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Visions of a post-Brexit Britain raise passporting concerns

Tuesday, June 28, 2016

Read Philip Lee’s insights into the passporting concerns that are now facing the UK.  With little precedent on the process of secession from the EU and little guidance from the Treaties, the major difficultly of a withdrawal from the EU is the uncertainty surrounding the question of a post-Brexit UK-EU relationship. However, having regard to various arrangements that the EU has with non-Member States, consensus identifies five potential models that the UK may move to adopt.


The Norwegian option:

 Norway has broad access to the single market through its membership in the European Economic Area (EEA), but remains bound by a significant body of EU law. The EEA brings together the 28 EU Member States plus Iceland, Norway and Lichtenstein in a single market. If the UK adopted Norway’s arrangement with the EU, it could leave the EU but retain the UK’s place within the single market by becoming a member of the European Free Trade Area (EFTA) and the EEA.


While the UK would be able to dictate much of its own rules, especially in areas such as agriculture, fisheries, transport and energy, it would remain subject to a significant amount of EU regulation surrounding financial services, employment and consumer protection. The UK will have no formal seat at the table regarding formation of the body of EU law to which it will remain subject. Arguably, remaining fully bound by single market rules but having greatly mitigated powers in making those rules would be an unattractive model for the UK.


This model’s principal caveat is that Britain will be unable to avoid certain aspects of the EU legal regime. The EEA Agreement provides for the adoption of EU legislation covering the four freedoms (goods, services, persons and capital) throughout the 31 EEA States. Given that the free movement of people is a point of contention surrounding the EU referendum, this requirement would not sit favourably with the UK’s Brexit agenda. Furthermore, the UK would be obliged to make financial contributions to the EU budget though such sums would probably not be as much as the UK currently pays.


The Swiss option:

The UK may seek to adopt a model along the lines of the current Swiss model, though this model was initially intended as a transition to full EU membership. The Swiss model is structured with some 120 bilateral agreements with Member States and limited access to the single market. Switzerland is also part of the European Free Trade Association (EFTA), along with Iceland, Norway and Lichtenstein, an intergovernmental organization that manages a network of free trade agreements.

Given that Switzerland has access only to specified areas of the single market this option would require greater negotiation than with the Norwegian model. UK exports would also need to comply with EU product standards for exports to the EU.

Switzerland is also outside the EU customs union. There is some tariff-free EU/UK trade in goods within the scope of the Swiss arrangement, however this is subject to country of origin conditions.

It may also require the UK to contribute to the EU budget and is likely to require the UK to accede to at least some of the EU rules on freedom of movement and to comply with EU law when trading in the single market, again without any say in their formulation.

Furthermore, the complexity of this arrangement has made it unfavourable within the EU. Given the lack of an adequate institutional framework to ensure that these arrangements are able to keep pace with constantly evolving EU legislation, this is not a structure the EU will be readily supporting.


The Turkish option:

The customs union between the EU and Turkey could serve as a potential arrangement for the UK to retain some form of a relationship with the EU, but without the requirements to accede to EU law.

This customs union applies only to trade in goods (not services), there are no internal tariffs applied to trade between Turkey and the EU, and, there are common external tariffs for trade with third states.

Under this framework, the UK would not be required to make the financial contribution to the EU budget, however, it would not have access to the single market regarding services.

While in form this seems like an arms-length arrangement, in substance the UK may not completely escape the reach of EU law. The two polities would still have to agree on trade rules which would be unlikely to omit the relevant EU rules the UK is wishing to escape, and those which again the UK would have no say in formulating.


The Canadian Option:

The Canadian free-trade agreement with the EU (which has been agreed, but is not yet in force, and took over seven years to negotiate) allows tariff free trade in goods and provides for the removal of certain non-tariff barriers in relation to both goods and services. However, Canada’s trade deal with the EU excludes most financial services. Under this model, the UK would retain control over tariff arrangements with other (non-EU) countries.

This is a fairly flexible option, however, is likely to take a long time to negotiate. While access to the single market and influence over single market rules would be restricted, the UK would obtain greater power to make its own rules.


The WTO option:

With this structure, the UK would be completely removed from the EU customs union and single market.  Trade in goods would be governed by the General Agreement on Tariffs and Trade (GATT) and trade in services by the General Agreement on Trade in Services (GATS). UK exports to the EU would be subject to the EU’s common external tariff.


While the UK would not be bound by single market rules, there would still be a need to comply for UK exports to comply with the EU’s product standards. While under this model the UK would remove itself completely from EU rules and regulations, and, would not be required to make any financial contribution to the EU budget, most economists agree that this is the most economically harmful route.


While all models vary in their degree of economic integration with the EU, whatever arrangement the UK adopts it is unlikely that it will be able to secure access to the single market while simultaneously removing itself from the scope of the free movement of people requirement. There is a clear positive correlation between the level of access to the single market and the extent to which EU law is required to be complied with, in particular, the four freedoms and financial contributions to the EU budget. While the acceptance of such EU rules is anathema to the result of the EU referendum, there has been much commentary that casts doubt over prospects of an agreement that will protect full access to the single market for the UK while at the same time will ensure complete regulatory and legislative freedom from the EU. Essentially, it is unlikely that the EU will allow a departing member to retain the benefits of EU membership free from compromise, as EU diplomats have indicated.


