10 May 2018
Originally published by Brexit Central.
The ability to raise capital is the key to economic growth and prosperity. Well-regulated financial markets lead to a better allocation of productive capital and increase long term economic growth. It is important that, in leaving the European Union, the UK Government makes the most of the opportunity to re-examine existing regulations and directives, learning from them and modifying them to better suit the UK’s needs as an independent nation.
The UK financial services and insurance industry is a major component of the UK economy, contributing 6.7% of GVA, 3.1% of jobs and a trade surplus of £68 billion in 2016. But UK financial services are not a purely domestic industry, there are 170 foreign banks operating in the UK, from over 50 different jurisdictions, so the UK has the potential to be a key player in developing a more efficient international regulatory framework after it leaves the EU.
In the IEA’s recently published paper, Improving Global Financial Service Regulations, we look at what the UK can do in the context of Brexit that would not only improve the UK’s financial service industry, but also improve the availability of capital, hedging mechanisms and insurance internationally. In doing so, it sets out to provoke thought as to what a more efficient financial services regulatory framework would be, and how the UK could help to implement this in its domestic regulation as well as with its international trading partners.
We consider what the UK can do unilaterally to improve its own financial regulations, then what it can do bilaterally to establish a workable relationship with the EU and finally we look at how the UK can develop an international regime based on shared principles, achieved outcomes and mutual recognition either bilaterally with other financial centres or multilaterally through the WTO.
The scope for adaptation of UK financial regulations
Outside the EU, the UK must re-examine what financial regulation is appropriate and necessary for its own markets and reject, remove or reduce regulation that is not. Outside of the EU, the UK will be able to reshape its financial regulations by removing any unnecessary processes and focusing instead on proportionality of the regulatory outcomes in a transparent manner. Outside the EU, the UK will also have the advantage of greater agility in decision making and could enter into regulatory recognition arrangements with non-EU countries quickly and simply.
In many key areas, financial regulation is already based on international standards recommended by the Basel Committee of Banking Supervision (BCBS), the International Association of Insurance Supervision (IAIS), the International Organisation of Securities Commissions (IOSCO) and the G-20’s Financial Stability Board (FSB) and implemented consistently to avoid systemic risks, fragmentation of markets, protectionism and regulatory arbitrage.
While financial regulations must ensure financial stability and protect investors from unacceptable conduct, they must also maintain competitive markets and facilitate the growth of new businesses. Financial regulations must not be so complex or burdensome that they restrict access to capital, investment opportunities or the availability of financial products such as insurance or hedging instruments.
Regulation based on global standards should apply to companies that are internationally active, but be more proportionately applied to purely domestic companies. Proportionate regimes of regulation and taxation for SMEs, start up and fintech companies enable new market entrants which keeps the economy dynamic. Smaller and start-up companies do not pose a systemic risk and so their regulations should reflect this with “de minimis” exemptions.
The European Union (Withdrawal) Bill will novate to the UK the present equivalence status that the European Commission has granted to 32 countries, but the UK should also re-examine applications for equivalence that were not granted by the Commission, despite ESMA recommending that it do so. The UK may wish to establish cooperative mutual recognition agreements with some of these non-EU countries provided that they achieve similar regulatory outcomes.
The UK has the largest asset management industry in the EEA, with a 36.3% market share, but over half of these funds are domiciled outside of the UK. While this business is mainly wholesale asset management for insurance and pension companies, some of it is retail UCITS funds. A UCITS fund is an EU only domiciled and managed retail investment scheme and so on leaving the EU, the UK will need to develop its own authorised retail investment structure. The UK authorities could encourage EU domiciled investment funds, managed from London, to move their domicile out of the EU by reinstating Section 270 of the Financial Services and Markets Act.
The UK regulators should allow EU27 banks to operate as branches in the UK provided that their home regulators continue to cooperate with the UK authorities, and expedite conversion from branches to subsidiaries if desired. The process of branch conversion should start now, before any EU/UK agreement is concluded, so that all necessary licences are in place for a smooth transition and continuous trading post Brexit.
