Of all the many issues to be considered by the sector post-referendum, the issue that will certainly be near the front of the queue for negotiation is the matter of "passporting" financial services within the EU.

UK financial institutions, including banks, insurers, investment managers and securities dealers currently rely on "passports" under Single Market Directives to offer their services across the EU. A list of these Directives gives an indication of the width of the industry which benefits from the passporting rights.

  • The Capital Requirements Directive (CRD) for banks, building societies and investment firms
  • The Solvency 2 Directive for insurers
  • The Markets in Financial Instruments Directive (MiFID 1 and, in January 2108, MiFID 2) for investment intermediaries providing services relating to transactions in shares, bonds, units in collective investment schemes and derivatives (together financial instruments) and the organised trading of those financial instruments.
  • The Insurance Mediation Directive for insurance intermediaries
  • The Undertakings for the collective investment in transferable securities (UCITS) Directive for UCITS managers
  • The Alternative Investment Fund Managers Directive for fund managers other than UCITS managers
  • The Mortgage Directive for retail property lenders and related services.

Under these Directives, an institution which has been authorised by the Prudential Regulation Authority or the Financial Conduct Authority in the UK, has the right to establish a branch or provide services in any other EEA Member State without the requirement for further authorisation or licence. By the same token, an entity authorised in another EEA Member State has the same type of access rights in the UK.

The UK will remain a member of the EU at least until the earlier of (a) two years following the UK's activation of the "Article 50 exit procedure" (subject to any unanimously agreed extension); or (b) the date agreed for a negotiated exit.

Assuming that the UK exits the EU, the answer to the question "what will happen" depends on the negotiated terms on which the UK leaves. Those terms will be critical for the UK financial services industry and, by implication, a fair chunk of UK GDP.

There are a number of models which could be followed.

The EEA model

The UK could follow the approach of Norway, Liechtenstein and Iceland and negotiate a deal whereby it becomes a European Free Trade Association State ("EFTA" State) within the European Economic Area ("EEA") and thereby retain access to the single market. It would also mean that the UK would continue to benefit from the passport to provide services into the EU.

However, this would also mean compliance with EU rules, compliance with EU free-movement requirements and a continuing obligation to contribute to EU finances, whilst having lost the seat at the EU rule-making table.

There are many who believe this route would be politically unacceptable given the rhetoric that fuelled the referendum campaign.

The Swiss model

An alternative would be to follow the Swiss approach and become an EFTA State whilst giving up EEA membership and accessing the European single market in part. This would mean potentially negotiating a large number of specific agreements with the EU.

It is worth mentioning, in this context, that Switzerland has negotiated largely unrestricted access to the EU market, at the price of accepting EU free-movement principles but has failed to obtain a passport under the EU financial services directives notwithstanding it has long been a European financial centre.

The UK as a "third-country"

A more fundamental break would involve the UK exiting the EU and the EEA entirely and seeking to negotiate completely new bilateral trade and access agreements and, possibly, gaining access to the single market to some degree by virtue of "equivalence" provisions. In recent years EU legislation has increasingly incorporated "third country regimes", which allow non-EU firms market access to the EU, usually on condition that they are authorised in a state which has a regulatory regime equivalent to that in the EU and which provides an effective reciprocal mechanism offering access to EU firms.

These mechanisms could provide an important basis for mitigating the impact of Brexit on continued cross-border business by UK and EU firms. The UK could ensure (at least at the outset following exit) that, at least from a legal perspective, its regulatory regime is equivalent to the regime in the EU by maintaining its existing regulatory regime and implementing new EU laws. Conversely, the UK could offer reciprocal access to EU firms.

However, the UK's perceived equivalence would likely depend upon how many EU rules the UK revokes and there is also an element of political risk for financial services firms, as other EU states may see a chance to boost their own financial services centres by not allowing UK-based entities to passport into the EU.

Furthermore, these regimes do not cover all services and activities. For example, they do not cover firms' rights to access market infrastructure, lending, deposit-taking, foreign exchange or other banking services falling outside the scope of MiFID 2 and the new Markets in Financial Instruments Regulation (MiFIR), nor to access payment services or retail investment services (including private wealth business).

Similarly, future EU legislation may also extend the scope of the regulatory regime in ways that do not include corresponding protection for third countries. Additionally, the Treaty and other protections under EU law against discrimination on the basis of location or currency would no longer apply to the UK.

CRD and MiFID2/MiFIR: third country cross-border banking and investment business

As discussed, a key concern of many UK banks and investment firms is that the exit of the UK from the EU would mean that they would no longer benefit from the CRD or MiFID passport. This is equally true of non-EU institutions (particularly the American banks), which have made London and other parts of the UK their European base. This has led to consideration being given to relocating activities into the EU and so undermining the benefits of being able to operate their business from a single hub in the UK. EU firms might have similar concerns as regards their cross-border business with clients and counterparties in the UK.

Neither CRD nor MiFID satisfactorily address the conditions on which non-EU firms may provide cross-border banking or investment services to clients or counterparties in the EU. Member States are free to define how their licensing regimes apply to non-EU firms providing cross-border services or establishing branches in their territory. However, a Member State must not treat branches of non-EU banks and investment firms more favourably than they treat branches of banks and investment firms from other Member States and, even where a Member State does authorise a non-EU bank or investment firm to establish a local branch, that branch does not benefit from the passport to provide services in other Member States.

In practice this has led to a patchwork of differing approaches across the EU to cross-border business by non-EU firms in the areas regulated by MiFID and the CRD.

All Member States are required to impose licensing requirements on investment services and activities regulated by MiFID (but are free to decide on the extent that those requirements apply to ancillary services, such as custody, foreign exchange or margin lending). However, they take very different approaches to cross-border business by non-EU firms.

The CRD only requires Member States to impose licensing requirements on firms taking deposits or other repayable funds from the public. However, a significant number of Member States go beyond the minimum requirements of MiFID and the CRD to impose licensing requirements on a number of other wholesale banking services, e.g., lending, credit and guarantee business, financial leasing, payment services, custody services and foreign exchange business. Non-EU banks and other firms seeking to conduct cross-border business of this kind with clients and counterparties in the EU encounter a patchwork of different approaches to the licensing of cross-border business similar to that described above in relation to MiFID. In particular, a number of countries, such as Austria, France, Germany and Italy, have restrictive rules which can make it difficult for non-EU banks to make loans to borrowers in those countries.

Therefore, if the UK were to leave the EU, UK banks and investment firms would cease to have the benefit of a passport under MiFID or the CRD and would need to determine the extent to which they could continue their business with clients and counterparties in the EU taking into account this patchwork of regulatory restrictions. This would be a much more restrictive environment than they face today.

However, the implementation of MiFID2/MiFIR (expected in early 2018) will introduce a new arrangement which could allow non-EU firms from an equivalent jurisdiction a "third country entity passport" to provide cross-border investment services to wholesale clients and counterparties across the EU. If this arrangement is activated, it could significantly mitigate the impact of the exit of the UK from the EU on cross-border investment banking and asset management business between the UK and the EU.

MiFIR will allow a non-EU firm to provide cross-border investment services covered by MiFID2 (including ancillary services) to eligible counterparties and "per se" professional clients, without having to establish a branch in the EU, provided that the firm is registered by the European Securities and Markets Authority.

It is clear that the banking and financial services industry must make its case loud and clear in the forthcoming negotiations and that any functioning settlement will require creative minds. At the present time, it is widely felt that the final position may not mirror exactly any of the models discussed above, and may well be bespoke to the UK.

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