29.Such is the size, complexity and interconnectedness of the UK financial services sector that many of our witnesses described it as an ‘ecosystem’. In the words of Douglas Flint, Group Chairman, HSBC:
“The principal priorities of our regulators and public policymakers [since 2009] have been to eliminate risk through consolidation, central counterparties and more transparent arrangements. That has led to an ever greater concentration of financial activity into the major centres of the world. What takes place in the ecosystem, the cluster that operates in London as one of the world’s greatest financial ecosystems … means that our biggest concern is to understand whether financial stability in the ecosystem can be preserved if you start playing with the range of activities that can be conducted from a single location.”
30.Andrew Gray, Global Financial Services Brexit Leader, PwC, explained that “It is not just about banking in isolation or asset management in isolation. You need to look at financial services holistically”. He added that “any forms of fragmentation of the existing way in which financial services are structured will have implications. You need to be clear about what those implications are before decisions are made”. Alex Wilmot-Sitwell, EMEA President, Bank of America Merrill Lynch, put it more graphically:
“It is not a Lego set in which little pieces can be built up and put somewhere else. The interconnectedness is very significant and … we need to be assured that whatever happens from this point forward, the consequences and implications of any steps are understood.”
31.Simon Gleeson, Partner, Clifford Chance, imagined a banker explaining his services to a corporate client:
“I sell the entirety of the product range of the bank, everything from payment systems to lending to foreign exchange hedging, you name it. I cannot tell you what my position would be if I lost the right to offer one of those products but not the others.”
32.The ecosystem effect provides the background against which any assessment of the impact of Brexit has to be made, and makes that assessment particularly complicated. Katherine Braddick, Director of Financial Services, HM Treasury, told us that ecosystem effects, or the network effects of having a concentration of financial services in the UK, had “defied quantitative analysis for a very long time. The industry can explain how it works, but we find it difficult to translate that into what the impact scenarios would look like. That is more difficult, and I do not think it is a nut we can crack analytically for these purposes and in this timescale.”
33.This complexity works both ways: analysing the impact on the City is hard, but replicating such an interconnected system may be harder. Simon Gleeson thought that it was not possible to create a rival financial centre to London “precisely because of that ecosystem”:
“An asset manager employs half a dozen portfolio managers; there are 200 skilled people ranging from accountants to consultants to lawyers. The fact that you have a big pool of those to draw on means that that is where you put the business. So the fundamental position that, almost whatever happens, London will remain the financial centre of the continent of Europe precisely because of the depth of that pool is correct. Therefore, it is also correct that that should be an important factor for the European Union in discussing future arrangements.”
34.Other witnesses spoke of London’s advantages as a financial hub. Miles Celic, Chief Executive, TheCityUK, said: “It is very difficult to identify another individual smaller financial centre in Europe that has anything like the sort of advantages that London has. Indeed, in some sectors of the financial and related professional services industry, London has an even stronger advantage than somewhere like, say, New York”. He gave the FinTech industry as an example: London had the creative, regulatory, legislative, funding and technology centres in one place. He described the ecosystem effect as a “virtuous circle that has kept feeding itself. It has led to greater competition, greater innovation and reduced costs. The risk of fragmentation is that you reduce that.”
35.Sir Jon Cunliffe also thought that London’s role was unlikely to be replicated elsewhere in Europe in the foreseeable future. He noted, however, that a similar system already existed in New York, which benefited from similar “economies of scale, scope, information-sharing and ancillary services”, and he thought that some business currently conducted in London could go there.
36.The Minister, Simon Kirby MP, described the possibility of an important element of the financial services industry moving to New York as “a very bad place for all of us, not only in the UK but for everyone in Europe”. The European and global impact of a fundamental relocation of activity was also expressed by Douglas Flint:
“If the benefits that come from consolidation allowing people to bring all the risk into one place and get the compression effects of risk management and offsets were fragmented, we would risk an element of financial stability as it adjusts, we would make the system more expensive and we probably do not know where the system ends up if it gets fragmented. Does it get split over a number of centres or does it find some other place in the world that can offer the consolidated benefits that come from the system that exists today in the UK?”
