The “Third Country Equivalence” Delusion

Attention conservation notice: Somewhat technical, but ‘splaining a few points which currently appear to be sustaining a delusion that there is a back door into the Single Market for financial services in London after Brexit.

MIFID 3rd Country Equivalence — what it can and can’t do
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This is a brief note to explain why some people think that the EU’s “passport” for financial services is not as important as it used to be, and that the “third country equivalence” regime that is being introduced in the coming Second Markets in Financial Instruments Directive (MiFID2) might be a suitable replacement which would allow firms in a post-Brexit London to continue operating across Europe without barriers. I will try to keep it short and light-hearted but there is no getting round the fact that this is about European financial regulation. So here’s a very short and oversimplified summary:

• The various bits of European legislation do provide a path for some kinds of firms to continue operating from London.
• But it is nowhere near as useful as the “passport” even for the firms it covers, and nowhere near all City firms could use it.
• And people who think that getting the UK certified as “equivalent” will be easy or instant are probably too optimistic.

The detail

Time to plunge into the detail. Maybe a question and answer format will help leaven things.

1. What is the “passport”?

It’s the Single Market concept, applied to financial services. Under the passport regime, any firm which is registered and regulated[1] in one EEA[2] country can offer all of its services across the EU as of right — it only has to inform the local regulator in the Member State where it wants to set up.

[1] Including EEA subsidiaries of non-EEA countries of course. So, for example, the Austrian company VTB Bank AG can passport into any European market because it is regulated and incorporated in Austria; the fact that its parent is a Russian bank doesn’t matter. But not branches! The rule tends to be that subsidiaries are regulated by the host (and so can get the passport), but branches are mainly regulated by the home country (and can’t).

[2] What about Switzerland? No, no, let’s not get into that now, that is definitely a different explainer.

2. What is “third country equivalence”?

BROADLY SPEAKING (so get off my back, regulation nerds) there are some areas of financial business where a financial institution from a non-EEA[3] country can set up a branch in the EEA and offer services across the Area. This is great news for the bank in question — because its European presence is a branch, it doesn’t need separate capital or separate regulation.

You can see right away that this is not a privilege that Europe is going to extend to everybody — there are lots of hurdles that have to be got through. In particular, since the European authorities aren’t going to be supervising this thing (because it’s a branch), they need to be 100% confident that the people who are supervising it are going to do so responsibly. Hence, the concept of “third country equivalence”.

[3] Seriously, I am not going to get distracted by a discussion of Switzerland.

3. What kinds of business have third country equivalence regimes?

At present, not very many. Payments firms and central counterparties, mainly — things where it’s obvious why there would be a benefit to the EU in making it as easy as possible for foreign service providers to do business here. There is a sort of third-country equivalence regime for insurance, but it is pretty limited in coverage and doesn’t really hold out a viable option for big UK insurers or for the Lloyd’s market. The reason why everyone’s excited about the concept is that MiFID2 (which has not been fully implemented[4] yet, I’ll get back to this) is going to extend the concept to a fairly large set of investment management and investment banking business lines.

[4] Regulation nerds I said get off my back! Yes, I mean that the delegated acts haven’t been adopted, yes I know that implementation is a different thing, yes, half of these things are in MiFIR rather than MiFID. I’m writing for a mass audience as you very well know.

4. What kinds of business don’t have any current proposals for third country equivalence regimes?

Quite a few, and some of them are important. Things like … banking. And insurance [5]. And selling hedge funds and mutual funds[6]. Also, even under MiFID2, third party equivalence is only available for firms which deal only with “per se professional clients” and with market counterparties. If you want to deal with retail, or with high-net-worth individuals or local authorities, then to do so across Europe would require a subsidiary and the full passport after all.

[5] Banking in the sense of deposit taking. Insurance does have a third country equivalence regime under Solvency II, but it’s entirely about the calculation of solvency, supervision and the recognition of reinsurance — it doesn’t allow permission of third country regulated entities to sell into the EU at all.

[6] Hedge funds are covered by their own directive, the Alternative Investment Fund Management Directive. So are most mutual funds (the Undertakings for Collective Investment in Transferable Securities Directive). Asset management companies are actually in a sort of half-way position — they could probably have the fund management bit delegated to London under something which looks quite like third-party equivalence[7], but the selling-to-customers bit couldn’t.

[7] Regulation nerds — yes I know. But it does, really.

