The EU and the City: Putting Equivalence in Perspective • Technical Politics

Last week it was reported that the ex-Chancellor, Sajid Javid, wanted a “permanent equivalence” deal granting the City of London access to the EU’s markets for decades¹ in order to quell the City’s fears that it could be shut out of EU markets at a moment’s notice. Michel Barnier responded that the EU would reject efforts to agree a financial services chapter in the new UK-EU trade deal or a long term deal on equivalence. But how realistic is the City’s fear of exclusion and who would be hurt if the EU did try to prevent access to UK financial services?

According to the Office of National Statistics (ONS)² of the £90 billion services the UK sold to the EU in 2016, 58% of this were in insurance, pensions, financial and other business services. While the UK bought £76 billion of services from the EU in 2016, with the largest category, travel, accounting for 40% of the total.

Whereas most people would advise against the UK government starting trade negotiations by stating: “if you don’t follow our rules, we will stop UK citizens travelling to the EU”. We know that UK citizens chose to travel to the EU regardless of the UK’s EU membership – the EU has many interesting destinations, competing providers keeping costs low and it is in a similar time zone so it is quick to get there and there is little jet lag. So I don’t expect the UK to spend less on travel in the EU now that they are no longer EU members.

But incredibly the EU is making such a threat: that the EU would forbid, or at least make it more difficult for EU companies to use the UK’s financial services even though the EU buys most of its financial services from the UK and financial service are not discretionary spending – companies actually need them. The EU would have to introduce currency controls to achieve its threat but with electronic trading it would be easier for the UK to stop its citizens traveling to the EU – at least people have to physically cross a border unlike most financial services.

What is EU equivalence anyway and how is it granted?

In EU regulatory language, equivalence means that the European Commission has decreed that one country’s financial regulations, as pertaining to a very particular area of EU financial regulation, are similar enough to the EU’s to allow firms regulated by that country to sell services in that particular competence to customers in the EU.³ Being granted EU equivalence in any financial competency does not require countries to have either the same financial regulations as the EU, nor to accept dynamic alignment to the EU, but their regulations should be similar to the European Markets and Securities Authority’s (ESMA) standards.

Unfortunately, the Commission’s decisions to grant equivalence can be motivated by political and competition considerations as much as by adequate regulation. There are many examples of countries having met the EU’s stated regulatory requirements, only for the European Commission to withhold equivalence for political or competitive reasons. Last year the EU allowed Switzerland’s granted equivalence to expire because Switzerland refused to put its many bilateral agreements with the EU into a single framework.

But the European Commission has only been able to withhold equivalence from eligible countries because EU businesses could use the UK financial markets and so refusing equivalence to countries for political or competitive reasons would not hurt the EU economy. That will obviously not be the case, if the EU decides to withhold equivalence from the UK – where would EU businesses go for financial services?

Which countries have been granted equivalence?

Looking at the current list of the countries who have been granted equivalence by the European commission as at Jan 9^th 2020,⁴ three things are clear:

There are a lot of areas of financial competency where very few or even no countries have been granted equivalence; For example:
1. there are no Non-EU countries with equivalence in Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR), as amended: Art.75(1) – Trade repositories;
2. While for Regulation (EU) No 600/2014 on markets in financial instruments (MIFIR), Art 28(4) – Trading Venues for the purpose of trading obligation for derivatives: only two countries have been granted equivalence – Singapore and the US;
3. Another example is Directive 2014/65 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (MiFID 2 – recast) Art.25(4)[a] – Trading venues for the purposes of trading obligation for shares: where only Hong Kong, Australia and the US have been granted equivalence;
4. Incredibly for Regulation (EU) 2016/1011 on indices used as benchmarks in financial instruments and financial contracts Art.30(3) – Specific administrators or benchmarks: only Australia and Singapore have been granted equivalence;
When equivalence has been granted it is generally to markets that are outside the EU time zone with the exception of the Capital Requirements Regulations (CRR);
There are many other areas of financial services that are missing from this list. Some are missing because equivalence status is not available in that competence which still falls under the authority of individual member states who can permit companies to operate but limited to that state’s jurisdiction.

