Regulatory Relations

A proposed transition after the UK leaves the EU, but remains in it in all but name and therefore subject to all its rules, does not particularly worry the UK financial sector. What sets pulses racing is what comes afterwards, on which there is still little clarity. By Justin Pugsley

A proposed transition period after the UK leaves the EU, which may leave the UK as a rule-taker, is unlikely to threaten the City of London – provided it is relatively short. 

After the UK leaves the EU on March 29, 2019, it is seeking a transition period lasting up to two years before moving to a new relationship. This has raised concerns that the UK’s financial sector could be hit with damaging new EU rules.

Essentially, the UK would remain in the single market and customs union for a limited period after leaving the EU, during which time it would be subject to all EU rules.

However, the UK would no longer have a role in the union’s policy-setting institutions such as the European Commission, Council and Parliament.

The transition period requested by the UK, which the European Commission warns is not inevitable, is controversial within the ruling Conservative party. Jacob Rees-Mogg, a Conservative member of the UK parliament’s lower house, the House of Commons, and an ardent eurosceptic, said it would make the UK a “vassal state”.

Since then the government has suggested a mechanism to exclude the UK from harmful new rules during the transition period which has not been endorsed by the European Commission.

"I’m not worried about the transition period if it is for a couple of years,” says Lord Francis Maude, advisor in the public policy and government affairs team at law firm Covington. “Typically, when new regulation is introduced, there is at least a two-year implementation period. It is possible some new regulation is introduced just after Brexit day and will come into effect before the end of the transition period, but it is highly unlikely.” 

Mr Maude, a Conservative, has held a number of government positions such as minister of state for Europe (1989 to 1990) and minister of trade and investment (2015 to 2016). He has also worked in investment banking.

Claude Brown, partner at Reed Smith, agrees. “I can’t see the UK getting completely blindsided by a piece of legislation that it doesn’t know about before the start of the transition period and which will be implemented completely within the [transition] period,” he says.

Not just legislation

There is much debate about the European Court of Justice (ECJ), which many in the UK ruling Conservative party view as a politicised institution bent on driving European integration.

“The ECJ will be the arbiter of some disputes. What is not clear is how they will deal with the UK during the transition period,” says Mr Brown. “There could be action from them if it was felt the UK wasn’t applying the EU rules during the transition period. Another possibility is that a [UK] court could apply for interpretative guidance on EU legislation from the ECJ.” 

Barney Reynolds, a partner at Shearman & Sterling, does not see a particularly big threat from the ECJ during a two-year transition period. He says the ECJ only occasionally makes politicised judgements that significantly alter the application of EU law in an unexpected manner.

Instead, Mr Reynolds raises other concerns. “There is a risk that the European supervisory authorities [ESAs] could issue guidance that is damaging to the City of London or that the European Commission could pass emergency legislation that is also damaging, though I don’t think the commission would generally use that power,” he says. Then there is the risk of full-blown EU legislation being expedited.

Mr Reynolds explains that it is imperative for the UK to have some safeguards during the transition period against potentially damaging legislation and guidance. “That could be some form of participation in the ESAs, an agreement for the UK to have the ability to disapply anything detrimental, or it could be a walkaway clause to end the transition period early and therefore pay less money to the EU,” he says.

Baroness Kishwer Falkner, a Liberal Democrat who chairs the House of Lords EU subcommittee on financial affairs, suggests another safeguard.

“The legislation has to go through the UK Parliament. A government with a busy parliamentary calendar may not find time to implement it,” she says, adding that it could in any case repeal unwanted legislation after the transition period.

After the transition

The real concern for the City is what follows the transition period. The European Commission has been firm regarding not including financial services in any potential EU-UK free trade deal. It said the UK would be a third country like the US and would have to rely on equivalence rulings to gain access to the EU’s financial services market.

One possible way for maintaining access to the EU’s financial services market is for the UK to remain regulated by the EU’s institutions or stay closely aligned.

Predictably, the UK government rejects this, and while it aims to stay close to EU rules, it also wants managed regulatory divergence and make mutual access based on regulatory outcomes.

“It would be a mistake for the UK to remain stuck in EU regulatory structures,” Mr Maude told GRR. Nonetheless, he does not believe that everything has to be negotiated before Brexit day. He says there could be a period post the transition where some regulatory arrangements around financial services are grandfathered.

