Passporting is top of the list of many UK financial firms’ concerns post-Brexit.
“Will we keep our passporting rights as part of any negotiated deal relating to single market access when the UK leaves the EU?”
What does this mean? Why is it such a problem if UK firms lose their rights to “passport” into Europe? What are the alternatives and why are they so unpalatable?
And what is a realistic scenario given the different “trade models” that are possible examples for the UK post-Brexit (Norway, Switzerland and others)?
This blog tries to shed some light on passporting and why these questions matter.
We also look briefly at different trade models and apply a new metric – the Prism-Clarity “Single Market Access Compatibility” (SMAC) score. This is a judgment-based measure of the extent to which passporting – or something like it – might be possible under different trade models.
What Is Passporting?
We’ll start with the authoritative definition. This link is the Bank of England Prudential Regulation Authority (PRA) page on passporting.
In short, an authorised firm in an European Economic Area (EEA) state can carry on permitted activities in any other EEA state. Either by exercising the right to establish a branch or agent (such as a representative office), or by providing cross-border services. The Financial Services and Markets Act describes this as an “EEA right”. The exercise of this right is described as passporting.
The important word in this definition is “right”.
We can think of this right as one of the benefits of EU – or, more strictly, EEA – membership. [In the rest of this blog we don’t distinguish between the EU and EEA for these purposes, except where it matters, such as the section on Norway below.]
As an EEA member you have to abide by rules and in turn you have rights. Including the right of access to all EU local markets, under the same rules as any local firm in those markets. In the jargon, a “level playing field”. As an EEA member your right to establish a new branch – or provide cross-border services – in another EEA state is quasi-automatic. It doesn’t require any additional approval by a regulator in your target market, with the extra time, cost and bureaucracy that involves. Simply an official notification to your “home” regulator, i.e. the one from your home country.
Is Passporting The Only Way In?
No. This is sometimes misunderstood. Passporting isn’t the only way of gaining market access to other EU states. It’s just the most efficient way.
A firm from outside the EU – from a so-called “third country” such as the US, Australia or China – has no right to passport in to the EU automatically. But it can still submit an application to a European regulator to open a branch or agency in a particular European country. It just takes longer to approve, and involves more local hoops for the applicant to go through: additional requirements on reporting, liquidity, local management structure, or whatever, according to the rules and whims of the local regulator.
This takes time, and is costly and bureaucratic. But from the regulator’s point of view it’s fair enough. He has to be confident that the firm making the branch application into his country is safe, sound and well run. And that, if it runs into trouble, it won’t cause contagious damage to the local market under the regulator’s nose. So he’s well within his rights to set appropriate hoops, so long as they’re fair and not discriminatory.
For an EU firm making a similar application, its safety and soundness are taken as read. Because it automatically submits to the EU rules on things like governance, capital and liquidity, the things that determine the firm’s safety and soundness. So our regulator can safely assume the EU firm who wants to set up in his country already fulfils these standards, by virtue of its EU membership. Its right to passport is quasi-automatic.
Losing The Passport
What would happen if you lost the right to passport – say due to Brexit?
Well, it doesn’t mean losing the opportunity to set up a branch in Europe for ever and ever, under any circumstances. It means losing the right to do so automatically. Any firm that loses the right to passport can still take its chances with an individual application to the local regulator and make a success of it. But it has to accept the extra time, cost and bureaucracy involved in that process. In much the same way as our firm from the US, Australia or China – or any other non-EU “third country” – has to do now if it wants to establish a branch directly in the EU from its home nation.
We should introduce a couple of important concepts at this point.
Branches, Subsidiaries and Subsidiarization
So far we have talked mainly about branches and “agents” (which for banks means mainly representative offices). These are common ways that a firm from a third country – the US, Australia or China, in our earlier example – can establish a business presence in the EU. But they’re not the only ways. It’s also possible to do this as a subsidiary.
A foreign bank branch is not a separate legal entity but is legally just an extension of the parent bank incorporated in its home country. As such, its liabilities are liabilities of the parent bank. Local regulators do not have full oversight or jurisdiction over it. And it does not have to fulfil all the governance, regulatory, reporting and company law requirements of a separately incorporated company (or indeed a subsidiary, as explained below).
It still has to fulfil some local requirements, and submit to local regulation in areas which are relevant to the local marketplace – for example conduct and liquidity – but the regulators have less direct control or oversight over its assets and liabilities.