So presumably, if the EU is serious about withholding UK equivalence, then EU companies that use financial services should be preparing to start work shortly after midnight to catch the Asian markets or stay late in the evening to deal into the US markets.

Who would be hurt if the EU were to restrict access to UK financial services?

In practice Barnier’s threats would only really hurt small and medium sized enterprises in the EU, as larger companies will already have an office in the UK and can run their financial transactions through them. All the larger EU based banks have offices in the UK and the Bank of England announced over two years ago that it would allow EU banks presently operating in the UK to remain. The EU’s professional and high net worth investors can use the EU’s reverse solicitation regulations that allow them to continue to buy UK managed investments provided that they initiate the transaction. There are a myriad of loopholes that will allow much of the present business to continue regardless of Barnier’s threats. There are also the aforementioned financial competencies that fall under member state authority and are outside Barnier’s control.

Could the EU develop its own financial markets?

Barnier may hope that restricting access to London will help develop EU financial markets but it will be very hard for financial markets in the EU to develop while there is a large, well regulated, well organised market next door that covers all possible products and due to basic economies of scale – will most likely be able to provide cheaper capital and services.

Consider a shopping mall, with shops ranging from Chanel to H&M, providing specialty products to supermarkets, where shoppers can wander protected from the weather, with ancillary services such as parking and restaurants, cinemas and baby crèches. London is effectively the same for financial services: it has services ranging from small private banks to multinational investment banks, products ranging from catastrophe insurance to plain vanilla mortgage finance, where customers are protected by the PRA and the FCA, with ancillary services such as accounting and legal services and with a pleasant living environment for the families of bankers and investors. And just as a glamorous new shopping mall will make it harder for a drab suburban shopping area to compete, London’s existence will make business very difficult for the 5 to 7 smaller EU financial areas that are hoping to take London’s crown.

Large, centralised markets always produce the best prices simply because there are a greater number of competing buyers and sellers, and more competition between service providers. The direction of travel in financial markets has been towards ‘large and centralised’ and away from ‘small and local’ for decades but this movement accelerated after money and financial markets became electronically traded.

But that is also why the UK government must not fall into the trap of believing that financial service providers need equivalence to get EU business. Most of the larger, as well as many medium sized, UK based firms have already established operations in the EU27 in preparation for the original Brexit date of March 29^th 2019. Yes, this is probably less cost effective than working out of their London offices but it won’t send them out of business. The Central Bank of Ireland has allowed UK companies to establish offices of only 3 to 5 people to gain EU access.

But what about the EU’s treatment of Switzerland?

It will also be difficult for the EU to try to withhold equivalence from the UK in the hope of gaining political concessions as it did with Switzerland last year – primarily because the EU does not have a competitive, alternative market to the UK in the same time zone, either internally or with granted equivalence. For the EU to withhold equivalence from the two major financial markets in its time zone would be truly economically illiterate. Only a bureaucracy that believed that financial services offer no real value to business would consider doing this. And the application process for gaining EU equivalence, like everything the EU does, is long and complicated so I don’t expect the EU to start doling out equivalence certificates to UK and Swiss competitors. The EU should accept that its businesses, banks and professional investors will be using the UK financial service markets and move on. At least with the UK, the European Commission knows that our financial regulations are gold plated versions of their own regulations.

The boot really ought to be on the other foot: it is the UK, with its gold plated regulations who should be considering whether it should be granting access to its markets to all of the EU member states – especially those states that have yet to fully implement MiFID II or Solvency II. Certainly Barney Reynolds has made a compelling case that not all Eurozone Government bonds should be given the same zero risk capital weighting when used as collateral.⁵ However EU law demands that Euro denominated sovereign bonds should be treated as risk free even though member states do not control the ECB and cannot print more Euros. Reynolds maintains that under Basel standards, Eurozone bonds should be treated like municipal bonds or sovereign bonds issued in a foreign currency and discounted when held as assets or used as collateral at clearing houses.

