What is a financial passport, and how does it work
For companies operating outside of the European Union, according to WTO rules, governments have the power to restrict cross-border financial services in order to protect their economies from systemic risk. As a result, firms engaged in financial services across international borders, must comply with regulation separately in each country in which they operate. Consequently, the cost of cross-border of capital flows are increased, since firms often need to incorporate a subsidiary in each of the other jurisdictions in which they wish to operate, to ensure that each subsidiary entity is compliant with the local regulatory regime.
Within the EU, a very different legal regime operates, whereby each EU member state has agreed to a common body of financial regulation, written through EU-level sectoral agencies such as ESMA (European Securities and Markets Authority). In return, financial services firms obtain authorisation from the regulatory authority in the relevant country of their choosing. They are then free to operate both within that country (of authorisation) and also throughout the other EU member states.
This authorisation process is known as the financial services ‘passport’. The ability to passport services means that a firm can either provide its services directly on a cross-border basis (e.g. via post, telephone or internet), or can establish a branch office in another Member State (i.e in-person). Having received authorisation from its home state regulator, and without the additional requirements and costs associated with establishing a full subsidiary in that Member State.
Subsidiaries, in contrast, may be subject to local governance and regulatory requirements, and may require separate capitalisation, both of which increase costs.
In the UK context, financial firms can set up in London, then obtain the necessary regulatory authorisation (‘outbound passport’) from the UK FCA (Financial Conduct Authority). Firms can then offer services remotely in the 27 other EU Member States, and to some degree in the three European Economic Area (EEA) Member States. The same is true the other way around, where European firms authorised (‘inbound passport’) in European cities (e.g. Amsterdam) with local national regulators, can offer services into the UK from Europe.
This system benefits businesses as it means a UK firm can be appointed to run a European fund without having to incur the costs of setting up a local office; a UK investment manager can be appointed to run an investment mandate for continental institutions; or continental corporations can make use of UK market infrastructure to access global markets. The passporting regime is also beneficial for consumers as it expands the range of products to which they have access, and it broadens markets by fostering competition and reducing costs.
Overall the single market, and the passporting system, has been a key element in maintaining the strength of London as the EU’s financial centre, to date. Therefore, the potential loss of this ability to ‘passport’ services throughout the EU is at the centre of the financial sector’s concerns over Brexit.
What are the passporting regulations
The introduction of the financial passport was started with the 2nd banking Directive in 1992, and the investment services Directive in 1994. The facilities provided by these two directives have recently been further developed and extended to other financial services. Particularly following the G-20’s commitment to ensure that all financial services, institutions and markets are responsibly regulated in the wake of the financial crisis.
Technically, there are many separate ‘passports’ available under different pieces of financial services legislation, covering different financial services such as banking, investment funds or clearing, each of which operate in an additive way. An individual firm can provide more than one of these services, so the extent to which a firm relies on passporting will vary depending on the range of its activities, with the result that the legislative regime governing a particular business can be complex.
|Financial Service||Regulation||EU Passport||Start Date||Comments||Remuneration rules apply|
|Payments & Transfers||CRD IV / PSDII / e-money||Extensive||1992 / 2007 / 1992||PSD and e-money Directive set rules for wiring services||N|
|Commercial Banking||CRD IV||Extensive||1992||Y|
|Trading||CRD IV / MiFID II||Extensive||1992 / 1994||Remote access for brokers to trading platforms||Y|
|Investment Banking||CRD IV / MiFID II||Extensive||1992 / 1994||Universal banking was the rule in the EU since 1992||Y|
|Insurance||Solvency II||Limited||1997||Unlike banking, solvency II does not allow a single capital base||N|
|Pension Funds||IORP II||Limited||2002||Labour market and tax rules have limited take-off||N|
|Investment Funds||UCITS IV-V||Extensive||1985||First single financial product passport||Y|
|Alternative Funds||AIFMD||Extensive||2012||Single licence for hedge fund managers||Y|
|Securities & Derivative Markets||MiFID II||Extensive||1994||Remote access to and collocation of trading servers in financial centres||Y|
|Settlement||CSDR||Extensive||2014||Code of conduct before the crises||N|
|Clearing||EMIR||Extensive||2015||Not regulated before the crises||N|
|Rating Agencies||CRA||Extensive||2012||Not regulated before the crises||Y|
|Data Providers||MiFID II||Extensive||2018||Licence from 2018 onwards||N|
European legislation also allows for ‘third-country’ access to the EU Single Market (i.e. from countries outside the EU without a passport), in respect of specific activities. Market access in such situations is based on demonstrating regulatory equivalence between the third country and the EU, which present a number of other challenges.
