The lonely Londoners: doubts plague UK quest for equivalence

Planned MoU won’t automatically bring equivalence, leaving firms in limbo for unknown duration

Four years, six months and nine days after the UK voted to leave the European Union, the country finally, practically speaking, left the single market. A transition period that had treated the departing nation as if it was still a member state lapsed on December 31.

Sine then, trading between UK and EU entities has been impeded by the lack of so-called equivalence determinations, through which the EU recognises the UK regulatory regime for various rules. That has led to restrictions being imposed on cross-border financial activities between the two jurisdictions. The path out is hazy and market participants wonder how long the current uncomfortable situation will last.

“I don’t think it is clear when we will see more equivalence decisions,” says Alastair Holt, a partner at law firm Linklaters. “The European Commission and other EU authorities are naturally keen to see the EU develop its own financial centres in Paris, Frankfurt and Dublin and compete with London.”

A non-binding political declaration published in October 2019 stated both sides would endeavour to conclude equivalence assessments before the end of June 2020. Few expected that deadline to be taken seriously. But there were hopes that key equivalence determinations would be granted in December, once a trade deal had been agreed.

As it turned out, a trade deal was only agreed on December 24. Two mutual equivalence decisions agreed in September allow firms in each jurisdiction to access the other jurisdiction’s central counterparties and central securities depositories. HM Treasury also granted some one-way equivalence determinations in November to avoid UK firms being penalised. But many big ticket determinations are still not in place.

“The key question on equivalence now is the timing of any further decisions,” says Oliver Moullin, a managing director at advocacy group the Association for Financial Markets in Europe. “An EC Q&A just states assessments are ongoing, but we don’t know what that will mean in practice. It is important that the assessments are completed as soon as possible.”

News outlets in the UK have reported that a deal on services could be agreed by March, but such stories conflate equivalence agreements with discussions on a memorandum of understanding. Sources say the MoU planned to be agreed by EU and UK negotiators by March should increase the likelihood of more equivalence decisions being granted.

But many doubt the MoU will provide an equivalence endgame.

“There is [going to be] a memorandum of understanding on co-operation. Great. So what?” asks Tim Cant, a partner at Ashurst. “That is not the same as equivalence.”

The European Commission and other EU authorities are naturally keen to see the EU develop its own financial centres in Paris, Frankfurt and Dublin and compete with London

Alastair Holt, Linklaters

He points to the phrase in the statement accompanying the December 24 agreement, which said equivalence discussions would be “without prejudice to the unilateral autonomous decision making of either side.” Cant notes: “That means the EU will declare equivalence when and if it thinks it is in its interest to do so. The relevant question is: why would it be if they’re trying to build up an internal market financial services system?”

Linklaters’ Holt also says it is doubtful the MoU will solve the lack of equivalence, as it won’t impose binding commitments on either side.

“It will likely set high-level principles which really any sophisticated regime would agree on anyway,” says Holt. “It will really be a framework for negotiation, sharing information and co-operation, but nothing binding.”

A spokesperson for the EC confirms the MoU won’t bring equivalence decisions automatically.

“The equivalence assessments are ongoing. We need further clarity from the UK side. This is an entirely autonomous process and we will only ever take decisions that are in our interests. This should not be confused with the discussions on the MoU,” says the spokesperson.

The deeper meaning of divergence

The EC request for clarity raises questions about what the UK will need to do to provide enough certainty to the EU on future regulatory developments through the MoU or in its dialogue with European counterparts.

A Q&A published by the EC on December 24 states the EC needs more information on how the UK intends to diverge from EU frameworks. The worry for the EC is granting equivalence to the UK now and having to reconsider its determination and possibly withdraw equivalence in the future.

But conversely, knowing exactly how the UK will diverge is not something that can be understood in the short-term.

Eric Litvack, Societe Generale

“It’s not a closed-end process, unfortunately,” says Eric Litvack, group director of public affairs at Societe Generale. “This is the difficulty of the whole Brexit exercise. There is a desire to achieve the ability to diverge, but there’s no clarity as to how the UK wants to diverge.”