37.The UK has a number of advantages as a financial services hub. The concentration of activity allows for economies of scale and a depth of capital market activity that cannot be easily replicated, except possibly in an existing major centre such as New York. Our evidence suggested that it would be to the EU’s advantage that such a system should remain intact.
38.The interconnectedness of the UK financial system presents serious difficulties for firms and the Government in determining the impact of changes to the relationship between the EU and the UK. Unless it is extended, the two-year period of the Article 50 negotiations would appear to be insufficient to resolve the uncertainty. We therefore recommend, both for the business environment and for financial stability, a considered and orderly transition to any new relationship. The earlier any aspects of this new relationship can be agreed the easier it will be to determine the impact on each sector of the industry.
39.Unless a deal is struck granting firms market access along the lines of the current passporting system the UK may find itself seeking third-country equivalence under provisions in EU legislation (see above, paragraphs 15–16). Equivalence allows for third-country firms to operate in EEA Member States on similar terms to those granted by the financial passport, as long as the third country’s regulation and supervision arrangements have been found to be equivalent to the EU’s. This type of access is, though, available to a smaller number of activities than those able to use the passport, and entails a potentially laborious equivalence process, which is vulnerable to political influence.
40.Some of the major activities covered by third-country equivalence provisions are:
41.Other major areas of activity are not covered by equivalence provisions. Simon Gleeson told us that the most important omissions were the provision of banking services such as lending and deposit-taking, under the Capital Requirements Directive (CRD IV), and retail asset management, under UCITS. Professor Eilís Ferran, Professor of Company and Securities Law, University of Cambridge, echoed this caution, particularly with regard to payment services:
“We should be careful about assuming that there will be equivalence solutions across the board. There are not. There are key areas that are not covered by equivalence. For example, the area of payment systems is one that is critically important and not covered. If we look at MiFID and MiFIR, yes, it is true that wholesale services will be covered under the new regime, but retail will not, and indeed that will depend on a member state by state permission to provide retail services.”
42.Professor Ferran also referred to complications in the position of the asset management industry. UK-based fund managers would not be able to market UCITS funds, and would instead rely on the equivalence provisions under the AIFMD. She described those provisions as “one of the most complicated and unsatisfactory sets of EU post-crisis law”—compliance with that regime would be “a heavy price”.
43.Professor Ferran was more optimistic about the longer term, suggesting that “there will be opportunities to do things differently while remaining equivalent and while remaining within the bounds of international financial regulation. We can more easily be super-equivalent, for example, and we can be a first mover in solving new problems that come along.”
44.Katherine Braddick said that it was difficult to assess the value of equivalence, as the regimes were new and many of them had not yet been used. She noted that the Government was analysing the difference between the current passporting arrangements and equivalence, both in terms of what equivalence made it legally possible to do and what was commercially viable.
45.Anthony Browne described equivalence provisions as “relatively untried and untested … uncertain and limited in scope”; they could be “removed at relatively short notice”, and were “subject to change in the future, if there are changes to regulation either side of the Channel”. Elizabeth Corley made a related point: “In financial services one needs a dynamic and agile means of regulation and supervision … anything that assumes a static status quo will not work in practice”.
46.As well as highlighting the narrow scope and potential unreliability of the equivalence regimes, many of our witnesses raised concerns about the process of demonstrating equivalence. On 2 October 2016 the Prime Minister announced plans for a ‘Great Repeal Bill’, to be introduced in 2017. The Bill would ensure that all existing EU law that is currently given effect in the UK through UK domestic law would still apply after Brexit, with the result that UK regulation and supervision would presumably be, at least initially, equivalent to that in the EU. That equivalence will, however, have to be signed off at the EU level. Katherine Braddick noted that the “process for deciding equivalence differs from one piece of legislation to the next”, and highlighted the complexities of equivalence decisions under MiFID II:
“That is a Commission decision. The parameters for that decision are not terribly clear; they are quite open. The way the Commission can make the decision is open to interpretation. There are no time limits for how long the Commission has to take to make a decision. Then there is a further process where, if it wants to give equivalence, it has to go through a committee of member states, and then the European Securities and Markets Authority has to [register] each individual firm from that jurisdiction. They do not approve them but they have to register them. That registration can be withdrawn and the equivalence can be withdrawn.”