What would be the downside of following EU regulations?

Rather than pushing for permanent equivalence, the UK government should be avoiding any agreement that would necessitate following all EU regulations. The existing EU financial regulation was developed with the UK markets in mind but we cannot assume that in the future the EU will continue to make regulations that suit large, international, financial markets. In fact, we should probably assume that future EU financial regulations will be catering to the exact opposite. The substantial difference between the London markets and the many smaller EU27 markets is beyond parody. In some sectors the UK even dwarfs the larger EU markets: for example the UK’s market share of global foreign exchange is 43% while Germany’s is only 2%.⁶

It would be ridiculous for the EU to maintain its present financial regulation now that the UK is out of the EU, and it would be equally ridiculous for the UK to agree to follow any new EU regulations that will no doubt be tailored towards smaller markets and the type of domestic bank lending preferred by Germanic companies.

The UK government should not be fooled into believing that allowing financial regulations to be made by EU bureaucrats with little knowledge of finance businesses and even less love of Anglo Saxon Capitalism, will keep financial services based in the UK. The UK does not own the international financial markets that thrive in its cities. The UK has given financial services a well regulated home, with common law, skilled staff, a central time zone and the English language – but with electronic trading it will be easy for the financial markets to find a new home if the UK were bound to adopt all of the EU’s, sometimes commercially questionable, regulations – and that new home will not be in the EU.

This may sound like scaremongering but the European Commission has already tried to force the UK to charge VAT on commodity derivatives traded on the International Commodity Exchange (ICE), the London Metal Exchange (LME) and the London Platinum and Palladium Market (LPPM). Last year, the Commission referred the UK to the European Court of Justice for the UK’s failure to bring its legislation into line with EU VAT law by continuing to allow commodity derivatives traded on “terminal markets” in the UK to be zero rated for VAT.

However if the UK were to agree to the EU’s VAT demands, the ICE, a completely electronic market which also operates in New York, would be able to move its commodity contracts out of the UK in a nanosecond. So the EU would not get a penny in VAT, the UK would lose a business and end users of that market would have to trade through New York. We can be certain of this reaction because the ICE has already moved 245 oil contracts, in February 2018, in response to the EU’s MiFID II regulations. But the LME is 143 years old and still uses an open outcry system as well as running an electronic trading platform, the historic open outcry ring would be unlikely to survive an EU VAT raid. As the LME is now owned by Hong Kong Exchanges and Clearing LTD, if the LME is forced to leave London, it will probably be moving to Hong Kong. So again the EU would gain nothing, the UK would lose a business and London based metal traders would have to start work a lot earlier.

How important is EU financial service business to the UK?

The UK government needs to keep EU financial service equivalence in perspective and not be tempted to quell the feigned fears of vested interests. Of the UK’s total exports of financial, insurance, pension and other business services in 2016, only 36% went to the EU, the other 64% went to the rest of the world even though the UK was under the EU’s politically motivated equivalence system. Outside of this regime, who knows, the UK’s financial service exports to the rest of the world might well have been much larger.

In the future more and more financial service business will be done with the Asia Pacific region as the emerging middle class accumulates capital, and requires trade finance and risk management. Meanwhile the next wave of financial markets are already developing in Africa.

The new Chancellor needs to get over his predecessor’s EU fixation, the EU is a great place for travel but Financial Services are so much bigger that the EU.

Catherine McBride is an economist with long experience in the financial derivative markets, and is the author of ‘Improving Global Financial Service Regulation‘ (IEA, May 2018, Shanker Singham and Catherine McBride), and ‘Not everyone’s cup of tea: The verdict on MiFID II‘ (IEA, May 2019)

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