21 May 2020

Yesterday, the UK Government published its draft legal text (here) for a proposed Free Trade Agreement with the EU. Borrowing heavily from previous EU agreements with Canada, Japan, and South Korea, the draft legal text published yesterday by the UK Government marks yet another significant milestone in the UK's withdrawal from the EU. However, it is unlikely to ease concerns about whether a deal can be reached before the end of the Brexit transition period in a little over six months.  

What amounts to a limited deal on financial services, the draft text is the first major illustration we have seen on the trade-offs occurring inside Number 10. Rather than attempting to push for full, unrestricted access for financial services, the draft text strikes to balance procedural concerns with the EU's equivalence process against EU demands on level-playing field commitments. By aiming low for financial services while the EU has gone maximalist for fishing, the UK has also created some negotiating headroom should a 'finance for fish' deal be done. As Andrew Bailey noted recently, "if it is possible to envisage a partnership agreement on fishing based on the convergence of regimes, of course it is possible to have open financial markets and mutual recognition of regulatory regimes, just as the TTIP proposal envisaged".  However, concerns will remain about how future access between the UK and EU markets will be guaranteed, and how equivalence processes could evolve as political instruments. 

In this note, we summarise the key elements of the draft text, its implications for the investment management industry, and the European response. As always, previous notes from the European Affairs team can be found here


David Frost begins by issuing an explanatory letter to Michel Barnier 

In a letter issued alongside the draft text to the EU's chief negotiator Michel Barnier yesterday, the UK's lead negotiator David Frost turned up the heat in already tense negotiations, accusing the EU of treating the UK as 'an unworthy partner' by insisting it agrees to a sub-standard agreement unlike those already offered to Canada and Japan. In particular, Mr Frost argued that the UK would never accept the EU's request on state aid rules, noting to do so would be 'inconsistent with the basic democratic principles' behind Brexit.  

Noting the EU's proposals for a trade deal represented 'novel and unbalanced commitments designed to lock the UK into the EU's regulatory orbit', Mr Frost categorically dismissed the EU's position that the UK's geographic proximity demanded tighter level-playing field obligations, with Michael Gove in Parliament going as far as saying the EU was refusing the accept the UK would' once again be fully sovereign', and that 'the time had come for the EU to drop its ideological stance' if it wanted a deal by December. 


But why issue a draft text now? 

Critically, unlike the EU which has sought to publish all documents as soon as possible during the Brexit process, the UK - appearing to have learnt from its mistakes in the first phase of Brexit negotiations under Prime Minister May - during this second phase has preferred to play its cards close to its chest, choosing to work through issues on a case-by-case basis with EU negotiators much to their frustration. Indeed, over recent weeks the EU has ramped up its efforts to point out that no such document had been made available to either the EU negotiating team lead by Michel Barnier or with the EU Member States, with Michel Barnier only yesterday morning suggesting this alone was the reason why neither side was unable to make significant progress in last week's third and penultimate round of negotiations.  

Some commentators suggest the publication yesterday of the draft text was a response to these criticisms with the UK keen not to be seen as negotiating in bad faith. But it is important to remember that issuing a draft text now is not just about the politics of Brexit or a negotiating tactic – it is a necessity. In just a month's time, in a joint UK/EU Committee will need to decide whether sufficient progress has been made in negotiations since the UK officially left the EU on 31 January. Critically, both sides will need to agree to either push ahead despite their obvious differences, noting October is now being touted as the final deadline for a negotiated agreement to then be passed to regional and national Governments for ratification and adoption, extend the transition period and continue to work towards a deal but with less time pressure, or walk away completely and begin planning for a no-deal scenario at the end of the year.  


Is this just CETA by another name? 

In essence, yes. As the UK Government has previously signalled, it wishes to agree to a 'Canada-style' Free Trade Agreement with the EU. It is therefore not surprising to see the inclusion of a financial services chapter based heavily on the text contained within CETA, and that of the GATS annexe on trade in financial services. In particular, the draft text confirms that like CETA the UK will be relying on the GATS' four modes' of providing services between two jurisdictions as the core of any relationship on financial services with the EU, namely: 

  • Facilitating the provision of cross border services between the UK and the EU (Article 17.1 (a) and (b); 
  • Permitting the sale of products and services between the UK and the EU (Article 17.1 (b) and (c); 
  • The right to establish a physical presence in each other's jurisdictions; and 
  • The right for individuals to visit the territory of the other in pursuit of financial services business (Article 11.6 (3). 

The draft text appears, in principle, to allow each side to access each other's markets under the first two modes of supply, as long as there is no physical presence, without the need for a local licence. In the context of investment management, this would mean a client based in an EU Member State would still be able to contract with a UK-based firm on a similar basis to that already provided for under reverse solicitation. Equally, it would allow EU-based firms to access the UK market through the Overseas Person Exemption, subject to usual conditions. Critically, the draft text also identifies portfolio management, and management of collective investment schemes and pension funds, as services which could be provided on a cross-border basis. 

However, the draft text does not extend to granting market access akin to what firms currently enjoy under the EU's Single Market Passport as many had hoped. Market access instead would depend on how each side defined 'doing business' or 'solicitation' as set out in Article 17.3. For the UK, these provisions contained within the draft text on financial services are essentially a restatement of existing WTO standards, with access instead dependent on what third-country arrangements were available under EU law – that is, a positive equivalence determination being made for the UK by the EU, and third-country provisions being included within relevant EU regulation. It does not foresee any expansion in the scope of those regimes, such as on banking. 