A subsidiary, on the other hand, is a separate legal entity. To all intents and purposes it is organised in the same way as any other local company, and subject to the same jurisdiction as any other firm that incorporates in the local market. Including things like company law and regulation, management structure, governance, prudential requirements (capital and liquidity), audit, public disclosure requirements, etc. In effect a subsidiary is like a microcosm of a larger indigenous company, submitting to local requirements in the way any other locally-incorporated firm does.
This is all very well. But a subsidiary structure may not be efficient from the point of view of the firm’s foreign parent, which inevitably has all these arrangements and mechanisms in place back home already. It does not really want to be duplicating those arrangements in other centres all over the world. Not to mention, the parent of the firm doesn’t want to be “trapping” capital and liquidity in an overseas subsidiary which it can then no longer deploy company-wide.
On the other hand the subsidiary structure is desirable from the local regulator’s point of view. Because – by virtue of local incorporation – the regulator has full oversight and regulatory authority over the local firm, its assets and liabilities. He can be confident that the firm has enough resources to operate soundly, and that it’s resolvable in the event of a serious crisis, with limited risk of dangerous contagion effects, or risk to local taxpayers.
Since the Lehmans collapse regulators in some countries have been trying to ensure that foreign firms looking to establish new operations in their country do so as subsidiaries – rather than as branches. We call this trend “subsidiarization”.
This is an ugly word but an accurate one. It basically means preferring subsidiaries to branches.
With passporting the regulator doesn’t have discretion to express that preference. If passporting rights are lost, he does have such discretion. He can insist on subsidiarization, with all the risks of inefficient allocation of capital and liquidity – and the other significant management costs – that running a subsidiary entails.
This is one of the reasons that the loss of passporting is perceived as a “bad”: it might reinforce the trend towards subsidiarization, which we have seen taking root in some countries since Lehmans, and as part of the movement to ring-fence retail bank activities in the UK and Europe.
In short, passporting is not the only mechanism available for branching into Europe. You can establish a branch directly, like third country firms already have to. Nor is branching the only game in town anyway. You can establish a subsidiary instead. But while these other mechanisms are available, they come at a higher cost.
What Is It?
Let’s assume for a minute we are running a bank in a third country (the US, Australia or China, as in the earlier example) and that we’ve found a local EU regulator who is prepared to grant a third country branch licence, rather than requiring our new business to be a subsidiary.
Why would he do this? Why should he be confident our third country has a good enough regulatory regime and framework that the bank wanting to branch into his country is safe and sound?
The answer is found in the concept of “equivalence”.
The global regulatory community has come up with agreements whereby if country A’s regulatory regime is deemed sufficiently “equivalent” to country B’s – in terms of ensuring safety and soundness of the banking system back in country A – then country B will look favourably on (or, at least, actively consider) an application to branch into country B. This is not binding but it is helpful.
And it could be important in the post-Brexit environment, for UK firms wanting to establish business in the EU. How important depends on which “trade model” we end up negotiating with Europe (Norway model, Switzerland model, etc) which we cover later.
Rights and Responsibilities
Let’s go back to the basic idea. As EU members we have rights and responsibilities. The rights include single market access – including via passporting, as set out in this blog. The responsibilities include adhering to European rules on free movement of workers, regulatory directives, etc.
Post Brexit, it’s safe to assume that UK firms are unlikely to be granted their current automatic rights of access – e.g. passporting.
But to the extent the UK can demonstrate it is at least “equivalent” to the EU on the responsibilities side of the equation, the UK may be able to persuade its European partners to maintain some of its current rights. This might not be automatic like passporting. It might take a different form, such as a bilateral trade agreement. But in the best case it might be substantively unchanged.
On the other hand some of the things on the responsibilities side of the equation are what triggered the Leave vote in the first place. And the UK government negotiators may see those things as “bright lines”, not to concede at all. For instance on the free movement of people, and elements of the EU financial regulatory framework that are controversial on this side of the channel, such as the bonus cap.
The UK financial regulators have already said that, in general, there won’t be a “bonfire” of EU regulations. This is for good reasons. There are actually some good rules in the EU financial regulation panoply – rules which, if they didn’t already exist in EU law, we might have invented for ourselves anyway. Among other things, these help the UK to fulfil the expectations of the Financial Standards Board, the G20, the Basel Committee and other supranational standard-setters.
