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Financial services – passporting and equivalence

Once Brexit occurs, a central concern for the financial services industry will be continued access to the EU27’s financial markets from the UK as well as access to the UK’s financial markets via any of the EU27 countries. As demonstrated by the evolving policy and advocacy emerging from the UK, views on how this might be achieved have now moved from focusing just on passporting. In the remainder of this section we summarise published research that has helped to inform the ongoing discussion on how access to UK and EU27 financial markets might be achieved, and provide background information on passporting and the EU’s current approach to equivalence.

Importance of financial services to the UK economy: In the October 2016 study undertaken by Oliver Wyman (OW) for TheCityUK, The Impact of the UK’s Exit from the EU on the UK-based Financial Services Sector, it was reported that the UK-based financial services industry earns approximately £200bn in revenues annually, and approximately 25% (or £40–50bn) of these revenues arise from international and wholesale business related to the EU. In the same study, OW looked at the impact which an exit from the EU – putting the UK outside of the EEA – could have on these revenues across a spectrum of regulatory outcomes relating to the degree of access that financial firms based in the UK would have to EU clients and infrastructure through:

  1. Financial services passport: a provision under the relevant single market directive (or regulation) that, subject to the fulfilment of conditions specific to the directive (or regulation), entitles a firm authorised in the European Economic Area (EEA) to carry on permitted activities in any other EEA state by either exercising the right of establishment (of a branch and/or agents) or providing cross-border services.
  2. Third country equivalence: a provision that exists in recent EU financial services acts that set out those cases whereby the EU may recognise that a foreign (i.e. ‘third country’) legal, regulatory and/or supervisory regime is equivalent to the corresponding EU framework. That recognition, in turn, makes it possible for authorities in the EU to rely on supervised entities’ compliance with the equivalent foreign framework.

In the OW report, the high-access scenario is one where the potential impact is least and is predicated on an exit that delivers: (i) the UK having full passporting and equivalence under the full scope of single market directives, and (ii) new access arrangements for those directives where a third-party regime does not currently exist.

The low-access scenario is one where the potential impact is greatest and is predicated on an exit where the UK is a third country without any recognition of regulatory equivalence and where the UK’s relationship with the EU rests largely on WTO obligations.

OW’s quantification of the estimated first order and ecosystem effects of the UK’s exit from the EU under these two scenarios is set out in detail on page 14 of the report. In summary, under the high-access scenario revenues from EU-related activity would drop by £2bn and 3–4,000 jobs would be at risk, while under the low-access scenario revenues from EU-related activity would drop by £18–20bn and up to 31–35,000 jobs would be at risk.

However, not everyone agrees with OW’s analysis.

The October 2016 report by Open Europe – starting with data supplied by the FCA to the UK Parliament Treasury Committee (and reproduced in the section on passporting below) – examined the financial services sector by sub-sector and concluded:

  • In Banking (wholesale and retail), passporting works well (from the UK and into the UK) and is most important (representing approximately a fifth of the sector’s annual revenue).
  • In Asset Management, passporting is less important given a number of technical barriers that hinder the marketing of funds across the EU, the fact that a number of larger funds operate subsidiaries in the EU, and the propensity for EU client assets to be domiciled in Dublin and Luxembourg with management delegated to the UK.
  • In Insurance, 87% of insurers operate across borders via subsidiaries rather than branches (which rely on the passport). Lloyd’s of London’s underwriting business is a noted exception to this although it is estimated that only 3% of the market’s gross written premium is directly reliant on the passport.

In light of this analysis, Open Europe does not support TheCityUK’s assertion that the City of London’s success is based on full and complete access to the EU single market in financial services. Instead, Open Europe arrives at a series of specific recommendations that are premised on the UK seeking a comprehensive free trade agreement with the EU27. In summary, the key recommendations concern:

  • Where the UK should be seeking retention of passporting arrangements.
  • Where and how equivalence arrangements can be achieved and bolstered (e.g. with pre-emptive equivalence).
  • The establishment of a UK equivalence system that offers reciprocal market access to the EU, and infrastructure that ensures that the UK maintains its equivalence standing with non-EU states.
  • Domestic reforms to ensure that London (and the UK) remains an attractive place for financial services to do business.

