The risk of the UK leaving the European Union without an agreement on terms is a nightmare scenario for financial markets, which are intensely regulated. When it comes to wholesale capital markets, the UK’s main role is as a service provider to EU-based clients.
Financial specialists have therefore been scrutinising the relevant parts of the batch of papers produced by the government on Thursday last week to give the private sector advice on how to act if the UK has to leave the union without a deal.
One of the government’s plans is to unilaterally allow non-UK financial firms in the rest of the European Economic Area (the EU plus Iceland, Liechtenstein and Norway) to "passport" into the UK for three years after Brexit, to give them time to set up regulated entities in the UK.
While this "temporary permissions regime" would not ensure that UK firms would enjoy passporting rights in the EEA, it would at least save UK customers from losing the services of other European firms. It might also induce the EU to reciprocate.
However, this is one more issue where the difficulty of Brexit is becoming clear.
Article II of the WTO’s General Agreement on Trade in Services (GATS) states that any member of the WTO “shall accord immediately and unconditionally to services and service suppliers of any other member treatment no less favourable than that it accords to like services and service suppliers of any other country”.
The clause, confusingly dubbed the "most favoured nation clause", in fact forbids any country from giving special favour to any other.
Countries can only give preferential status to other states as part of a formal trade arrangement that is reciprocal — like the EU and EEA.
In this case, the UK would be granting special favours to EEA banks that it was not offering to banks in other countries.
The government’s Brexit papers do not draw attention to this problem, but lawyers have commented on it and GlobalCapital has learned that the government is well aware of the issue.
The Treasury argues the plan can be allowed under an exemption in WTO rules for financial services, which allows countries to protect their markets. But specialists say this will be open to challenge.
“In the area of financial services WTO rules permit use of a prudential exception,” said a Treasury representative in an email to GlobalCapital. “The exception, which is in the GATS Annex on financial services, provides that WTO members may take measures for prudential reasons, including for the protection of investors, depositors, policyholders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system.”
The statement added that the UK's proposed temporary permissions regime (TPR) was one such measure. The Treasury argued it would minimise the disruption faced by EEA firms and UK businesses and consumers due to the loss of passporting rights arising from EU withdrawal.
“In practice it means that eligible EEA firms can continue their activities in the UK for a time-limited period after exit day, in order to allow them to obtain UK authorisation or transfer business to a UK entity as necessary,” said the Treasury statement. “Given the use of this prudential exception, the most favoured nation rule does not oblige the UK to provide the same measure to financial institutions of other WTO members.”
TPR could theoretically be challenged
Experts familiar with WTO rules believe there could be strong arguments to support this measure as a short term bridge to avoid a Brexit day cliff edge. But if the right lasted for three years, they say, other WTO member states could challenge this as preferential.
In article 2(a) of the financial services annex of GATS — where the prudential exemption relied on by the Treasury is set out — the rules say that although there is scope for a member state to use prudential measures to preserve financial stability, those measures “shall not be used as a means of avoiding a member state’s commitments or obligations under the agreement”.
Impartiality towards all third countries is a central tenet of the WTO and of GATS.
A note from law firm Berwin Leighton Paisner, published in 2017, argues that the UK cannot offer inward passporting rights just to EU firms, as that would contravene the WTO’s most favoured nation clause.
“It’s certainly my understanding that the UK cannot give preferential treatment for EEA financial services firms under WTO rules,” said Jason Hunter, a former international trade negotiator. “The problem is that the UK is in unknown territory as a country and nobody knows how it’s going to go. I truly don’t think we are going to find an answer which would allow a no-deal scenario to work.”
A source close to the Treasury confirmed that the UK was putting the TPR in place to avoid a “cliff edge” next March and that it was not meant to be a permanent measure. But the person admitted that since the UK had never been an independent member of the WTO (having always participated as a member of the EU), it was in uncharted territory.
“Most people’s views are that if you do it on a temporary basis, people will turn a blind eye, but you couldn’t make that permanent,” said a former WTO trade official. “Nobody knows what the case law is. Most people’s views are that a few weeks or a couple of months is not going to be challenged.”
But the ex-official thought “Three years might be tricky.”
