Financial Regulatory Divergence between the UK and EU

Financial services has been lauded by the UK government as an area where regulatory divergence between the UK and EU will yield a Brexit dividend. The appropriate extent, and associated benefits, of divergence are, however, widely contested and context-specific.

Much has been made of the package of ‘Edinburgh Reforms’ for financial services outlined in November 2022 by HM Treasury (the Treasury),^[1] as updated by the Mansion House reforms of July 2023,^[2] which heralded an ambition to build a ‘smarter’ financial services framework for the UK and deliver economic growth through regulatory reform. The announcements are, however, unlikely to lead to much immediate change. To a large degree, the Edinburgh Reforms restate or build on reviews or plans which are already in progress (harking back to the October 2020 Financial Services Future Regulatory Framework Review – Phase II Consultation and the follow-up Future Regulatory Framework Review in November 2021),^[3] and which will take some time to realise. Many of the reforms trailed do not, in any event, concern divergence from EU legacy rules. For example, the proposed reforms responding to the recent review on bank ring-fencing,^[4] or to adjust the Senior Managers and Certification Regime (SM&CR), are domestic initiatives.

The Treasury is working to deliver its vision for UK financial services regulation through the Financial Services and Markets Act 2023 (FSMA 2023),^[5] which sets up the legislative architecture to allow for a smooth transition to a comprehensive Financial Services and Markets Act 2000 (FSMA) model of regulation tailored to the UK. When the UK left the EU, the body of EU legislation that applied directly in the UK at the point of exit was transferred onto the UK statute book by the European Union (Withdrawal) Act 2018, and became known as 'retained EU law'. This was a quick fix to ensure that UK legislation worked in the immediate period after Brexit, but was not meant to be a long-term solution, particularly because the PRA and FCA are unable to make changes to rules set out in retained EU law under this structure.

FSMA 2023, which received Royal Assent in June 2023, makes provision for the revocation of retained EU law relating to financial services and transfers responsibility for these areas of regulation to the financial services regulators. It sets out the laws to be revoked in Schedule 1, which will remain in force until the regulators have drafted and consulted on replacement rules in order to facilitate a smooth transition. The revocation programme commenced on 11 July 2023.^[6] At the end of this revocation process, industry should generally expect firm-facing provisions to be set through regulator rulebooks, and a more accessible and streamlined legal framework overall.^[7] In its journey towards a FSMA model of regulation, the Treasury will make use both of the existing regulated activities framework under the FSMA Regulated Activities Order (RAO) 2001, as well as the new Designated Activities Regime (DAR). The DAR was established under FSMA 2023 and is, in short, designed to enable the regulation of activities where it is not proportionate to require those carrying out the activities to become authorised persons.

The government has identified 43 ‘core files’ of retained EU law ripe for repeal.^[8] In practical terms, the government’s programme of revocation will be delivered by splitting this retained EU law into tranches. The first tranche aims to deliver the outcomes arising from the Wholesale Markets Review,^[9] Lord Hill’s Listing Review,^[10] the Securitisation Review,^[11] and the review into the Solvency II Directive.^[12] The second tranche is focused on those areas with the biggest potential to deliver improvements to UK economic growth, and the government expects to make significant progress on these two tranches by the end of 2023. Beyond the high-priority retained EU law identified in tranches 1 and 2, there are significant pieces of retained EU law remaining for future tranches where the government or the regulators may identify beneficial policy changes, or where policy reviews will be appropriate, including large EU files such as the European Market Infrastructure Regulation.

Complementing this process, some EU files will be considered for a ‘lift and shift’ approach—that is, the relevant provisions will be brought into line with the FSMA model, but no policy change will be made—where policy change is not appropriate and the status quo should, at least initially, be maintained. The government will announce which pieces of retained EU law will be initially considered for this ‘lift and shift’ process when setting out future tranches.^[13] More generally, the Regulatory Initiatives Grid will be used to update stakeholders on the progress of regulatory requirements that will be brought in following legislative repeal.^[14]

Hovering over this process of transition to the FSMA model of regulation is the new secondary objective of the FCA and PRA, introduced by FSMA 2023, which is to facilitate the international competitiveness and growth of the UK economy. How this ‘step-change in the regulators’ approach’ will shape the UK’s regulatory project is yet to be seen.^[15]

Talk of divergence must be further contextualised by the imminent expiry of two important decisions relating to market access for UK and EU financial services. The UK ‘Temporary Permissions Regime’ (TPR) — allowing EEA-based financial services firms to maintain their ‘passporting’ rights and enjoy access to the UK market—expires on 31 December 2023. An EU ‘equivalence’ decision, permitting UK-based clearing houses to service EU companies, expires on 30 June 2025. In December 2022, the EU published proposals designed to make EU companies clear a greater share of their derivatives trades in the EU (known as the active account requirement or AAR) because it sees a ‘strategic vulnerability’ in relying on a clearing market over which it has no regulatory oversight.^[16] This appeared to suggest that the equivalence decision for UK-based clearing houses is unlikely to be extended after 2025, despite the threats to market efficiency and financial stability that this may entail.^[17]