Both reports, however, highlight that this is not a ‘zero-sum game’ – i.e. organisations will not shift activities from the UK to the EU on a one-for-one basis. As such, the UK government will be in a position to remind EU negotiators that EU businesses will have an interest in ensuring that the agreement governing the relationship between the UK and the European Union also benefits EU companies and governments.

Politeia has also published a report – A Blueprint for Brexit: The Future of Global Financial Services and Markets in the UK by Barnabas Reynolds, a partner at Shearman & Sterling LLPUnlike the OW and Open Europe reports, the Politeia report rejects maintaining the passport on the grounds that it would require the UK to continue to be a rule-taker of EU regulation (which it describes as burdensome), in all likelihood require the UK to sign up to the authority of EU supranational bodies (EBA, ESMA or ECJ), and require some form of commitment to the EU (financial or free movement of people).

Instead, and not unlike Open Europe, it looks to the equivalence provisions that are already in place (and detailed in Annex A of the report) and considers two options for addressing where there are gaps in the current equivalence regime (which are detailed in Annex B of the report). The first option is an ‘expanded equivalence model’ that would expand the availability of equivalence to address current gaps and require the UK and EU27 to assess their respective rules fairly (i.e. base the assessment on outcomes rather than the existence of identical laws). In the event that the first option is not achievable, the second option is the ‘financial centre model’ where these equivalence gaps are not filled and the UK redevelops its regulatory regime so that it is market friendly and removes the cost of losing the passport. The report also points out the need for careful analysis of which activities are actually cross-border activities, and the appropriate use of the ‘reverse solicitation’ exemption by which financial institutions operating in the UK can transact business with EU customers who wish to access their services, subject to the provisions of the exemption.

A closer look at passporting: On 20 September 2016, the UK Parliament’s UK Treasury Committee issued a press release concerning its publication of a 17 August 2016 letter from Andrew Bailey, the Chief Executive of the Financial Conduct Authority (FCA), that provided an overview of passports issued by UK and other EU member state competent authorities and the directives that they have been issued under. The tables below reproduce the data set out in the letter, however, like Open Europe’s report, we have also sought to group the data in the second table by sub-sector as well as ensure the outbound and inbound columns in both tables align.

An outbound passport refers to a passport issued by the UK’s FCA or Prudential Regulation Authority (PRA) to a UK firm, enabling that firm to do business in one of the other EU member states (or, where relevant, an EEA state). An inbound passport refers to a passport issued by a competent authority in one of the EU member states (or, where relevant, an EEA state) to a firm from that state that allows the firm to do business in the UK or other member states.

When reviewing the first table, it is essential to note that a firm conducting one type of activity under one directive in 30 countries (i.e. 27 EU member states plus Iceland, Liechtenstein and Norway) would need to be registered as holding 30 passports. Moreover, some directives require multiple passports for different activities and the total number of passports includes activity delivered through branches or provided from outside the member state (i.e. on a cross-border basis). Apart from underlining that passporting works in both directions, these details go some way to explaining why there are many more passports than there are firms, and why the total number of outbound passports is greater than inbound passports although the number of firms passporting from the UK is less than those passporting into the UK.

Total inbound and outbound passports

 TotalOutboundInbound
Total number of passports359,953336,42123,532
Number of firms using passports13,4845,4768,008

It is clear that a significant number of inbound and outbound passports have been issued in relation to the directives affecting banking and insurance (although it is essential to note that MiFID I is distinct from MiFID II/MiFIR which will replace it in January 2018 and includes an equivalence regime). The data also provides no detail on the effectiveness of the passport regime or the extent to which the passports, once issued, are used. As mentioned above, Open Europe’s October 2016 report provides some analysis in this regard.

