Abstract: Brexit is destined to have a heavy impact on the cross-border regulation and supervision of financial services between the EU and the UK. Henceforth, both parties must find the right regulatory mechanism to manage their relationship in this complex field. Can a UK-EU trade agreement also discipline cross-border finance between the two parties? The present blogpost highlights the risks of over-relying on trade law as a regulatory mechanism to fix post-Brexit finance. Previous attempts to use trade agreements to foster cross-border financial integration, such as the “financial exception” in the TTIP negotiations, have not proved successful. Hence, negotiators cannot use previous templates, but rather need to find innovative technical solutions. This may not prove realistic in the present situation, since Brexit negotiations must work under severe time constraint and political pressure.
The post-Brexit regulation of financial services represents one of the most controversial issues left open by the imminent departure of the United Kingdom (UK) from the European Union (EU). Both parties need to keep their financial markets open to each other, given their economic interdependence and the importance of market-based finance for the EU economy. The UK cannot afford to lose access to the EU Single Market, being the largest worldwide exporter of financial and insurance services (Wyman, 2016). However, this is only one side of the coin, as EU firms need to import financial services coming from London as much as their British counterparts need to export them into the Single Market. Benefitting from economy of scale and a friendly regulatory environment, the City is currently the “investment banker” of Europe, with a lively financial “ecosystem” that would be very hard to reproduce elsewhere (Moloney, 2017a). It constitutes a one-stop shop where European firms go in order to purchase every kind of financial services, ranging from syndicate loans to derivative hedging. Finally, the EU is politically committed to diminishing the EU economy reliance on banking, which was considered among the causes of the sovereign debt crisis. In order to enhance financial stability as well as the financing capacity of EU firms, the EU Commission has promised to increase the financial integration of EU markets. This flagship integrationist project, the Capital Market Union, would be very difficult to achieve without the technological and financial inputs of London (Moloney, 2017b). Overall, the need to maintain London as the financial capital of Europe is of extreme importance for both parties.
This blogpost firstly analyses the effects of Brexit on cross-border financial trade between the EU and the UK. Then it reflects what role a future EU-UK trade agreement may play on regulating post-Brexit finance. The blogpost focuses in particular on the failed TTIP negotiations between the EU and US, where the Commission proposed an innovative and ambitious chapter on financial services, the so-called “financial exception”, assessing whether it could provide a template for the Brexit negotiators.
The United Kingdom as a third country in the area of financial services
As a member state of the European Union, the UK has been part of the most integrated financial system ever created between sovereign nations. Thanks to EU membership, EU financial firms can enjoy “passporting rights”. The passport allows firms located and authorised in an EU member state to operate, directly or on a cross-border basis, across the entire EU single market without further authorizations or regulatory burdens. “Passported” firms can also branch out their activities in other Member States, without being obliged to set up costly and more capitalised subsidiaries. Those are very favourable terms for financial firms, which would otherwise be required to comply with the regulatory framework of each different Member State. Passport rights have made EU wholesale financial markets extremely integrated, so much that in 2016 many British financial firms were simply taking for granted their right to trade with the rest of the EU, without being fully aware of the complexity and importance of passports (House of Lords EU Committee, 2016). Furthermore, they have been particularly important for the UK, given that most international financial firms have established the main base of their European operations in London. However, Brexit will entail the transformation of the UK from an EU member state to a third country (Ferran, 2017). The latter category cannot benefit from passporting rights, being reserved to EU and European Economic Area (EEA) countries. Without passports, UK-based firms would incur great regulatory, supervisory and capital costs to provide financial services to EU financial markets. For example, many UK banks would be forced to establish subsidiaries in continental Europe, rather than relying on less-capitalised branches or cross-border transactions. This would substantially hinder UK-EU trade in financial services with economic repercussions that are very difficult to predict (Armour, 2017).
