Here in full is an article that I wrote for FT Adviser about the prospects for financial cooperation between the UK and the EU. Since Brexit took effect at the turn of 2021, the UK's and EU's legal systems have diverged through a natural process of "drift". An increasingly noticeable benefit of this divergence is regulatory competition: UK and EU authorities competing to have better rules and a better financial system (and often learning from each another's successes and mistakes). A similar process of competition between states fuelled the historical rise of Europe.
What are the prospects for UK/EU financial regulatory cooperation?
The Brexit agreement between the EU and the UK controversially did not include any commitments on financial services, although the then prime minister Boris Johnson said it would be preferable if it had done so.
However, the trade agreement was accompanied by a (political rather than legal) joint declaration committing the two sides to agree a memorandum of understanding on financial services regulatory cooperation by March 2021.
The MoU was duly agreed but has since existed in limbo, having not been formally signed off by the EU’s institutions.
The European commissioner for financial services, Mairead McGuinness, admitted that the EU is in no rush to approve the accord, evidently considering access to the EU’s single market to be a greater benefit to the UK than vice versa, given the strength of the UK’s financial services.
The suspicion is that market access is also a bargaining chip that the EU might trade for other priorities, not least over the trade border with Northern Ireland.
Following the Windsor framework agreed between the UK and the EU on February 27, some have hoped for a thawing of relations between two jurisdictions and, perhaps, agreements on market access for financial services and products.
Now is a good time to assess the prospects for regulatory cooperation, divergence, and the outlook for firms.
Agreeing to disagree
At the time of writing, parliament is scrutinising the Windsor framework, and the government’s proposal faces some opposition.
Experience suggests it is not wise to predict the political outcomes of Brexit, but having reached an agreement, it is fair to assume that relations between the UK and EU could improve.
Consequently, the EU could be willing to approve the MoU on financial services – although there are two good reasons to believe that an agreed MoU will not change the course of regulatory divergence.
First, the content of the MoU. A leaked draft suggests the EU/UK model for financial services cooperation is based on the EU/US model: a regularly scheduled forum for discussion.
Talking shops can be helpful for the airing of issues, as the joint EU-US forum has proven in respect of thorny areas such as the EU’s research unbundling provisions that conflict with US rules.
But neither the US or UK forum have "teeth": the arrangements do not compel the parties to agree on shared rules or market access, but only to the exchange of views and transparency over common issues and equivalence decisions.
In this respect, the MoU compares unfavourably with the Comprehensive and Progressive Agreement for a Trans-Pacific Partnership (CPTPP), which the UK has announced that it will join. The CPTPP is a liberalising agreement.
Its financial services chapter does not require signatories to adopt specific rules, but rather requires them to remove barriers that prevent CPTPP members from accessing their markets on fair and equivalent terms compared with domestic financial services. So, the CPTPP does not require the UK to become a rule-taker and it plays to the UK’s strengths in financial services, but unlike the MoU, the CPTPP does bind the parties to ensuring market access.
Second, the degree of regulatory drift since Brexit means the two jurisdictions have different regulations – for example, the packaged retail and insurance-based investment products regulation mandates disclosures to retail investors.
But there are differences in the form and content of the prescribed key information document in the EU and the UK, meaning cross-border firms must comply with two sets of rules and bear the additional costs imposed by divergence. Moreover, both sides intend to further diverge in their regulations.
Drifting to divergence
The gradual emergence of differing regulations since Brexit was due to separate EU and UK institutional processes.
The UK has adapted inherited EU rules to suit its own needs (such as changes to Mifid II best execution reporting), and the EU has continued its process of scheduled legislative reviews (such as Mifid II and AIFMD) that are not replicated in the UK.
In addition, policymakers have sought to keep apace of market developments, such as in environmental, social and governance-based investing, and digital assets.
However, more recently, there has been a recognition of differing policy objectives and an explicit intention to diverge from the other.
On the EU side, this has taken the form of protecting the EU’s markets from UK competition or, as EU policymakers would see it, third-country firms seeking to access the EU while undercutting its rules.
The focus has been on the delegation of portfolio management from the EU to the UK within the AIFMD and UCITS legislation, and the marketing arrangements permitted under Mifid II, such as offshore firms using tied agents and secondments to sell their products in the EU.
In both instances, the EU has settled on more transparency about firms’ arrangements rather than hard limits.
Interestingly, these negotiations have unveiled conflicts between EU member states – such as France, which wishes to grow its financial services status – and international hubs such as Luxembourg and Ireland.
Meanwhile, the UK has a political imperative to demonstrate "Brexit dividends" and an acceptance that EU passporting rights are unlikely to be granted.
The Edinburgh reforms announced in December 2022 address various regulations; some, but not all, derived from the EU, such as short-selling and securitisation rules.
The government has clearly sought to tip the balance towards economic growth and away from the regulators’ customary risk aversion.
This too has provoked internal conflicts between the government and regulators over Solvency II reforms and the Financial Conduct Authority’s upcoming consumer duty.
The financial services and markets bill, which will soon be finalised, will scrap all on-shored EU financial services legislation and will require the FCA and Prudential Regulation Authority to copy, amend, or scrap each rule.
The FCA has responded with a review of its asset management regime, contemplating changes to AIFMD and Ucits rules. Expect more conflict between the government and regulators over the direction of policy, particularly considering recent bank failures and market instability.
Where does this leave us?
The first big test of the "new" relationship between the EU and UK will be the overseas funds regime, which is due to begin this year, granting permanent access to EU Ucits funds that pass the UK’s tests.
The Treasury will decide whether Ucits are equivalent in regulatory terms (which seems likely), although the FCA might decide to impose additional conditions.
We are already seeing the FCA impose these additional requirements on overseas managers seeking permission to market their funds in the UK; for instance, demands to comply with UK value assessment and ESG expectations.
A toothless and still-to-be-finalised MoU and an increasing level of regulatory divergence means firms should not expect comprehensive agreements to align rules or grant passporting rights.
Costs will increase for cross-border firms because of the need to comply with two sets of rules, although the UK’s efficiency drive might ease burdens on onshore firms.
Regulatory competition is the new order. This could lead to better rulemaking as each jurisdiction seeks to improve on the other (we already see this in the UK's learning from the EU’s challenges in the Sustainable Finance Disclosure Regulation and the EU looking at the UK’s experience with value assessments and an inducement ban).
But firms will navigate an increasingly complex and costly regulatory environment.