47.Professor Ferran, while noting that a recent equivalence decision in relation to US clearing houses had been slow, was confident that such decisions could be taken “pretty efficiently, provided that politics does not get in the way”. She thought mutual interest and a common commitment to open markets would ensure that politics did not intrude. She also pointed to a history of regulatory cooperation between the UK and the EU, and to the technical role of the European Supervisory Authorities in providing a “buffer zone” and a “shield against political interference”.
48.Professor Ferran’s passing reference to the possibility of politics getting in the way was developed by other witnesses. George Hay, European Financial Editor, Breakingviews, Reuters, agreed that, in technical terms, there was no reason why Europe should not grant equivalence, but pointed to forthcoming elections in France and Germany as a possible “check on being too generous to the UK”.
49.Miles Celic also thought it could be “a political as much as a technical decision”. Simon Gleeson, referring to the US clearing houses decision, said it had been “fairly notorious that the regulatory experts took less than six months to conclude that they broadly were [equivalent], and there was then two and a half years of discussion before the recognition was actually made”. He thought that the latter discussion “happened almost entirely at a political rather than a technical level”.
50.Stefan Hoffman, Head of European Affairs, Swiss Bankers’ Association, suggested that the UK and Switzerland could be allies in pressing for the EU to establish “an EU equivalence regime or process that is streamlined and more structured, in the sense that in the end you would get a right to be granted EU equivalence when you met certain conditions”. In contrast, there was currently no right to be judged equivalent: “You really depend on the mercy, so to speak, of the Commission”.
51.Sir Jon Cunliffe acknowledged that equivalence decisions could “conceivably” be politicised, but noted that the issue went wider than equivalence between the UK and EU. The EU’s equivalence regimes were relatively new, but responded to a lesson of the financial crisis: “If we want globalised financial services, we all have to have confidence in each other’s regulatory and supervisory machinery”. He pointed to the importance of international standards and noted that, while the EU and the US treated the issue of prudential capital for banks differently, both regimes were equivalent, in that they were implementing a Basel international standard. Equivalence regimes were easier to establish when they were based on such international standards. Although Sir Jon did not make this point, we also note that, to the extent that the UK already benefits from equivalence regimes between the EU and the US, such as that for CCPs, new agreements between the UK and US will be needed following Brexit.
52.Though he accepted that the UK would lose influence in setting the EU regulatory regime post-Brexit, Sir Jon believed that the UK was and would remain influential at the international level. The UK had “much of the machinery and investment in international standard-setting”. As for the EU, he said that “to the extent that we are able to show that we have analysis, good evidence-based approaches to dealing with financial service regulation and practical ideas, I think we will continue to have an influence”.
53.Officials from HM Treasury endorsed Sir Jon’s approach. Katherine Braddick referred to the UK’s “massive intellectual capital through the regulation and supervision of some of the most complex markets in the world”, which had “given us a lot of influence in international fora”. Lowri Khan, Director of Financial Stability, pointed to the UK’s level of engagement in the Basel Committee and the Financial Stability Board.
54.Huw Evans, though, questioned the ability of the UK to use international standards to manage equivalence from outside the EU. He said that there was a “much less well-developed international architecture for insurance than there is for banking”, and pointed to significant differences in the attitudes of the US and EU to regulating insurance.
55.The existing third-country equivalence regimes in certain pieces of EU legislation are an inadequate substitute for the financial passport. They do not cover the full range of financial services activities, excluding in particular deposit-taking and lending, retail asset management and payment services. As they are agreed at a point in time, and are static, they may also be vulnerable should regulation change to respond to the development of the financial system. The process of updating them as EU-wide regulation changes would be laborious and time-consuming.