Aware of the risks of losing access to EU financial markets, the UK Prime Minister has recently expressed the “need to be creative as well as practical in designing an ambitious economic partnership that respects the freedoms and principles of the EU and the wishes of the British people”. According to the UK government, the preferential means to achieve this objective would be a “free trade agreement on goods and services” with full liberalisation and regulatory cooperation in the field of financial services (May, 2017). According to the government’s view, it would constitute a “bespoke agreement” especially tailored to the economic and political needs of both parties. However, no trade agreement so far has established a deep liberalisation of financial services, nor it has created a legal harmonization in this controversial area of the law (Andrew Lang and Caitlin Conyers, 2014). The only past example in this direction is constituted by the failed attempt of the EU to enhance regulatory cooperation in the field of finance with the United States (US) during the negotiations of the Transatlantic Trade and Investment Partnership (TTIP). Although the EU proposal, labelled as the “TTIP financial exception”, was unsuccessful, the UK manifested the intention to insert a similar clause in a future “bespoke agreement” between the EU and the UK. Can the TTIP “financial exception” provide a template for the Brexit negotiators in the field of financial services?
Trade and financial services
Trade law is beyond doubt the most effective and institutionalized area of international economic law (Lowenfeld, 2007). The World Trade Organization (WTO) provides a rule-based system constraining the regulatory autonomy of its member states to enhance the liberalization of goods, services and intellectual property.
Financial services are also covered by WTO Law. In particular, WTO member states signed in 1995 the General Agreement on Trade in Services (GATS), establishing a framework for the liberalization of international trade in services. Within the GATS, WTO member states can still take binding commitments to liberalize an individual service sector within the GATS. However, the GATS has not been particularly successful in liberalizing financial services, given the presence of the “prudential carve-out” (paragraph 2(a) of the GATS annex on Financial services). This rule allows a WTO member state to adopt, notwithstanding any other provision of the GATS, “measures for prudential measures” with the aim to protect “investors, depositors, policy holders”, as well as to ensure “the integrity and stability of the financial system”. In other words, WTO member states are always free to regulate their financial markets for prudential reasons, namely to ensure financial stability and prevent systemic risks. Although those rules are non-discriminatory, they have the effect of hindering the cross-border flows of financial services, as each member state can impose different prudential rules ranging from capital and liquidity requirements to consumer protection rules (Ohle, 2017).1
The prudential exception ensures the financial regulatory autonomy of WTO member states who, as long as they do not openly discriminate against foreign firms, are free to regulate their financial markets as they see fit (Cantore, 2018).
If the WTO does not provide the legal means for the convergence of financial regulations, bilateral trade agreements also tend be unfit for purpose, as they all substantially reproduce the “prudential carve-out”.2 Overall, both multilateral and bilateral trade agreements, based on hard law and equipped with a dispute resolution mechanism, have proved unable to facilitate regulatory convergence in the field of finance (Brummer, 2010).
The TTIP “financial exception”
The post-crisis re-regulation of financial services on both sides of the Atlantic has led to market fragmentation between the US and the EU (Lehmann, 2016). Despite the cooperative efforts of international bodies such as the G20 and the Financial Stability Board, transatlantic regulators and supervisors have often adopted contradictory regulatory and supervisory rules, hindering cross-border financial flows. The Commission, alarmed by the possibility of EU firms losing access to US financial markets, proposed to use the TTIP negotiations to enhance regulatory convergence in the field of financial regulation.
The proposal of the EU Commission would have constituted the most ambitious and overreaching chapter of regulatory cooperation in the field of finance ever concluded in a trade agreement. In the Commission’s view, the activity of international bodies, although important, had proved unable to prevent legal fragmentation in transatlantic markets, so much that both parties had implemented inconsistent rules in relevant areas such as banking oversight and derivatives markets. The only vehicle to amend such divergences and avoid further fragmentation was an innovative forum of enhanced regulatory cooperation enshrined in a trade agreement.
