If, as many expect, the UK does not remain part of the European Economic Area, then it will need to write its own laws to mirror those in the EU if it wishes to retain access to the single market.
In the area of financial services, that raises the prospect of the UK and Europe having to thrash out several so-called “equivalence assessments” which may prove critical to the ability of UK firms to access EU customers. If those agreements are not reached in time, single market access would be denied and UK firms would probably have to scale up their in-EU operations.
Jonathan Haines, a partner at law firm Ashurst, said the “obtaining of equivalence decisions will be key” if the UK was outside the EEA, but added the process would be “political and time-consuming. There is no guarantee that even identical rules will be treated as equivalent, particularly in a difficult political climate.”
Given the equivalence concept is a relatively new part of EU legislature, here’s how it works.
What is equivalence and why it so important?
All new EU financial services legislation crafted since the crisis has a so-called third country provision, which determines how those rules apply to firms in non-EU countries (or third countries, in EU-speak), and how EU firms operate elsewhere.
The system was created to help maintain open links between the world’s largest financial centres and prevent firms being subjected to a patchwork of rules in every region, but also to ensure other regions have rules in line with those of the EU. Put simply, the provisions require firms from non-EU countries to be subject to an “equivalent” legal and regulatory framework in order to get access to the EU’s single market.
A post-Brexit UK would be especially keen to secure equivalence to the EU’s new trading rulebook, Mifid II, coming into force in 2018, which contains key EU passporting rights for non-EU firms provided they operate within equivalent regimes. Many UK firms have already spent millions getting ready for the new rules.
How is equivalence determined?
Each piece of EU legislation sets out how equivalence is determined, but the ultimate decision lies with the European Commission, which obtains technical advice from the European Securities and Markets Authority.
Broadly, the Commission sets out three key conditions. The first is that a non-EU country must have an effective equivalence system of its own to determine how its domestic firms can operate abroad. Second, that country must have a legal and supervisory framework that is effectively equivalent to that in the EU. Third, co-operation agreements should be in place between Esma and the relevant authority in the third country to allow for information sharing and procedures around firm visits.
If that sounds like a lengthy and complicated process, it is. James Hughes, a lobbyist at Cicero, said: “Equivalence is not just a box-ticking exercise, it is often a very dry and technical process which looks at each piece of regulation line by line.”
Have any equivalence decisions been reached and do they allow for small differences to remain?
Yes. Several equivalence decisions have been reached between the EU and third countries on the European Market Infrastructure Regulation, which covers derivatives markets. However, in the case of the decision between the US and the EU, this took many years because of differences in clearing regimes.
There is some scope for two regimes to not be identical and still deemed equivalent. The UK might be able to scrap the banker bonus cap and short-selling restrictions and still be deemed equivalent, for example – but a significantly looser regime in London is unlikely to pass muster.
Cicero’s Hughes said: “There is a chance for some minimal differences. But the EU would obviously not want the UK to be running a lighter regulatory regime which would make it more attractive than the EU.”
Surely the UK should be given automatic equivalence given it already complies with EU rules?
In theory, yes. The UK should easily pass any equivalence assessments given it has been complying with EU rules for many years. It will hopefully have been compliant with Mifid II for at least a year, if the UK operates by the current assumed timetable and leaves the EU in 2019. But as the ultimate equivalence decision is at the discretion of the European Commission, politics could play a part and the Commission could make the process as easy or difficult as it wants.
Marco Boldini, a European regulatory counsel at ETF Securities, said: “While the fact that the UK already largely complies with EU legislation suggests it could be an almost automatic process, the reality is that political considerations could be taken into account and make it a very protracted affair.”
Haines said: “One would hope the UK achieves a deal that safeguards access to the single market or equivalence, but that depends a lot on political goodwill.”
What if equivalence is not agreed by the time Brexit happens?
There is a risk that the Commission will not begin to make an equivalence assessment until the UK has formally left the EU, in 2019. Alternatively an agreement may simply not be reached during exit negotiations.
Either case would be highly undesirable. A senior regulatory expert at one European bank described it as “the gap risk” and an issue many were gradually waking up to. In that instance, the UK would have no single market access and firms wishing to operate in the eurozone would need a presence in the bloc.
Yet, it might not such a big issue if the amount of a UK firm’s cross-border business into the EU was minimal. And that is something lawyers in the City are furiously trying to figure out.
Cicero’s Hughes said: “There is a very big focus among the legal community to determine just how much London activity depends on cross-border access. There is a lot of wholesale financial activity in the UK that does not necessarily need a passport into the EU.”
The European Commission and the UK’s Financial Conduct Authority declined to comment.