The ‘passporting’ dilemma

As Dublin is overwhelmed with passport applications from those seeking dual nationality, long term questions regarding the EU’s ‘passport’ rules at a corporate level have divided City of London advisers.

These rules have been instrumental in crowning London as the financial capital of Europe and have made the City an attractive home to global financial institutions. ‘Passporting’ has allowed banks, asset managers and other types of financial institutions which are established in one Member State to provide financial services to customers in the other 27 states without having the need to establish local branches in each state. It is through these rules that British subsidiaries of non-EU financial institutions are able to do business throughout Europe. Unless these passporting rules feature in a post-Brexit Britain, the European ventures of the world’s largest banks will be compromised. London’s mayor Sadiq Khan, has determined that such an outcome would be disastrous, especially given the HM Treasury backed estimates value passporting privileges at £10 billion. A post-Brexit loss of passporting rights may be likely as France’s central bank governor, Francois Villeroy de Galhu, has warned that if the UK were to leave the single market, they would lose their passporting rights along with it. Eurogroup President, Jeroen Dijsselbloem has expressed similar sentiments in that restricted access to the single market would be the ‘price’ of leaving the EU.

If the UK refrains from joining the EEA, the inclusion of passporting in a UK-EU agreement is possible if the EU considers that UK standards satisfy the ‘equivalence’ requirement (in that they maintain the same regulatory strength as their own regulations to avoid unfair competition).


Alternatively, it would be possible to retain such passporting privileges if the UK were to join the EEA and adopt a Norwegian model. However, this has its drawbacks. Given the UK’s desire to remove itself as much as possible from EU oversight and concerns over immigration, which played a key role in the Brexit campaign, it may have to trade off passporting powers in order to gain independence in regulation and legislation and enhanced control over domestic issues. A compromise which carries both legislative independence and passporting may be difficult to achieve, for the same reasons that full access to the single market is unlikely to be possible without adherence to EU law. Potential motivations of France and Germany to promote their own financial hubs as alternative headquarter locations may further reduce the chances of the UK obtaining an agreement that would be favourable to them in safeguarding the interests of London banks.

Both the Swiss model and the Canadian model in excluding financial services would not provide viable alternative arrangements. If the UK were to adopt the WTO model, such a scenario would be likely to leave big barriers on financial services.


Licencing issues

To complicate matters, simply establishing a holding company with a number of employees would not be sufficient to obtain a financial passport. Banks would have to obtain a banking licence to operate in whatever setting they land in, which would involve actually carrying out business in that Member State. Generally, a new entity will require local management, a significant number of staff and capital to meet the demands of the EU’s bank recovery rules. Even banks which already have licences are not guaranteed the continuation of their passporting privileges, especially if their businesses are banking specific. Furthermore, applications for banking licences are time-consuming, and currently lengthy time-frames are at risk of extending given the current climate.


EU legislation providing a potential solution

In an attempt to find an alternative solution to these issues faced by London-based banks, some have turned to Articles 46 and 47 of the incoming Markets in Financial Instruments Regulation (MiFIR), which set out parts of the MiFIR third country regime. Through these provisions, many of the rights accorded to EU ‘passport’ holders under the current regime can be extended to non-EU countries and their financial services group. Among other matters, MiFIR attempts to remove barrier to entry to trading venues. By modifying and extending this regime, the Markets in Financial Instruments Directive (MiFID II) will establish a harmonised EEA regime for granting access to EEA markets for firms from non-EEA states. It will require EEA Member States to permit firms that are established in approved non-EEA states to provide MiFID II services in an EEA Member State (a ‘passport’ arrangement). They will be entitled to do this either by establishing a branch in an EEA Member State (relevant when dealing with a retail client or a retail client opting up to professional client) or on a cross-border basis (relevant when dealing with professional clients or eligible counterparties). MiFID II does not come into force until January 2018, and given that it is likely to take two years for the UK to be removed from the EU, the transition from EEA to non-EEA may not disrupt passporting arrangements.

While these developments provide some source of comfort to international banks’ passporting concerns, there are a number of caveats. Such cross-border provision of services may only be permissible in a case of regulatory reciprocity between the relevant states. Furthermore, the scope of MiFIR provisions may be limited and there is doubt over whether or not the UK could take advantage of these provisions in reality.

 Overall, passporting is in no way guaranteed with a new UK. With an arrangement that does not provide for third country access, the need for an EU subsidiary that could provide banking services to the remainder of Europe under the passport system would become vital. Similarly, for EU firms that wish to provide banking services into the UK, it would be necessary to consider establishing a UK subsidiary.


A mass exodus?

 While it is unlikely that Brexit will mark a complete demise in London’s role as a gateway to Europe, it is plausible that banks will redistribute the weight of their European operations to other financial centres (such as Dublin, Luxembourg, Frankfurt and Paris) in order to maintain passporting rights and secure banking licences. There are many banks that already have established operations in other EU financial centres and can afford the time to move gradually until an exit has been formally initiated. Conversely, those banks lacking a full EU licence may need to act quickly, especially given the lengthy process involved. For now, international banks are largely silent on their contingency planning, though there has been some activity regarding the relocation of staff and operations outside the UK.

With the financial markets in turmoil and political chaos in the UK, much remains uncertain. The outcome of discussions at the Brussels summit, where the four main political groups of the EU called on Cameron to formally notify the European Council of the referendum outcome and initiate the UK’s departure, there will be more of an indication of what is to come.


Philip Lee