The “financial exception” proposed by the EU was based on a two-stage mechanism. First, the chapter would have obliged each party to inform the other in the event of a new regulatory project entering the legislative pipeline. In particular, the proposal established the obligation of both actors to “consult each other at the earliest stage of the regulatory process”, with the consequence that cosmetic compliance with the requirement, such as informing the counterparty just before the final approval of a new legislative proposal, would have amounted to a legal violation. This obligation would have forced transatlantic regulators to confront each other on a more equal footing, instead of relying on the “first mover advantage” and a more unilateral approach. However, the Commission was aware of the fact that an obligation to cooperate was not an obligation of result. Compelling regulators to talk at the earliest stage of the legislative process was a necessary, but not sufficient step to adopt convergent legal rules. Sometimes even the most elaborated cooperation mechanism can fail for political reasons as well as the impossibility regulating different markets with the same approach. Hence, the Commission proposed a second step, namely, the “commitment to assess whether the other jurisdiction’s rules are equivalent in outcomes”, proposing a system of mutual recognition of supervisory and regulatory rules. If the first stage of the financial exception was aiming at creating common transatlantic financial rules, the second one was directed at ensuring that the two systems were convergent on the outcomes. An important element to take into consideration was that the proposal, despite creating a binding mechanism of cooperation, did not have the intention of hindering or reducing the regulatory autonomy of the parties. Notwithstanding the obligations to cooperate as much as possible, the TTIP chapter on financial services would have contained a strong “prudential carve-out”, fully preserving the financial sovereignty of both parties.
Unfortunately, it is not possible to assess whether the double-staged mechanism proposed by the Commission would have worked, facilitating transatlantic cross-border trade. The EU proposal spectacularly failed because US citizens, represented by the Congress and Non-Governmental Organizations (NGOs), perceived the financial exception as a political favour to big banks in the aftermath of the global financial crisis (Jones and Mcartney, 2016). They successfully lobbied the US government, persuading the latter to refuse any regulatory compromise with the EU in the field of financial services.
Can the TTIP negotiations constitute a template for Brexit?
Financial actors like banks and capital markets firms are not ordinary service providers. The manner in which they are regulated and supervised can have strong repercussions on capitalist societies. When a regulatory framework proves to be ineffective, the spillover effects created by a financial crisis on the “real economy” can be very painful. This is the reason behind the “prudential carve-outs” in trade agreements: financial liberalization should not come at the expense of the freedom of each polity to regulate their financial system as it deems fit. There is a clear parallelism between the TTIP and the Brexit negotiations, as in both cases technocratic discussions are being thwarted by political considerations.
A trade agreement is clearly not the best regulatory mechanism to fix cross-border financial trade in the aftermath of Brexit. As the prudential carve-out clearly demonstrates, trade agreements have never played an important role in regulating finance. Given the short time allotted to the parties, designing an innovative chapter on financial services in a Brexit trade agreement would require a herculean technocratic effort. In other regulatory areas, both parties can take stock from the great experience of the EU as trade actor and regulatory superpower, relying on the last-resort option of simply taking an already established governance and regulatory template and applying it to the Brexit situation. The blooming of variegated trade templates and the consequent Brexit jargons (the Norwegian, the Swiss and the Canadian models) are there to show that, when it comes to trade, many options are still on the table. In the field of finance, this is not the case. The only possible template for an innovative chapter in the area of finance is a failed chapter of a never-concluded trade agreement (TTIP). This should give pause for thought.
Technocratic solutions to the post-Brexit management of financial services can always be found, provided that politics does not come in the middle. It is possible to see many similarities between the TTIP and the Brexit negotiations, with technical discussions being thwarted by political considerations. The TTIP financial exception failed because US citizens denounced the democratic deficit of the regulatory mechanism proposed by the Commission. In a similar way, the Brexit negotiations also became heavily politicised, with the UK demanding to “take back control” and the EU refusing any “cherry-picking” solution. Although public and more particularly parliamentary scrutiny of international negotiations should always be welcomed, they also pose a substantial challenge to their successful outcome. This is true for every regulatory area, but it is particular pertinent in the case of financial services, where the politicisation comes on top of a shortage of technical solutions.
A “Brexit financial exception” would not produce the same level of financial integration ensured by EU passporting rights. Both parties could always rely on a “prudential carve-out” clause, retaining their regulatory autonomy. It would substantially damage the status of London as global financial capital, failing to prevent market fragmentation and regulatory divergence in many cases. However, it could constitute a starting point for further negotiations, in order to adapt the TTIP model to the Brexit situation. At this point of time, any technical solution would still constitute a better option than the total absence of regulatory cooperation.
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 For example, a banking institution cannot easily trade across nations if it has to establish a subsidiary, with different requirements, in each state.
 For example, the North American Free Trade Agreement (NAFTA) between Canada, US and Mexico contains a similar clause (art. 1410), as well as the Comprehensive Economic and Trade Agreement (CETA) between the EU and Canada (art. 13.6).