So there is a fair chance the UK will end up keeping many of the EU financial regulations we currently adhere to, even after Brexit, because they help us to align to globally-expected standards.
Could Equivalence Help?
If we are “equivalent” to the EU it might help the UK’s negotiating position, or at least help UK firms at a practical level when they are looking to establishing an EU presence. Since we can use it to demonstrate to our European partners that – as a matter of choice rather than responsibility – we are continuing to abide by most or many of their rules. [Though perhaps not the more controversial areas noted earlier.]
There’s even an argument that in financial regulation the UK is often “super-equivalent” to its EU obligations. This is jargon, but what it means is that in the UK we have gone beyond the needs and expectations of the EU ruleset, and for our own reasons set standards that are even higher than the EU standards.
So equivalence and super-equivalence could help offset some of the “bright lines” we won’t be able to cross in the negotiation. But, in truth, they will only help up to a point. They may mitigate the loss of our passporting rights, but only mitigate.
In the end if we want to maintain anything like current levels of market access for our European operations, whether via branches or subsidiaries, we are going to depend on the goodwill of local European country regulators and – ironically still – the EU itself. In the end if we don’t give way on “bright lines” such as free movement of workers we will likely reduce the effect of mitigating arguments such as equivalence.
The Different Trade Models
Let’s finish with a brief examination of the different “trade model” scenarios that the Brexit negotiation is likely to end up considering.
In shorthand we call these the Norway, Switzerland, Canada, Singapore and UAE models. Though the final outcome is likely to be a hybrid – or evolution – of more than one of these models.
We also introduce our new Prism-Clarity SMAC score – SMAC standing for “Single Market Access Compatibility” – a judgmental measure of the potential for a passporting style arrangement under each of the different trade models.
Norway is an EEA member and maintains open tariff-free access to the EU market for goods, services and capital. Yet Norway is not part of the political structures of the EU, is not subject to the Common Agricultural Policy, has control over its own fisheries, has no prospect of ever being required to join the Euro, and is free to agree bilateral trade deals with other countries or trade blocs.
The quid pro quo for this arrangement is a large contribution to the EU budget and an acceptance of single market rules – including free movement of workers to and from the EU (subject to an emergency brake in times of serious economic, societal or environmental difficulties – which has never been applied). And of course no ability to affect those rules because Norway is not a member of any of the governing or representative bodies: Parliament, Commission or Council. It is membership without membership.
To help us assess this and the other “trade models” we now introduce a new Prism-Clarity metric, which we call the SMAC score. This measure is a summary judgment of the degree to which passporting – or some passporting-style arrangement – for financial services firms could potentially occur under different trade models.
From this narrow viewpoint, the Norway model does look quite similar to the current EU framework. So we give it a SMAC score of 4.5 out of 5. The only reason it is not a 5 is that Norway – as a non-member of the EU – is not at the table to determine policy changes around the passporting framework and its evolution over time.
Switzerland is a member of the European Free Trade Association (EFTA) but not the EEA like Norway. What this means is that its access to EU markets is governed by over 120 bilateral agreements covering some – but not all – areas of trade. And it pays a reduced contribution to the EU budget accordingly. Switzerland doesn’t have a general duty to apply EU laws but does have to implement some EU regulations to facilitate its trading.
It also signs up to the free movement of labour, though controversially declared a cap on this after a referendum two years ago. Although not yet implemented, this cap has resulted in some difficult negotiations with the EU leadership in recent years. Indeed some of the bilateral agreements are in some danger of unravelling over this issue, which looks like a red flag in terms of the suitability of the model for the UK post-Brexit.
More importantly for our purposes, the bilateral agreements in any case do not include full access to the single market for the Swiss banking sector and other parts of the services sector. In other words passporting for financial firms is not possible under the current Switzerland model. It would have to evolve some way to allow for this.
This means we give the Switzerland model quite a low SMAC score – 1.5 out of 5 – and the only reason it is as high as 1.5 is that at least a strong bilateral negotiation framework already exists – and it could potentially be leveraged to include financial services and thereby passporting.
Some commentators cite Canada as a good comparator for post-Brexit UK trade relations with the EU, on grounds that Canada is currently negotiating its own free trade deal with the EU, the Comprehensive Economic and Trade Agreement (CETA). This agreement would give Canada preferential access to the EU single market without the obligations that Norway and Switzerland face, eliminating most trade tariffs except on sensitive food items.