56.We endorse the Government’s work in analysing the difference between the opportunities afforded by passporting and third-country equivalence. That analysis will be problematic, thanks to the complexity and newness of the regimes, but it will be crucial in determining the true impact of third-country status on the financial services industry. The priority should be to establish at an early stage the extent of the lacunae in the regimes, the likely restructuring that will have to be undertaken by businesses to adapt to changed circumstances, and the consequent effects of such adaptations on the financial services sector and the wider UK economy.
57.If the Great Repeal Bill successfully ensures that the UK continues to apply EU legislation post Brexit the UK will, on a technical level, have a regulatory regime that is initially identical to that in the EU. However, it will remain for the European Commission to decide whether the UK is equivalent for the purposes of retaining market access. This process could be lengthy and could be politicised: the Government should seek agreement prior to withdrawal that the UK will be determined to be equivalent at the point of withdrawal, to avoid damaging disruption to financial services providers.
58.While the UK might be deemed equivalent at the point of withdrawal, there is no guarantee that it will remain so. Regulation must adapt to changes in the financial services system, raising the risk of regulatory divergence between the UK and the EU, and indeed between the UK and the US. The UK’s influence on international standard-setting bodies, such as the Basel Committee and the Financial Stability Board, will be crucial to ensuring that changes to regulation are consistent internationally. But it is in the UK’s and EU’s mutual interest that the UK should maintain direct influence within the EU, especially in areas such as certain types of insurance, where there are less well-developed international standards. The Government should encourage direct regulatory cooperation between UK and EU authorities and, as part of its negotiation, should seek UK input to EU regulation-setting upstream.
59.When a trade takes place in financial instruments, such as equities, derivatives or bonds, a central counterparty (CCP) or clearing house sits between the buyer and seller. It acts as the buyer to every seller and the seller to every buyer: if either party defaults the CCP owns the risk and becomes accountable for the defaulter’s liabilities. As part of the process the CCP collects collateral, or ‘margin’, from buyers and sellers. This process aids financial stability and introduces efficiencies to the market, as buyers and sellers can make transfers to the clearing house rather than to each entity with which they trade.
60.Following the financial crisis of 2007–08 the role of CCPs became more prominent, and G20 leaders introduced a requirement for certain over the counter (OTC) derivatives to be centrally cleared. At EU level this requirement is contained in the 2012 European Market Infrastructure Regulation (EMIR).
61.The UK is a major centre of OTC derivatives activity and central clearing, accounting for around half of global activity in interest rate derivatives, and over a third of global activity in foreign exchange derivatives contracts. The UK’s share of such activity is illustrated in Charts 1 and 2.
63.The UK’s dominance in this area has drawn the attention of European politicians and the European Central Bank (ECB). In 2011 the ECB launched its Eurosystem Oversight Policy Framework, or ‘location policy’, under which it would have refused to provide liquidity support to any CCPs dealing above a certain threshold of euro-denominated transactions that were not legally incorporated and run from the eurozone. The UK challenged this policy at the Court of Justice of the European Union, and in 2015 the General Court annulled the requirement for CCPs to be located in the eurozone, on the ground that the ECB’s competence was limited to regulating “payment systems” alone, by virtue of Article 127(2) TFEU and Article 22 of the ECB Statute, and that this competence did not extend to the activity of securities clearing systems.
64.Following the referendum on 23 June the issue was re-opened. For example, President François Hollande of France said on 28 June that that the City should be prevented from clearing euros, describing such a step as “an example for those who seek the end of Europe … It can serve as a lesson.”
65.Professor Ferran noted that the UK had previously been able to use its position as a Member State to resist the ECB’s location policy, but thought the ECB would return to the issue following Brexit. Sir Charles Bean went further: “I will not say that it is likely that we will lose it: I will say that it is certain that we will lose it.”
