way in which business can be done between the UK and the EU.
In the new world, UK firms wanting to do business from a place of business in an EU member state must generally be authorised to do so by the host state, and must then operate under host state rules and supervision. It is the same the other way round, although EU firms have been temporarily spared the need to go through a full authorisation UK application and approval process under the UK’s Temporary Permissions Regime.
Cross-border business (i.e. business done directly into a host state, rather than from a host state place of business) has also been restricted. Cross-border business from the UK into the EU is prohibited by some member states, at least for some types of business. There is little prospect of this changing in the medium term – “equivalence” recognition, which some had touted as the solution, is not going to be granted for UK firms for a while at least. But equivalence was never going to be a panacea anyway. Its coverage is patchy (it doesn’t exist for retail business, or for ordinary insurance and banking), and it is a precarious foundation on which to base a business model as equivalence recognition can be withdrawn on short notice.
Cross-border business is generally easier from the EU into UK. This is not so much because of the UK’s equivalence decisions (though these are more extensive than the EU’s), but because of the “overseas persons exclusion” which is potentially available to all overseas firms, including those in the EU.
There have also been changes for infrastructure. The UK is continuing to permit EU firms to use UK trading venues and clearing houses in the same way as before, but the same is not the case the other way round. EU restrictions on the use of UK trading venues have led to a sizeable proportion of EU share trading moving from the UK to the EU. The dust has not yet settled for clearing houses – the EU has not yet said whether it will prohibit EU firms from clearing derivatives on UK clearing houses once its temporary equivalence recognition expires.
These various restrictions on UK-EU business have seen financial services firms establishing new legal entities, obtaining new local authorisations, relocating jobs and moving capital and assets in order to continue to service their clients. The fact that the EU has been less accommodating than the UK has meant that UK-based firms have needed to do more of this restructuring than their EU counterparts, and more business appears to have moved from the UK to the EU than the other way round.
Besides the direct effects on UK-headquartered firms, the new limitations on the UK’s access to EU markets are likely to have some effect on the UK’s attractiveness as a European hub for firms headquartered outside Europe: the model by which these firms could establish a single subsidiary in the UK to service the whole of Europe may not work any more.
For all these reasons, Brexit has posed serious challenges for the idea of “global Britain” in financial services. But the advantages that have made the UK by far the largest financial centre in Europe remain. Its deep and diverse “ecosystem” cannot be rapidly replicated elsewhere. And Brexit has opened up some new opportunities for the UK, as discussed below.
The UK government has been pursuing two opportunities opened up by Brexit: the UK’s new freedom to do its own trade deals around the world, now that it is no longer subject to the EU’s common commercial policy; and the ability to adapt its regulatory regime to better suit its own needs, freed from the constraints of EU single market rules. The hope is to negotiate better access to foreign markets and attract liquidity and activity to the UK.
However, recent precedent suggests that the scope for significantly opening up foreign financial services markets through trade deals is limited. The financial services chapters, even the most extensive recent ones, rarely go far beyond reiterating commitments already made under the WTO General Agreement on Trade in Services. These typically provide protection (or more typically, lock in existing protections) against discrimination, both vis-à-vis other countries’ providers and the host country’s own providers, but do not confer positive rights of access or provide an alternative to host state authorisation requirements. These limitations are not accidental: besides the usual wariness about exposing domestic players to foreign competition, there are also consumer protection concerns, and the global financial crisis has shown how foreign financial institutions can pose a threat to a country’s financial stability.
There are two reasons why the UK is likely to find these obstacles at least as difficult to overcome as other countries have done. The UK’s strength in financial services may make a foreign trade partner particularly uneasy about exposing its domestic market to this competition. And the UK’s ordinary legislation and regulatory rules are very accommodating to foreign players anyway (as discussed below), so that it doesn’t have much leverage in this area to extract concessions.
There is not yet much of a track record, but the few trade deals that the UK has negotiated so far bear this out. The financial services provisions of the UK-EU Trade and Cooperation Agreement go little further than recent EU-third country deals such as EU-Japan and EU-Canada, even though the two sides were starting from a uniquely close and integrated relationship. This was not for want of trying by the UK, but the EU was simply unwilling to go further. The Comprehensive Economic Partnership Agreement with Japan closely follows the EU-Japan deal, and goes further only in relatively minor respects (protections regarding data storage, and commitments regarding host-state authorisation processes). The deal with the EEA EFTA states (negotiated but not yet signed or published at the time of writing) is relatively modest, judging from government statements.
A deal in principle with Australia was announced in June. Both sides had wanted financial services to be covered, but the text has not been published at the time of writing and the level of commitments actually agreed is currently unclear.
Discussions on a possible UK-US deal began under the Trump presidency, although the US has recently said that any deal would take “some time”. Both sides’ negotiating objectives include coverage of financial services, including more open access to each other’s markets. The UK government wants “best in class” commitments, saying that “the UK and US have a unique opportunity to set a new gold standard for what can be agreed in FTAs on financial services”. But at this stage it is unclear whether any deal is likely to go much beyond, say, EU-Japan provisions. In some areas it is unlikely to go that far – for example, it seems unlikely the US would agree to the full range of EU-Japan provisions on regulatory cooperation. Its reluctance to make commitments in this area led to financial services being withdrawn from the EU’s offer for an EU-US trade deal (the Transatlantic Trade and Investment Partnership) back in 2014.
Talks on possible deals with Canada and Mexico are expected to begin later this year.
The UK has agreed a number of lower level cooperation and dialogue arrangements, both before and Brexit. These include “fintech bridges” – with Singapore, Hong Kong and a number of others, designed to strengthen engagement on fintech policy and regulation, facilitate trade flows and access to capital opportunities and address barriers to international growth. These kind of arrangements can help to open markets by building trust and fostering the development of common approaches to particular regulatory issues.