5. How else could London-based firms access the European market post-Brexit under MiFID2?

By setting up a branch in every single EEA country they wanted to do business in (as long as the host countries allowed this for the kind of business they wanted to do), or by setting up an EEA subsidiary. The first of these is pretty expensive once you get past two or three countries, while the second is not without its problems either. Europe is not really hospitable to brass-plate subsidiaries — if you are taking advantage of the passport, then the entity with the EEA authorisation is going to have to be a proper thing for the EEA supervisor to regulate, with all of its essential management functions located in the same country as the EEA supervisor. After a while, anyone looking at this sort of structure is quite likely to start asking questions like “why don’t we make the EEA subsidiary the main entity, and make the London office a branch of that”?

6. But in principle, there are quite a few investment banks and asset managers who could take advantage of MiFID2 third-party equivalence?

In principle, yes … as long as the UK gets it?

7. Cough! Splutter! What do you mean? Mexico has third country equivalence!! Mexico!

Well… not really, not in the sense that you’re trying to use here. Mexico has third country equivalent status for central counterparties. It has equivalent status for certain purposes related to the calculation of regulatory capital for European banks and insurance companies, but this doesn’t give Mexican banks or insurers equivalent access to the European market. And its derivatives exchange is recognised as being a “proper” derivatives exchange for the purposes of European regulations requiring some derivatives to be traded on exchanges. But show up in Europe as a Mexican-regulated bank and try to start doing business, and you’ll quickly be apprised of the situation. Nowhere, of course, has the MiFID2 equivalent status that people are talking about, because the relevant parts of the Directive haven’t entered into force yet.

8. Cough! Splutter! But the UK’s regulatory regime is *exactly*the*same* as the EU! How can it possibly not be deemed equivalent!! We’re a global financial centre I’ll have you know!

It’s more complicated than that. The decision to give third country recognition is ongoing and forward-looking. It depends on a lot of factors, including governance, resources and regulatory culture; it’s not just assessed by going through the local statute book and deciding that the rules written down are sufficiently similar to the European ones. The UK is a strong and well-regulated financial centre, but the decision needs to be audited and justified and that will take time. It’s also subject to “comitology”, so as well as the European Commission, a qualified majority of EU27 Member State governments would have to agree to it. Naturally, having a bunch of half-informed political commentators trying to suggest that a liberated post-Brexit Britain could become a deregulated financial powerhouse when freed from Brussels red tape, and could use this as a loophole, is that sort of thing that really does feed into this decision.

It’s also important to understand that the level of scrutiny of the third-country equivalence decision is going to be proportionate to the risk, and the UK is a very big financial centre[8]. Europe (and everywhere else that runs a similar third-country regime) is very aware of the “circle of trust” issue — analogously with 1980s AIDS awareness campaigns, if you allow open access to one party, you’re also allowing access to anyone they choose to allow access to. When you’re making a decision about Hong Kong or the Cayman Islands, you can be pretty sure that the impact of third country equivalence is going to be limited, but if you’re thinking about the UK, then as a European supervisor you are going to be aware that you’re potentially taking a decision to allow a large fraction of the EEA’s financial business to pass out of your direct control. That’s not a decision anyone’s going to take lightly, or quickly.

[8] This is very visible in the case of the USA, where the equivalence decisions have taken a long time and required a lot more work than those for Mexico, Bermuda, South Africa etc. Not because the USA has bad regulations, but because it’s very big.

9. Are you seriously trying to tell me that the UK wouldn’t get third country equivalence?

Nah, not really. It would be a negotiating screw-up of cosmic proportions for us not to get it. But a) it will take time, and b) it will be subject to us agreeing to a lot of things to build trust and to ensure the Europeans that there wouldn’t be “post authorisation drift”. And any time the EU passed a new Directive, we would be scrambling to incorporate it into our own regulations in order to maintain our equivalence; exactly the sort of “government by fax” that causes so many problems for Norway. The decision to grant third country equivalence is always under constant review (it can be pulled with 30 days’ notice), and this lack of certainty probably also weighs on companies’ minds, particularly when there is the alternative of moving the business to an EU-regulated subsidiary. With the best will in the world and even with great certainty about the transition period, this doesn’t look like the sort of thing you can build a business on.

10. But shopping! And nightclubs!

Hmmm. Try telling an investment banking management team that you’re turning down a new assignment because it’s not convenient for Bouji’s and see how your career develops. More seriously, there seems to be a real level of arrogance among British financial professionals in believing that the only way that business could move overseas would be if they themselves decided to move. We shouldn’t be thinking about the Citigroups or JP Morgans here — although they are likely, at the margin, to take corporate decisions which preserve their regulatory flexibility too. We ought to be thinking about the dozens and dozens of Asian and East European banks which put their main European subsidiary down in London and which operate through the rest of the EU under passported branches. Going forward, it’s a much easier structure for them to have London as the branch, and somewhere in Europe as the European headquarters. And that has consequences for hiring, activity and the tax base.