He added: “This is new ground and I have heard that there are plenty of discussions going on in government about WTO law, and there is advice being given about WTO law and the reach of WTO law, and what the UK is going to do about it, and about WTO consistency.”
If another member state challenges the three year passporting period for EU firms, the dispute would be deliberated on by a panel with “necessary expertise relevant to the specific financial service under dispute”.
Potential defences
GlobalCapital understands that lawyers consulted on the issue have presented strong arguments for and against TPR and its theoretical acceptability under WTO rules.
Some argue that the UK is only bound by most favoured nation rules on various specific banking services.
Although non-preferential treatment is a general principle, it only applies in areas where a state has made commitments under the WTO. The EU, under its own WTO services schedule, has made commitments on certain aspects of financial services, but not all. When it joins the WTO in its own right, the UK would be likely to replicate these commitments.
According to the GATS schedule agreed to by the EU, the areas covered by WTO commitments are described as: "provision and transfer of financial information and financial data processing... and advisory and other auxiliary services, excluding intermediation, relating to banking and other financial services...."
Sam Lowe, a senior research fellow at the Centre for European Reform, a thinktank, said that because WTO commitments for services were narrower than for goods in this way, the UK government might be able to defend its TPR plan.
In his view, the UK could only be challenged for giving EEA banks preferential treatment on certain issues. These would include offering cross-border advisory and auxiliary services on a number of investment banking services as well as credit reference and analysis, investment and portfolio research and advice, advice on acquisitions and on corporate restructuring and strategy.
"It says for example you have to treat all countries equally on the provision and transfer of financial information," Lowe said, "which is essentially why you see companies moving their data processing capabilities and back offices into other countries.”
In Lowe's view, the UK would be free to discriminate on most retail banking activities.
Because the UK has said it intends to replicate the EU GATS schedule, all its provisions will need to be changed to apply just to the UK. The UK could therefore argue, if challenged, that the three year period allowed time for EEA companies to move and meet these provisions.
For example, across all EU member states, a specialised management company must be established to manage unit trusts and investment companies. And only firms with registered offices in the EEA can act as depositories of investment fund assets.
The EU’s schedule on financial services also requires that sterling securities issues be lead managed by a firm in the EEA. This would have to change to "the UK” in the new schedule.
The UK is already fairly open on market access compared with the rest of the EU and grants favourable access to foreign banks. It could also claim that EU firms were equivalent to those in the UK and could continue to passport into the country on that basis while seeking regulatory approval, while other third countries were not.
“Even if those areas did pose a slight problem then the Treasury’s arguments will likely hold," said Lowe. "In my experience anyone complaining would be reassured by the Treasury’s argument that there is a clear time limit on this and it is an emergency. I’m not sure whether they would take it any further. The WTO has a number of issues to deal with and while a firm in one of those countries might have a problem with this regime it is up to a country’s government to bring a dispute."
The UK could also act unilaterally to placate any party that was complaining, such as a US bank that was trying to establish a regulated subsidiary in the UK during the same period and wanted to enjoy similar passporting rights to what was on offer to EEA firms doing the same.
But it is clear from how tricky such a simple idea as the TPR could be that a no-deal Brexit poses many potentially thorny issues for financial services.
“None of this is easy at all and no-deal is a terrible idea,” said Lowe. “If I was the government I would be more concerned about making [TPR] work on a practical basis, in so far as how you actually do this. They need to determine what the criteria is going to be, how they make it fair and what conditions they apply to each of these banks."
Far from the only WTO difficulty
This is just one of many difficulties the UK’s capital markets are facing in contemplating a no-deal Brexit.
The immediate hurdle for the UK to overcome is getting its WTO schedule approved. This means applying to become a full member of the WTO, independent of the EU.
“The UK is facing objections to its WTO quota scheduling,” said Hunter. “There are up to 10 objections now to the UK’s schedule in the WTO. Say the EU allows 100,000 tonnes of Argentinian beef in each year. The UK has said it just wants to divide up that quota and take 1/28th of that quota.”
But such decisions have the potential to displease other countries. In the example above, it would cause a problem if Argentina was not actually in the habit of exporting any beef to the UK. “If the UK takes some of that quota, then that means they can sell less to the EU27 and the UK leaving would damage that trade to the rest of the EU,” Hunter said. “There are some situations which are the reverse of that.”