In the glass half full corner, Afme’s Moullin says the MoU could help to tackle this problem, if the EU and UK are able to “reach a common understanding on divergence and equivalence”. But some lawyers are more glass half empty, warning the UK government is unlikely to commit to anything that limits its ability to diverge.

“The UK generally sees that [ability to diverge] as an advantage of Brexit, so it’s not going to want to give up that right by tying its hands,” says Linklaters’ Holt. “I don’t think the UK can do anything that will guarantee equivalence decisions of the EU in favour of the UK because the EU has been very reluctant. The UK has essentially got the same rules as the EU at the moment, but without the benefit of equivalence.”

No chance

One equivalence decision seen as almost certain to be refused in March is article 47 of the Markets in Financial Instruments Regulation (Mifir), which allows investment firms in third-country jurisdictions to access clients and counterparties in the whole of the EU, if granted. If article 47 Mifir equivalence were granted, UK-based firms would therefore be able to continue trading with their EU clients from London – an objective the EC doesn’t share.

“I am not seeing an enormous amount of enthusiasm for granting significant cross-border access,” says SocGen’s Litvack.

In a footnote within a stakeholder communication the EC published in July last year, the EC stated it had not begun the equivalence assessment due to the relevant EU legal framework not being fully in place.

Amendments were made to Mifir’s article 47 equivalence as part of the Investment Firms Regulation (IFR), which sets out capital requirements for non-bank investment firms. That regulation will come into force on June 26.

I am not seeing an enormous amount of enthusiasm for granting significant cross-border access

Eric Litvack, Societe Generale

If firms in a third country are likely to have systemic importance for the EU – as is the case with many in London, which has acted as an EU-wide financial centre – the EC must undertake a “detailed and granular” assessment of the country’s rules. This forensic examination under the IFR amendments is likely to be more difficult for the UK to pass than the original Mifir equivalence test.

The European Securities and Markets Authority (Esma) drafted a regulatory technical standard (RTS) on September 28, which provides extra details on the information third-country firms must submit to the regulator. The RTS still needs to be ratified by the EU’s three co-legislators: the EC, the European Parliament and Council of the EU.

Due to the lack of motivation on the EU’s side to grant equivalence, Ashurst’s Cant doubts any positive determination will be forthcoming.

“For people who think there is going to be equivalence [for cross-border trading] in March, dream on. Is it on the cards next year? I suspect not,” says Cant.

The determination isn’t important for large global investment banks that have set up subsidiaries in Europe to trade locally, but it is important for smaller firms that have baulked at the costs of setting up in Europe but want to keep their European clients.

A regulatory source at a broker told Risk.net before January 1 they would rely on reverse solicitation – an exemption from cross-border restrictions where EU clients request the services of non-EU dealers – in the absence of an article 47 equivalence decision. A legal source at a small international investment bank tells Risk.net they are also looking at ways to keep activity in the UK.

Looking for leverage

The UK also doesn’t have leverage to force the EU’s hand on Mifir article 47, because the Financial Conduct Authority already allows foreign investment firms to access UK clients through the overseas person exemption. EU firms have started using this exemption since the loss of single market passporting rights on January 1.

On December 15, HM Treasury launched a call for evidence on the framework for overseas firms accessing the UK, as there are overlaps between the exemption and the new powers HM Treasury has from their version of Mifir article 47, which was replicated into UK law.

“It is hard not to be a bit cynical and think about the timing of this,” says Ashurst’s Cant. “Are they investigating it to see whether they can make changes to allow UK regulators more control over third country firms or as a political point to make UK equivalence more attractive?”

Unaligned interests

There are two further equivalence decisions under Mifir that market participants have urged the EC to grant. But whether it is in the EU’s interests to do so remains debatable.