For investment management, assuming that equivalence determinations are granted in the UK's favour, this would mean that UK firms would be able to market or solicit business from EU institutional clients under the MiFID/R third-country arrangements, and if it was made available following the Commission's review of AIFMD expected early next year – market AIF's under an AIFMD third-country passport. It would also extend to the use of trading venues, clearing houses, and settlement facilities – again assuming the existence of a positive equivalence determination for the UK. Any other regulated activity not covered by third-country arrangements would need to be carried out through an EU-based entity and subject to supervision by an EU national competent authority. For UCITS funds seeking to market into the UK, this would be subject to the new Overseas Funds Regime, as announced by HM Treasury in early March. 

There are innovations in the UK's draft FTA that are neither in CETA nor the EU draft.  For example, for financial services, there is a section on the performance of back-office functions (17.16).  This reads that while a Party may require financial service suppliers to ensure compliance with any domestic requirements applicable to those functions, they recognise the importance of avoiding the imposition of arbitrary requirements on the performance of those functions; for example requiring a financial service supplier in its territory to retain certain functions.  For investment management, this approach could extend to protection on delegation rights.


Has the UK dropped its 'enhanced equivalence model? 

No – the UK is still pursuing a number of treaty-level procedural guarantees in this draft text, including the establishment of a new Financial Services Committee, maintaining the close regulatory and supervisory cooperation between authorities, limits on the use of the prudential carve-out, and commitments on dispute settlement, although these would not be binding as per the EU's objections to anything which would constrain its ability to act unilaterally to withdraw equivalence. We discuss these below. 

Financial Services Committee: 

Recognising calls from across the financial services industry, including the IA, the draft text proposes the establishment of a Joint Financial Services Committee (Article 17.18). The JFSC would contain a UK and an EU representative from the respective authorities responsible for financial services (likely HM Treasury and DG FISMA), and would be responsible for: 

  • Supervision of the Financial Services Chapter within the FTA; 
  • Assessing the functioning of the over-arching agreement as it applies to financial services 
  • Consideration of issues regarding financial services referred to it by either party; and 
  • Carry out functions as described in an undisclosed annexe 17-F. 

Given the proximity of the UK and EU markets and the interconnectedness between the UK and the EU in financial services, the IA has long argued for the need for such a Committee to be included in any UK-EU FTA. The Committee will meet once a quarter, but it is unclear, however, to what extent such a Committee would be able to issue binding recommendations, noting the EU insists any access for financial services must be subject to unilateral withdrawal. Instead, it is likely that this Committee will be used to discuss possible regulatory divergences or differences in interpretation of internationally agreed guidance. 

Regulatory cooperation: 

Mr Frost's letter says that 'in services, the EU is resisting the inclusion of provisions on regulatory cooperation for financial services, though it agreed to them in the EU-Japan EPA.' Noting the importance of ongoing regulatory cooperation between the UK and the EU, the draft text includes a commitment to maintaining such cooperation beyond the end of the transition period (Article 17.19). Critically, as recommended by the IA, the draft text includes a commitment to 'transparency and appropriate consultation' on the process of adoption, suspension, and withdrawal of equivalence decisions, but is silent on whether such access could be revoked unilaterally. The draft text also sets out the shared desire for 'close and structured cooperation on regulatory matters', alongside a commitment to information exchange on regulatory initiatives which should help ensure continued alignment in supervisory and regulatory practices between the UK and the EU at least in the short-term. 

Given the scope of its coverage, we understand that this article will make the MOUs signed between the UK and European authorities in January 2019 permitting the delegation of portfolio management between the UK and EU all but redundant, thus achieving the aim of having an FTA, to provide the industry and savers with greater certainty. However, we understand that the MOUs would continue to apply in all circumstances, including a no-deal scenario at the end of the Brexit transition period, although these may need to be updated to account for the new provisions set out in this article. 

Prudential carve-out: 

As we expected and is common in other trade agreements including a financial services chapter, the draft text includes provision for a prudential carve-out. It makes clear (Article 17.13) that either side will not be prevented from limiting access to one another's markets, or the ability to provide select services on a cross-border basis, on prudential grounds including: 

  • The protection of investors, depositors, policyholders, or persons to whom a financial service supplier owes a fiduciary duty: 
  • The maintenance of the safety, soundness, integrity, or financial responsibility of a financial service supplier; or 
  • Ensuring the integrity and stability of each other's financial systems. 

As we have indicated previously, the IA welcomes the commitment to limit the application of the prudential carve-out, but there is clearly still room for manoeuvre on the basis of the 'integrity and stability' which may cause concern for firms. Clearly, it will be essential that an appropriate process is developed to support the operation of the prudential carve-out and prevent it from being used for political purposes, although the draft text makes clear that the prudential carve-out cannot be used to void any other obligations contained with the draft text. 

Most-favoured-nation clause: 

Like CETA, the draft text also includes a most-favoured-nation clause, although the UK, like the EU, has reserved the right to publish this at a later date. Assuming it would be similar in content to the provision contained in CETA, it would mean that the UK or the EU could not treat each other less favourably than any other third-country, but this is only an obligation to treat each other in a certain manner rather than provide a specific outcome.

Dispute settlement: 

Long a key issue for the UK, the draft text includes provisions on dispute settlement specifically for financial services, in addition to those for the over-arching agreement (Article 33). Disputes would be handled by a 15-person panel of 'sufficient objectivity, reliability, and sound judgment' comprised of 5 representatives from the UK, 5 from the EU, and 5 independent members. Where it found a breach of the provision of the FTA, the UK or the EU could elect to suspend the benefits of the FTA for the financial services sector but would need to account for potential adverse impacts on the financial stability of each other's markets. 

As always, if you have questions on the above, speak with the Investment Association Brexit team, or have colleagues added to future notes on this subject, please contact us at europe@theia.org