A financial services agreement between the UK and EU
It is in both the UK’s and the EU’s best interest for them to agree to a mutual recognition agreement in financial services especially as at the point of Brexit both jurisdictions will have identical regulation. This objective should be announced as soon as possible and be operational the moment the UK leaves the EU. Creating trade barriers in financial services that limit access to capital, hedging instruments, investment products, foreign exchange or insurance will only restrict the growth of EU companies and the EU’s economy.
It has been estimated that the UK provides 90% of the EU wholesale financial services and EU27 domestic providers do not have the capacity to replace this business. The EU wants the UK to comply with its Equivalence regime for non-EU countries, however there are many problems with this system; principally it does not cover the entire spectrum of financial services, it is granted and withdrawn unilaterally by the European Commission and it is not granted on transparent or consistent criteria: politics, reciprocal benefits and local protectionism all play their part as well as comparable regulations.
While some EU member states believe that they could benefit from restricting EU27 access to UK financial markets we believe that this could actually undermine financial stability in the European financial markets. Forcing euro-denominated clearing into the Eurozone would simply create two markets, echoing the creation of the Eurodollar market in London in the 1960s, reducing the netting effect for Central Counterparties (CCPs) and Clearing Houses and dividing the traded volume. This would necessarily reduce the traded volume in any one market and produce less efficient pricing making it more difficult for professional investors to buy and sell large positions without influencing the market price. A handful of global cities have become the major financial market places in their time zone, without any government legislation, because of the efficiency of concentred capital markets.
Even if the European Commission passed a directive that EU financial services could only be conducted in EU27 financial centres, trying to force people to use their local markets with electronic banking, machine trading, fintech and the free movement of capital would be impossible without external currency controls. The euro is now a global reserve currency; it has grown beyond the constraints of the ECB.
A better solution would be for the ECB and the Bank of England to agree to a collaborative arrangement along the lines of the USA and UK arrangement for clearing US$ denominated instruments by UK CCPs, to address the ECB’s systemic risk concerns regarding euro-denominated transactions. Disputes should be settled in a dispute settlement mechanism by an independent tribunal as is included in most modern FTAs. This will ensure financial market stability and investor protection without confining euro trade to the Eurozone.
The EU and the UK must develop mutual recognition based on international standards and common outcomes, with mutual transparency and cooperation between home state regulators, with the provision that such cooperation does not prevent either party from diverging, nor allow any divergence to trigger the loss of recognition.
In default of any other arrangements, the national regimes of each member state regarding overseas providers, professional or qualified investors, reverse solicitation and characteristic performance could allow non-EU service providers to offer investment services and activities to clients in that member state to without requiring authorisation or registration in the EU.
The evolution of the global regulatory regime
The UK should renew the built-in agenda on services in the WTO, first proposed in 1997, and actively push for mutual recognition, greater market access and the removal of trade barriers. Ensuring that domestic regulation and competition are sufficient and proportionate to achieve their prudential goals, without sheltering anti-competitive and discriminatory regulation. Equally mutual recognition should not be prevented by technical divergence if the achieved outcome of the regulation is the same. The WTO Most Favoured Nation (MFN) principle of non-discrimination should be at the core of any agreement on international financial service provision.
The UK should also consider forming an alliance with other global financial centres to agree an acceptable mutual recognition regime. Such an alliance would give the combined bloc a strong negotiating position when discussing regulatory matters with global regulatory and standard setting bodies and other countries. This alliance could include other financial centres such as New York, Chicago, Tokyo, Singapore, Hong Kong or even the Crown Dependencies and Oversea Territories that that have established adequate home regulatory standards in key financial service sectors such as banking, asset management, insurance and reinsurance.
Outside the EU the UK should evolve its own regulations and work with other financial centres and international standard setters to create a more competitive regulatory environment globally.
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