Unfortunately this agreement only partially includes services. In any case is not yet in force, having been seven years in the making so far. Based on the current agreement a CETA type deal would not give UK financial services firms the EU market access – including passporting rights – they have now.
For all these reasons we give the Canada model a similarly low SMAC score to Switzerland – 2 out of 5. It would likely take a huge and heroic effort to extend the CETA template to include financial services and passporting. Against this, the fact that CETA is still being negotiated – compared to the Switzerland model which is already in place, though unravelling – may give it more potential to evolve in a positive direction than the Switzerland model, with its numerous existing bilateral agreements.
Singapore is an interesting comparator for the UK post-Brexit: a successful, open country with a strong financial services sector, a hub for international companies, and a global network of trading relationships including free trade agreements with the USA, the EU, China, Japan and India. Paradoxically, closer regional integration with other ASEAN countries has been at the core of Singapore’s economic strategy for many years; in contrast to the UK, which of course seeks looser integration post-Brexit. The common perception of a dynamic go-it-alone free trading nation is a bit misleading: regional engagement is a critical complement to Singapore’s bilateral relationships.
In spite of this, looking at the EU-Singapore Free Trade Agreement (EUSFTA) – which is formally still being ratified – gives us some clues as to how the Singapore model could pan out if we adopt it as the template for the UK post-Brexit. It represents partial integration of trade in goods and services, with no obligation to accept free movement of people, no financial contribution, and conversely no ability to influence (or interest in influencing) EU laws or regulations. EUSFTA will phase out tariffs and duties on trade in goods, though quotas will apply to some products; and will provide some (but not unlimited) access to the market in services.
On these grounds we give the Singapore model a slightly higher score for potential Single Market Access Compatibility (SMAC) than the Canada or Switzerland models: 2.5 out of 5. At least the concept of trade in financial services exists already in the agreement, to an extent. It would need a lot of beefing up, to eventually resemble full integrated market access. But this model could be quite seductive on political grounds in the UK. So we give it a higher (more realistic) SMAC rating than Canada or Switzerland.
United Arab Emirates
Finally we look at the idea of a free financial sector (or free zone) within an existing state, as set out by law firm Shearman & Sterling in this link.
We cite the UAE here because it already has several free zones, including two for financial services: the Abu Dhabi Global Market (“ADGM”), a broad-based international financial centre for local, regional and international institutions; and the Dubai International Finance Centre (“DIFC”), which encourages businesses and financial institutions to tap into Middle East, Africa and South Asia markets.
Following the UAE model the London International Financial Centre (“LIFC”) would be a new financial free zone in London, demarcated for financial institutions on a more free-market basis than the rest of the UK. It would have its own laws and regulations, but tailored for a high-growth, dynamic market. The new free zone would not seek equivalence with the EU but would be a standalone deregulated regime in the EU time zone, with its own territory (outside the City and Canary Wharf) and separate regulators.
How does passporting fit into this free trade model? Well the short answer is it doesn’t, as such. Passporting as described in this blog involves a high degree of regulation to ensure mutually acceptable standards of safety and soundness and a high degree of integration. The LIFC idea is almost the polar opposite of this. Nevertheless there is a presumption that “main UK” would have an equivalence or passporting relationship with the EU, thus giving firms in London two possible organisational models to pursue, free zone or EU-equivalent.
We include the free zone model here, to encourage lateral thinking about the bounds of what is possible. But we give it – or the LIFC variant of it – a SMAC score of just 1 out of 5.
Passporting is complex, and involves a lot of different technical and legal aspects. This blog is intended as no more than a cursory introduction to the issues associated with passporting, and some of the likely paths the Brexit negotiations may take in terms of allowing full market access.
In particular this blog does not constitute advice: anyone considering establishing a new financial services business in the UK must take formal legal or consultancy advice and should not rely on the content of this blog as being comprehensive or up-to-date.
Further reading is however available from the following sources:
- Bank of England Prudential Regulation Authority (PRA) page on passporting
- FCA Guide to Passporting
- Civitas blog on the impact of losing passporting rights post Brexit
- Moody’s assessment of impact of loss of passporting rights: Sept 2016
- FCA Letter to Parliamentary Treasury Committee on Passporting: Aug 2016
- UK Government guide to alternative possible models for the UK outside the EU: March 2016