Total inbound and outbound passports by sub-sector and directive

 DirectiveOutboundInbound
BankingCapital Requirements Directive (CRD IV)102552
Markets in Financial Instruments Directive (MiFID I)2,250988
Asset ManagementAlternative Investment Services Directive (AIFMD)21245
UCITS Directive3294
InsuranceSolvency II220726
Insurance Mediation Directive2,7585,727
Payments and e-moneyPayments and Services Directive (PSD)284115
Electronic Money Directive6627
OtherMortgage Credit Directive120

A closer look at equivalence: As summarised by the FT, prior to the outcome of the 23 June 2016 referendum being announced, most banks were not focused on the equivalence provisions. However, since then the provisions contained in MiFID II/MiFIR and other directives and regulations have become a point of focus. These equivalence provisions currently rely on a determination ultimately made by the European Commission. On 29 September 2016 the Commission produced a summary table of their decisions to date. A closer look at selected equivalence provisions is provided below.

Markets in Financial Instruments Directive II and Markets in Financial Investments Regulation (MiFID II/MiFIR): Articles 46 and 47 of MiFIR come into effect on 3 January 2018 with the other MiFIR II/MiFIR requirements. Subject to the conditions under MiFIR Article 46.2 being met, MiFIR Article 46.1 states that:

A third-country firm may provide investment services or perform investment activities with or without any ancillary services to eligible counterparties and to professional clients within the meaning of Section I of Annex II to Directive 2014/65/EU [i.e. MiFID II] established throughout the Union without the establishment of a branch where it is registered in the register of third-country firms kept by ESMA [The European Securities and Markets Authority] in accordance with Article 47.

In turn, MiFIR Article 47 gives the Commission the power to adopt a decision in relation to a third country stating that the legal and supervisory arrangements of that third country ensure that firms authorised in that third country comply with legally binding prudential and business conduct requirements which have equivalent effect to the requirements set out in regulations, directives and implementing measures specified under Article 47. The rules pertaining to the establishment of branches in member states where a third-country bank is seeking to provide services to retail (or elective professional clients) are set out in MiFID II Article 39.

Separately, in relation to the trading obligation provisions under MiFIR, MiFIR Article 28.1(d) also allows for recognition of third-country trading venues subject to the Commission finding (under a procedure referenced in MiFIR Article 51) that the legal and supervisory framework of the third country ensures the trading venue authorised in that third country complies with the requirements listed in MiFIR Article 28.4. The MiFIR trading obligation is also linked to the clearing obligation specified in the European Market Infrastructure Regulation (EMIR).

While the equivalence provisions in MiFIR should be helpful to the wholesale market, MiFID II/MiFIR do not allow third-country investment firms or third-country credit institutions to provide investment services to retail clients or elective professional clients. Instead, MiFID Article 39 gives member states the option of requiring these third-country firms intending to provide investment services or perform investment activities to this set of clients to establish a locally regulated retail branch in that member state. Where a member state has taken up this option, subject to a series of specified conditions, the third-country firms can seek authorisation to set up a branch.

European Market Infrastructure Regulation (EMIR): The concept of equivalence also features in EMIR in relation to the recognition of third-country central counterparties (CCPs) (Article 25) and trade repositories (Article 77). EMIR has been in effect since 4 July 2012, and is concerned with the clearing and bilateral risk management requirements for over-the-counter derivative contracts, reporting requirements for derivatives, authorisation and supervision of central counterparties as well as their obligations, and requirements for trade repositories.

Capital Requirements Directive IV and Regulation (CRD IV/CRR): CRD IV allows deposit-taking institutions to conduct services throughout the EU using their home-state authorisation. As summarised by Ashurst, these services extend to deposit-taking, lending, and participation in securities issues, as well as trading securities for customers or on own account, as well as custody services, and these are activities that overlap with MiFID II/MiFIR activities. The CRD also allows third-country banks to establish branches in the EU with the agreement of the EU authorities but does not detail how such an agreement would be reached or which services would be covered.

The concept of equivalence also finds expression in the capital calculations set out in the CRR. For instance, under well-defined conditions certain categories of exposures to entities located in countries outside the European Union can benefit from the same preferential treatment applied to EU member states’ exposures in terms of capital requirements. Similarly, recognition (or lack thereof) of third-country CCPs under EMIR also has implications for the CRR capital calculations that directly inform the total capital which financial services firms (that are subject to CRD IV/CRR) must hold.

As mentioned above, a complete analysis of the equivalence regime is set out in Annexes A and B of the Politeia publication A Blueprint for Brexit: The Future of Global Financial Services and Markets in the UK.

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