He explains that there is no  genuine EU single market in financial services and that access varies from sector to sector. “I think people exaggerate the extent of the single market the City enjoys,” he says. “Everyone focuses on banking and the passport. But that’s not even half the story and even if there are no arrangements equivalent to passporting there are a lot of things that can happen to make things work smoothly.”

He says it is important for the UK to have regulatory freedom to harvest the long-term Brexit benefits – adding that these are far from guaranteed – and stressed that it is not about a regulatory race to the bottom but creating a flexible and risk-based system.

“It’s being able to be fleet of foot in a way that European regulators aren’t and nor the US ones,” he says.

There seems to be a palpable fear in the commission of the UK enjoying regulatory freedom or deregulating, despite the UK routinely gold-plating EU rules even under the current Conservative government.

In terms of mutual regulatory recognition, Mr Maude says the trend is shifting away from rigid detailed global rules towards a system of accreditation and certification that meet a broad set of standards. “What you want is alignment of outcomes,” he says.  

Former European Commissioner Jonathan Hill, who was responsible for financial services (November 2014 to July 2016), wrote on the website Reaction that the UK was influential on EU financial services regulation.

Baton passes to France

Mr Hill warned that the void is being filled by France, and that EU rulemaking is moving in a direction the UK has traditionally resisted, such as more screening of overseas investment, more centralised supervision and even a possible financial transaction tax.

Some industry sources blame France for the commission’s intransigence regarding not including financial services in a trade deal.

Mr Hill also believes that the UK’s heavy dependence on services means it must make its own rules. Like Mr Maude, he sees the UK needing to control its legislation to rapidly adapt to technology-driven change.

Ms Falkner told GRR that it is also important for the UK to know what it is transitioning to. David Davis, secretary of state for exiting the EU, recently told parliament that he expects a ‘barebones’ framework to be in place possibly by October.

“You can have a framework agreement by autumn and then you could continue negotiating the details,” says Ms Falkner.

She adds that the view of the committee she chairs is that it is better to get the details right, but admits it is a struggle getting clarity from the government.

The government refused to release a planned position paper setting out a vision for the City of London post-Brexit. “Maybe they want to keep their cards close to their chest,” says Ms Falkner.

In political circles some attribute the government’s reticence to publishing the paper to not wanting to be accused of capitulating if they fail to get everything they want from the talks. Another view is that the Conservative party is too divided to fix a position.

Still apart  

The UK government’s position is to leave the single market, customs union and end ECJ oversight and sign a trade deal with the EU, which maintains as far as possible the current arrangements. It also proposes various degrees of regulatory alignment for different industries.

Following a speech by the leader of opposition, Labour’s Jeremy Corbyn, the government might be subtly shifting its position or at least recognising the limits of what is achievable.

On February 26, Mr Corbyn called for a customs union between the UK and EU and to stay close to the single market. He said this would ensure no tariffs between the two jurisdictions or a hard border in Ireland. As part of the arrangement, the UK would have a say in the trade deals the EU negotiates with other countries. He also said the UK would not be a passive rule-taker. He made no mention of financial services.

On March 2, UK Prime Minister Theresa May gave a speech calling for a bespoke deal with the EU whereby mutual access for financial services would be based around regulatory outcomes.

Ms May said EU and UK regulators should work together to maintain financial stability.

“We are not looking for passporting because we understand this is intrinsic to the single market of which we would no longer be a member,” she said. “It would also require us to be subject to a single rulebook, over which we would have no say.”

She added that it is unrealistic for UK taxpayers to bear the risk for the financial stability of the world’s largest financial centre while automatically implementing new EU rules.

UK chancellor (finance minister) Philip Hammond, in response to questions from the House of Commons European scrutiny committee, said he agreed with the prime minister. He has previously said that financial services must be included in any EU-UK free trade deal.

However, this has been flatly rejected by Bruno Le Maire, France’s minister of the economy and finance, who left open only the possibility of equivalence whereby the EU can terminate any arrangement under this mechanism with 30 days’ notice. This mirrors the commission’s current position.

Although the UK side is split, the EU is not entirely united either. Some EU countries, such as Ireland, Luxembourg and Italy, appear favourable to a deal that includes financial services.

It seems that some EU-based manufacturing industries would not be opposed if it meant maintaining tariff-free access to UK markets.

Also, there is no strongly united front (among EU member states) for the UK to closely follow EU financial rules.

Mr Reynolds believes that the push for close regulatory alignment post-Brexit is mainly coming from the European Commission, France, and possibly elements of the European Parliament.