Moving apart – the financial sectors in UK and EU post-Brexit

Brexit has created significant challenges for policymakers in the European Union (EU), particularly in the financial sector, as the UK is now outside its regulatory framework. The EU-UK Trade and Cooperation Agreement includes a very thin financial sector chapter and thus a limited basis for regulatory cooperation. This policy brief discusses recent trends in financial sector regulation in the UK, divergence between the EU and the UK, and the threats posed by this divergence for financial stability in the EU, based on a report for the ECON Committee of the European Parliament. In the medium to long term, the UK is expected to diverge actively from the EU regulatory framework, with a focus on flexibility, common law principles-based approach, competitiveness, growth, and innovation. Such divergence could deepen regulatory fragmentation and undermine financial stability. The brief also elaborates on ways to deepen regulatory cooperation.

Brexit poses unique challenges for financial sector policymakers in the European Union (EU) as the most important financial centre in Europe is now outside its regulatory framework (Beck and others, 2022). At the same time, the United Kingdom (UK) regards its financial sector as a potential growth engine and has been embarking on regulatory reforms to further strengthen the status of the UK as a global financial centre (Edinburgh Reforms, 2022 and TIGRR Report, 2021). In a recent report for the European Parliament, we summarise and discuss recent trends in financial sector legislation and regulation in the UK, divergence between the EU and the UK and threats from this divergence for financial stability in the EU (Petit and Beck, 2023). Critically, we assess the equivalence policy and strategy of the EU towards the UK and options to deepen regulatory cooperation while ensuring financial stability, market integrity and competitiveness.

The UK’s approach to regulation will lead to the transfer of most rules from statutory level to the regulators’ rulebook, reinforcing the UK tradition of common law and principles-based approach to regulation. Greater responsibility for regulators is one important objective of the recently introduced Financial Services and Markets Bill that intends to amend, repeal or replace specific retained EU law that impacts financial services and insurance activities. This bespoke regulatory overhaul is led in parallel to the Retained EU Law (Revocation & Reform) Bill, a politically controversial bill, which might also raise implementation challenges considering the breadth of the thousands of acts to amend, repeal or replace. In addition, secondary objectives would be added for regulators to ‘facilitate, subject to aligning with relevant international standards, the international competitiveness of the UK economy (including in particular the financial services sector) and its growth in the medium to long term’ (Hunt, 2022). The secondary objectives of growth and international competitiveness would then differentiate the UK regulators’ mandate from its EU counterparts that have a mandate for financial stability, market integrity and investor protection, while protecting the level playing field in the EU Single Market.

Divergence of UK regulation from EU regulation is almost a given outcome following Brexit. Active divergence would occur when the UK ‘deliberately legislates to move away from retained EU Law’ (Reland, Ritter and Menon, 2022 and see Table 1). Passive divergence would reflect a status of the UK not keeping up with EU legislative changes.

There are several areas where the UK has already taken initiatives that could result in regulatory divergence from the EU:

While there has been thus limited divergence so far, we can expect substantial divergence across different segments of the financial sector during the next five to ten years.

The degree of divergence can have important repercussions for future cooperation and access of UK-based financial sector providers to the EU Single Market and vice versa. We discuss three possible scenarios of divergence.

While an extensive Trade and Cooperation Agreement (TCA) was agreed in December 2020 between the UK and the EU, it includes a very thin financial sector chapter, with eight out of 783 articles directly covering this sector. Deeper cooperation in the financial sector has so far been held back by the stand-off over the Northern Ireland Protocol. The resolution of this conflict through the Windsor Framework might allow for closer cooperation between the UK and the EU in several policy sectors, but there are a number of impediments. While a Memorandum of Understanding that allows for regulatory cooperation on Financial Services, including the establishment of a Joint UK-EU Regulatory Forum (UK Government, March 2021), is now likely to finally go ahead, the European Commission has made it clear that it sees any action that allows access to the EU’s financial market by third country providers as a unilateral decision, not subject to negotiation, as we will discuss in the following.

Since the end of the transition period on 31 December 2020, the UK is a third country and therefore subject to the existing provisions in EU financial services and banking regulation that may provide for equivalence with third country regimes. Such equivalence may give access to the EU market and foster cross-border activities as the EU recognises a partial or full equivalence of a third country’s regulatory and supervisory framework (see Table 2). The European Commission bases its equivalence decisions on the principle of proportionality and a risk-based assessment (European Commission, 2017), but there is some degree of unilateralism and discretion, including political factors.

In the case of granting equivalence to the UK, there is a trade-off: on the one hand, granting equivalence and thus allowing provision of financial services by UK based firms in the EU Single Market can have positive repercussions for efficiency and competition, safeguarding the level playing field. On the other hand, insofar as the control of risks rely on third country’s regulators, there are clear stability concerns, including concerns on data exchange, supervisory cooperation and cooperation during crisis situations, and for the EU’s strategic autonomy. In practice, one equivalence expired for Central Securities Depositories (CSDs) and one equivalence has been extended for UK-based Central Clearing Counterparties (CCPs) until June 2025, which is a very thin recognition of equivalence between the EU and the UK in the field of financial services. A similar equivalence has been granted to other third countries (see Table 3). The extension of CCPs equivalence worldwide demonstrates the EU effort to redirect clearing beyond the UK while the EU works on building its own infrastructures.

One specific challenge for European authorities is the treatment of CCPs in London. On the one hand, there is the intention to build more clearing capacity with infrastructures within the EU, in particular with the legislative proposals from the European Commission to develop further the EU Capital Markets Union in December 2022 (European Commission, 2022).3 On the other hand, there are financial stability concerns on having a large part of transactions be cleared outside the EU. Supervisory cooperation is therefore critical, but equivalence decisions are not exclusively driven by technical criteria but also by (legal/political) risks stemming from a scenario where such an equivalence would be withdrawn. All in all, equivalence decisions are contingent, limited in scope and require reciprocity. The 2022 legislative proposals from the European Commission show a tightening of equivalence regime in the financial sector.

The resolution of the conflict around the Northern Ireland Protocol with the Windsor Framework gives momentum for effective closer cooperation between regulatory authorities in the UK and the EU. However, it is clear that such cooperation will face limits and that divergence between financial sector regulation in the UK and the EU will happen through reforms on both sides. Regulatory cooperation, however, can limit any negative repercussions from such divergence, ultimately safeguarding the stability of the interconnected financial systems.