First, the EU’s share trading obligation (STO) requires European stocks listed on EU venues to only be traded on EU venues or equivalent third-country venues. The UK has also implemented the STO for stocks that are traded on UK venues.

Without equivalence, European firms have been forced to trade those European shares on EU-regulated venues, which has meant the relocation of share trading from London to the bloc. The EU seems unlikely to want to change that now.

“There’s been a redirection of where equities trading is happening, but at least different venues were ready to switch on their EU entities to redirect volumes,” says Societe Generale’s Litvack. “That seems to have been relatively seamless.

Second, the EU’s derivatives trading obligation (DTO) requires certain interest rate and credit default swaps to be traded on EU or equivalent third-country venues, which the UK has also replicated. The absence of an equivalence determination means EU buy-side firms have been forced to only trade those derivatives on venues in the continent.

Tim Cant, Ashurst

“Part of the reason behind the relative inflexibility of the European Union on the trading obligation is they want liquidity on EU venues, and they want to build that up,” says Ashurst’s Cant. “[The EC] doesn’t view that as happening by providing the UK equivalence. Although DTO/STO equivalence could conceivably be granted, as it has been granted [to other countries], I’d be surprised if we see those by March.”

However, the lack of equivalence on the DTO has had some unwanted side-effects for EU dealers, especially as many of them operate via branches in the UK. It means the only place EU dealers can trade with their UK clients is on US swap execution facilities that are deemed equivalent by both the EU and US. The threat to EU dealers is that they lose UK clients to rivals that can operate on UK venues.

“We believe it is in the European side’s interest to grant DTO equivalence, but there is a tension between the interest to limit negative impacts for EU financial market actors and the political reflex to onshore or re-balance financial services activity so that a greater share takes place in the EU,” says Roger Cogan, head of European public policy at the International Swaps and Derivatives Association.

The Financial Conduct Authority passed last minute relief on December 31 for UK dealers and EU dealers accessing the UK, allowing them to trade on EU venues with EU clients. The relief, however, doesn’t solve much for EU dealers that trade with clients in the UK via branches, as they are still bound by both the conflicting EU and UK DTOs.

Isda’s Cogan says the FCA relief only helped mitigate “a limited set” of barriers. EU and UK dealers still cannot trade with each other on EU or UK venues for products subject to the DTO, UK branches of EU-nexus firms still cannot trade with non-EU clients or the UK branches of EU firms on EU or UK venues, and UK-nexus firms cannot trade contracts subject to the UK DTO with third-country clients on EU venues.

“EU and UK authorities have it in their power to resolve the other major issues faced by firms in their jurisdiction…. They should find each other’s jurisdictions equivalent, preventing negative pricing and liquidity impacts for firms in their own jurisdiction,” says Cogan.

Is it painful enough?

However, Litvack says the long-term aim of the EC is more volume in the EU, rather than EU markets “dominated by offshore finance”. EU authorities will therefore want to examine evidence of negative consequences stemming from the lack of equivalence before removing those restrictions. The trouble is, the most likely consequences may not be enough to soften the EC’s heart.

“There are the beginnings of fragmentation and the market becoming less efficient,” says Litvack. “This is not a disruption risk, it is more of a franchise risk and slow bleed risk [for UK branches of EU banks].”

If negative consequences do take place, it could either lead to a positive equivalence decision or forbearance. Afme’s Moullin says the FCA’s relief may prompt EU regulators to reconsider whether to follow suit.

“The regulators on the EU side might look at the DTO further in light of the FCA statement and how trading has gone,” says Moullin. He also notes a speech by Robert Ophele, chairman of French regulator Autorite des Marches Financiers, delivered in December 2020. Ophele criticised the EU for not coming up with a pragmatic solution to adjust the DTO to avoid any negative consequences on EU dealers – French bank branches have significant derivatives markets activity in London.

Moullin continues: “Equivalence remains the preferred solution, but if equivalence isn’t forthcoming there, then it’s possible that might be an area that they would – and we would say should – look at forbearance.”

Editing by Philip Alexander