Following Brexit, unless the UK were to join the EEA or negotiate an alternative bespoke arrangement allowing full single market access, it would be classed as a ‘third country’, and UK firms would be subjected to these ‘equivalence’ provisions, as firms will no longer qualify for financial passports across the EU.
UK-based firms would also lose protection against discrimination, as the passports guarantee incoming firms will be able to do business on the same terms as local ones. There is no such protection for third country firms that are allowed to operate in a Member State’s market (i.e. using equivalence). This means that UK-based firms (including subsidiaries of non-EU businesses which have set up offices in the UK to access the Single Market) would face regulatory and prudential barriers which can impact the viability of their businesses.
To what extent are passports used?
Many UK-based firms use the passporting rights granted under the various legislation outlined in the above table.
The Financial Conduct Authority (Andrew Bailey. FCA CEO) provided the below figures (as of 27 July 2016) on the use of passports, to the House of Commons Treasury Select Committee Chair, Andrew Tyrie MP, on 17 August 2016.
[N.b. The IMD* (Insurance Mediation Directive) data is plotted separately, for enhanced graphical representation].
Click to download the original letter and data tables contained in the FCA note to the Committee:
An ‘outbound’ passport refers to a passport issued by a UK competent authority to a UK firm. This allows it to do business in one of more EU or EEA member states. An ‘inbound’ passport refers to a passport issued in an EU or EEA member state to a firm from that state, enabling it to do business in the UK (or other Member States).
Notably, it is possible for a firm to have more than one passport in order to provide different services under different directives. It is also possible for a firm to hold more than one passport under the same directive. In reality, more EU companies than UK companies hold passports, but more passports in total are held by UK companies.
The impact of a loss of passporting and mitigation strategies for firms
The extent and complexity of passporting add to the difficulty in assessing the impact of Brexit.
Most firms will have to look at their own business on a case-by-case basis, and think about which of their activities and bundles of services they operate use some or all of the passporting permissions.
An analysis (below) of the existing arrangements between the EU and non-EU countries shows that no country outside the EU enjoys full passporting rights into the EU. If the UK were to leave the EU, an entirely new and bespoke arrangement would need to be established for the UK to preserve fully its current EU passporting rights. There would be no certainty of achieving this.
The obvious way for firms to mitigate a loss of passporting, is that UK-based financial firms will have to create subsidiaries in continental Europe and acquire licences from national supervisors. Additionally, where companies already have branches operating under a passport within EU member states, steps must be taken to convert these to locally established subsidiaries in order to provide services (with the associated capital implications) or cease operations. EU-based firms would also need to apply for separate UK authorisation to do business in the UK either remotely or through a UK office.
Some estimates suggest that 15% to 30% of UK’s financial service activities could relocate to the EU27, as a result of this.
The challenge is when to take the decision to go ahead with such relocation plans. The best time for a bank or insurer to decide with certainty, would be when the outcome of the negotiations are known. However, given that the UK government has only just stared negotiations in June 2017, and won’t conclude until spring 2019, that optimum decision point is about two years away.
However, it takes time to move a bank or financial organisations to an alternative location, particularly for larger companies. Considerations must be made regarding necessary logistics (premises, and staffing), gaining regulatory permissions, internal planning and sign-offs, mobilisation of budgets.
There is also some degree of a first-mover advantage, whereby early companies that establish new base in EU member state cities, are likely to find the best facilities and lowest costs – a gold rush if you like. Therefore financial services companies may be inclined to move earlier rather than later, to avoid being left without suitable options in 2019.
As a result of this timing dynamic, the sector has been putting pressure on the government to negotiate a period of transitional arrangement, to bridge the gap between the end of the Brexit negotiations and the implementation of the new EU-UK trading environment. Ideally such arrangements would replicate as far as possible the current arrangements that we have with the EU, partly through regulatory equivalence, partly through bespoke provisions in the exit terms. This would avoid a ‘cliff-edge’ type scenario, and would help business to plan more effectively.
We will have to wait and see how the negotiations go, and what is the likely new arrangement.
In the meantime, look out for our next article on what firms might think about when relocating their operations to European cities.
Comment or get in touch if you have any questions or feedback!
Summary of EU Directives relating to passports
Click on the buttons for a high level summary of each EU Directive:
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