So, trade deals including financial services have already been done and more seem likely, but it is doubtful whether they will dramatically open up UK or foreign markets. They will have some value in locking in existing levels of access and in facilitating ongoing dialogue and cooperation. But perhaps their significance will lie as much in a demonstration of the government’s “global Britain” intentions as in their direct practical effects for this sector. Other cooperation and dialogue arrangements may in fact be equally important.
The UK’s financial services reputation is based at least as much on the attractiveness of London as a financial centre as it is on the strength of its financial services providers. The “Wimbledon effect” means all the world’s strongest players are present in London, even if most of them are not UK headquartered.
The UK’s long-standing policy of unilateral openness to foreign players has sustained the Wimbledon effect over many decades, under governments of many different persuasions. In a series of recent publications, the UK authorities have been taking stock of the current legislation and regulatory rules that form the basis of this approach. The government has published a Guidance document setting out how it will operate the equivalence framework, and a Call for Evidence on the overseas framework more generally. The aim is to ensure the overseas framework achieves the goal of attracting liquidity and activity to the UK while supporting financial stability and openness in financial markets. The focus is on the overseas persons’ exclusion, the regimes for overseas investment exchanges and financial services advertising (particularly as it affects overseas long-term insurance products), and investment services equivalence. There may well be some scope for improving clarity here, and perhaps also for some rationalisation – there is considerable overlap between the overseas persons exclusion and investment services equivalence, but they take very different approaches. There is no suggestion the government intends to curtail overseas access, but equally it does not look like it will be significantly expanded either.
The two main regulators, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), have also reviewed their approaches. The FCA has published a detailed document explaining its approach to international firms, without changing its rules, and has restated its commitment to “open and vibrant markets”. The PRA has consulted on relatively minor changes to its supervisory statement on its approach to supervising the UK activities of international banks. It also explicitly reasserts its “responsible openness” stance, and proposes only minor changes to its previous policy document for the sake of transparency and clarity.
The UK’s openness to foreign market participants is therefore set to continue.
Innovation and regulatory change
Of course, the fact that foreign players can participate in the UK market does not mean that they will. The attractiveness of the UK as a place to do business must rest largely on other factors. One of these is the quality of its regulatory regime. Now that the UK is no longer bound to adopt the EU’s regulatory rulebook, the government is looking at whether changes to UK regulation can make the UK a more attractive location for financial services.
Developing areas such as fintech and green finance are a major focus here. The Kalifa strategic review of UK fintech, which reported earlier this year, recommended a wide-ranging digital finance package of measures to create a new regulatory framework for emerging technology. This would include a digital finance ID trust framework, common data standards, progress towards mandatory “open finance” and guidance on the use of artificial intelligence, as well as specific recommendations relating to market infrastructure and the regulation of payments and cryptoassets. The government has not yet responded fully, although it has already announced that the FCA will develop a “scalebox” to provide a one-stop-shop for growth-stage fintechs. The authorities will also provide a “sandbox” and improved access to central bank settlement facilities for fintechs focussing on financial market infrastructure.
The UK also intends to remain a leader in green finance. A key aspect of this is climate-related financial disclosures, including disclosures by key financial services providers such as banks, insurers, asset managers and pension providers. The regulatory framework for these is still developing, but the global impact of climate change, and the global view of the investment community and of the largest companies, suggest that movement towards internationally comparable standards is inevitable. From a “global Britain” perspective, it seems there is limited scope for a purely national approach. The government’s planned reporting requirements are aligned with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) – an industry-led and geographically diverse body established by the Financial Stability Board. In the medium term, the IFRS is looking at the possibility of establishing a Sustainability Standards Board to set globally comparable standards for climate-related disclosures. The EU has been at the forefront internationally in developing a taxonomy to underpin some of this – the UK intends to align with it, at least to some extent, but the details are not yet clear. But if the UK has limited scope to make the running on the substance of the rules, it can take a lead on timing. The government has been very ambitious here, saying that it wants the UK to be the first country to make TCFD-aligned reporting fully mandatory across the economy by 2025, and many requirements will come into force by 2023.
A series of diverse initiatives has also been taken to reform UK regulation in its more traditional areas of coverage. Some of these are specifically aimed at making the UK a more attractive place to do business, including reviews of the listings regime and possible regulatory (and tax) changes to the funds regime. Others may nevertheless have that effect, including a relaxation of the restrictions on dark trading in equities, and the possibility of simplified prudential regulation for domestic and non-systemic banks and building societies. An ongoing review of prudential requirements for insurers might also have that effect if it concludes that some easing is appropriate.
It is therefore clear that the UK intends to make use of its new-found freedom to fashion its own rules. But there are limits. The government constantly reiterates its commitment to high standards of regulation, and the potential downsides of inadequate regulation are particularly high for a country whose financial sector is so large relative to its economy as a whole. In addition, fundamental prudential requirements for banks (at least the larger and internationally active ones) are covered by international standards to which the UK remains fully committed. The same is true for derivatives regulation. There is also some disincentive to diverging from EU rules in those areas where the UK may still hope for a positive equivalence assessment from the EU.
It is clear that the government is pursuing a “global Britain” approach to the UK financial services sector. There is no doubt that a responsive and nimble approach to regulatory change, continuing enthusiasm for open markets and competition, and an ambitious approach to free trade agreements, can all play a role in sustaining and perhaps even expanding the UK’s leading international position. But Brexit itself has demonstrated the outsized impact that wider political developments can have. It seems likely that geo-political and economic shifts will play a substantial role in shaping the future of UK financial services in the years to come.