66.Sir Jon Cunliffe accepted that the political weight attached to euro clearing might determine the outcome. While he would not speculate on the politics, he helpfully outlined some of the technical considerations. The benefit of the post-crisis move towards central clearing was that the margin provided against changes in the value of derivatives contracts was provided centrally and transparently, so regulators could look at the models that generated the amount of margin required. Concentration of central clearing allowed firms to net their risk: “A firm that has some contracts with a plus direction and some with a minus direction with different counterparties can put them into central clearing and only has to take the margin cost of the net rather than the gross positions. That is a huge reduction in the margin that they would otherwise have to post.”
67.Sir Jon noted that because clearing was a multi-currency infrastructure firms could net in different currencies: “you can take the pluses on your dollar-denominated interest rate stocks and the minuses on your yen-denominated ones. It all goes in and it comes together.” This reduced costs, a benefit that would be lost if the system were fragmented. If one followed the argument that clearing had to take place in the jurisdiction of the relevant currency the multi-currency system would break down. Central clearing was thus an important contributor to financial stability.
68.Xavier Rolet, Chief Executive of the London Stock Exchange Group, which owns the LCH.Clearnet clearing house, provided figures for this netting effect. In 2015 LCH’s SwapClear engine “cleared the equivalent in US dollars across 17 currencies of $555 trillion of interest rate swaps. Through its compression service, which is done across all these currencies, it compressed $328 trillion, which enabled LCH to eliminate $110 trillion net of risk … that saved our customers the equivalent of $25 billion of regulatory capital.” Mr Rolet pointed to a study by Clarus Financial Technology Group, which had shown that the disaggregation of the euro component of LCH’s clearing engine would cost the financial services industry $77 billion of additional margin. This would affect banks’ balance sheets and their ability to lend to the real economy.
69.Mr Rolet noted that other countries were keen for that business to migrate, but argued that clearing was “systemically relevant, and the migration of such businesses, while technically possible, also entails a number of non-financial risks, particularly operational ones, of a systemic nature that must be taken into consideration by all policy stakeholders”.
70.Mr Rolet also thought that the compression benefits available in London were a key attraction for his clients. Clearing in euros could not be efficiently separated from other currencies, and if these benefits were lost then the “whole engine has to move”—he described New York as an attractive alternative location. At the same time, Mr Rolet acknowledged that any attempt to repatriate euro clearing to the eurozone would prevent it taking place in New York as much as in London: he believed that such a move “would not be consistent with the existing agreement around equivalency in mutual recognition”.
71.The Minister suggested that the whole of Europe, including the UK, would be worse off if clearing were to be dismantled and redistributed across Europe. A move to New York would also be “a very bad place for all of us”. He said that euro clearing would be an element in the negotiations, but continued: “Is it the most important element? Probably not, but it is a significant consideration … as things develop and when we are in a stronger place and have listened, and understood exactly what we are seeking, it will become more apparent how important that particular element is.”
72.In the General Court’s judgment on the ECB’s location policy it suggested that the ECB could revive its policy were its Statute to be amended to give it competence to regulate euro-denominated clearing:
“It must be pointed out that Article 129(3) TFEU provides for a simplified amendment mechanism—derogating from the mechanism in Article 48 TEU [Treaty revision]—in respect of certain provisions of the Statute, including Article 22. It enables the European Parliament and the Council, acting in accordance with the ordinary legislative procedure, and on a recommendation from the ECB or a proposal from the Commission, to amend those provisions.”
73.It thus appears that the legislative changes necessary to bring about repatriation of euro clearing could take place without recourse to treaty change. The UK, as a non-EU Member State post-Brexit, would not be able to challenge its lawfulness before the General Court. Other EU Member States could, of course, and it is notable that Sweden supported the UK challenge in 2015. A further consideration, however, is that, in order for UK-based CCPs to clear trades involving an EU firm, the UK would have to be found to be equivalent under EMIR and the relevant CCPs recognised by ESMA. The US has already been judged equivalent, in a process that took several years.
74.The current clearing regime provides benefits to the wider economy by aiding financial stability through the compression of risk and therefore of the collateral required to support trades. These benefits, which depend in large part on the ability to conduct multi-currency clearing, are felt in Europe as well as the UK and internationally. The possibility of a new attempt to require euro clearing to be conducted within the eurozone thus presents significant risk to both the UK and EU economies. Nonetheless, the ECB has attempted to do so once before and the risk of its doing so again should not be taken lightly, particularly in view of the jobs at risk.
75.New York has been suggested as a plausible alternative to London for clearing activity, but a move to ‘repatriate’ euro-denominated clearing to the eurozone would appear to rule out New York as well as London, notwithstanding the positive equivalence decision already granted to the US. The question is whether any eurozone location could provide the same benefits to the wider economy as London and New York, and whether a politically-driven attempt to repatriate euro clearing to the eurozone would invite retaliation by other non-eurozone states, leading to the breakdown of the system of multi-currency clearing.
36 On 24 October 2016 Katherine Braddick was appointed Director General, Financial Services at HM Treasury.
37 . It should be noted, however, that Oliver Wyman has attempted to calculate the impact of ‘low access’ and ‘high access’ scenarios, taking into account the ecosystem effect. Its estimate of the first order effects of a low access scenario is the loss of £18–20 billion in revenues and 31,000–35,000 jobs. When the ecosystem effect is taken into account it estimates that £32–38 billion of revenues and 65–70,000 jobs are ‘at risk’. Its estimate of the ‘high access’ impact is a loss of around £2 billion. Oliver Wyman,
43 Over-the-counter (OTC) derivatives are securities traded in a context other than on a formal exchange, such as through a dealer network.
51 Though our witnesses were generally discussing the equivalence regime as it currently exists, the various legislative provisions granting third country access could themselves be altered to the UK’s detriment. A recent Financial Times article suggests that the European Commission is considering making the process more rigorous. ‘EU reconsiders financial market access rules’, Financial Times (6 November 2016): [accessed 14 November 2016]
61 . The UK is represented on the Financial Stability Board by HM Treasury, the Bank of England and the Financial Conduct Authority. The Bank represents the UK on the Basel Committee on Banking Supervision (BCBS) while the FCA represents the UK on the International Organization of Securities Commissions (IOSCO).
62 . Though it should be noted that a forum analagous to the BCBS and IOSCO exists for insurance: the International Association of Insurance Supervisors (IAIS). The three organisations meet jointly as the Joint Forum and are represented on the Financial Stability Board.
63 See footnote 43.
64 Bank of England, ‘Over-the-counter (OTC) derivatives, central clearing and financial stability’, p 286 [accessed 29 November 2016]
65 Bank of England, ‘Over-the-counter (OTC) derivatives, central clearing and financial stability’, p 286 [accessed 29 November 2016]
66 Bank for International Settlements, Triennial Central Bank Survey—Global foreign exchange market turnover in 2013, (February 2014), table 6.2: [accessed 29 November 2016]
67 Bank for International Settlements, Triennial Bank Survey—Interest rate derivatives market turnover in 2013 (December 2013), table 3.2: [accessed 29 November 2016]
68 ‘Francois Hollande rules out City’s euro clearing role’, Financial Times (28 June 2016): [accessed 29 November 2016]
73 . SwapClear describes its compression services as allowing “members and clients to combine or offset trades with compatible economic characteristics, resulting in a reduction in notional outstanding. This simplifies portfolio management by allowing members and clients to reduce the number of individual positions in the portfolio, while maintaining the same risk profile. As a result, fewer reconciliations are needed, delivering more efficient portfolio transfers and, in some cases, lower capital requirements for financial institutions under Basel III.” See: SwapClear, ‘Compression Offerings’ [accessed 29 November 2016]
74 Clarus Financial Technology, ‘Moving Euro Clearing out of the UK: The $77bn problem?’ (28 September 2016): [accessed 29 November 2016]
77 . New York is London’s nearest competitor in the GFCI rankings. See Appendix 4.
80 United Kingdom of Great Britain and Northern Ireland v European Central Bank (ECB), Judgment of the General Court (Fourth Chamber, 4 March 2015) , para 108