This position may have changed, however, in light of a statement on the AAR published by a number of trade associations in September 2023, including the Alternative Investment Management Association (AIMA), the Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA). Here, the associations called on the European Commission (EC) to delete the proposed AAR, highlighting the ‘detrimental implications [it] would have on EU capital markets by introducing fragmentation, loss of netting benefits and making the EU less resilient to market stresses with no benefit to EU financial stability’, and it was further asserted that ‘this requirement will create a competitive disadvantage for EU firms compared to third-country firms, which will remain able to transact in global markets without restrictions’.^[18]

It is up to the UK and EU respectively to decide what level of access they want to grant each other after this point. The more the UK continues to distance itself from EU regulation through its ongoing reform programme, the less likely it is that the EU will grant decisions on the equivalence of UK regulation.

The framework for the UK’s trading relationship with the EU was set by the EU-UK Withdrawal Agreement (which entered into force on 1 February 2020) and the Trade and Cooperation Agreement (TCA) (which entered into force on 1 May 2021). The TCA provides for tariff-free trade for goods, but provides little in the way of regulatory alignment and contains limited arrangements for trade in services.

Of greater bearing, on 27 June 2023 it was announced that the UK and the EU have signed a memorandum of understanding (MoU) on regulatory cooperation (following the two sides agreeing to the Windsor Framework in March 2023, in order to improve trade between Great Britain and Northern Ireland).^[19] The text of the MoU indicates that future cooperation in this area is reminiscent of the existing Joint Financial Regulatory Forum between the EU and the US, taking the form of a regularly scheduled forum for discussion.^[20] 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.

It is our expectation that, in general, nascent areas of regulation, such as regulation relating to artificial intelligence (AI), cryptoassets and ESG, will present more immediate areas of divergence.^[21] Where the UK and EU regulatory regimes have grown together for many years, any appetite for divergence will be more susceptible to countervailing arguments regarding the cost of divergence (including on legacy systems) and the benefits of equivalence. This suggests that, overall, an incremental approach to regulatory divergence will be preferred over a bonfire of regulation.

This conclusion is borne out by statements made by the UK government and regulators. While the government has championed FSMA 2023 (in its previous life as the Financial Services and Markets Bill) as delivering on its ‘ambitious vision’ for the financial services sector to ‘promote and enhance the UK’s position as a global leader’,^[22] it has also noted that in many instances it would ‘expect the regulators to initially replace the repealed provisions with rules that are similar to those which are currently in place’,^[23] calling into question the appetite for divergence. Although the Treasury has declared that, in addition to its tranched programme referred to above, it is ‘repealing almost 100 unnecessary pieces of [retained EU law] which implemented various EU obligations across a wide range of financial services policy areas’, this is not as portentous as it appears at first glance, as the effect of the amendments made by these statutory instruments is preserved by FSMA 2023.^[24]

FCA officials have previously displayed support for ‘the government’s determination to ensure our regulatory framework is tailored to allow UK financial markets and their users, from around the globe, to thrive’, but notes that this ‘doesn’t mean change for the sake of change’.^[25] The PRA has similarly expressed enthusiasm about removing ‘unnecessary rules we inherited from our time in the EU’,^[26] while noting that ‘we should [reform] with care and avoid suddenly all rushing to one side of the boat’.^[27]

Most anticipated divergence is so far just that – anticipated, largely arising from ongoing EU legislative initiatives and FSMA 2023 in the UK. These two features of divergence differ widely in their purpose, however. In the EU, legislative reform is responding to market and political developments, whereas in the UK, reform is geared towards establishing the UK’s post-Brexit regulatory regime. Important examples of anticipated divergence include:

• The UK’s fundamentally different approach of housing detailed technical rules in the regulators’ rulebooks rather than in relatively inflexible legislation. Once in PRA/FCA rulebooks, many requirements will, at least in principle, be capable of waiver or modification by the regulators, including potential forbearance.
• Investment services (MiFID) reform, including removal of the share trading obligation in the UK from 29 August 2023.
• Reform of the prudential regime for insurers (UK Solvency II), which is being introduced at the same time as a major review of the directive is being carried out by the EU.
• Consumer credit, where the UK has confirmed that it will simplify and modernise this regulatory regime.
• Potentially significant differences between prospectus and listing regimes.
• A much more principles-based and guidance-led approach to the regulation of some emerging technologies in the UK, including AI.
• Some emerging but important differences in prudential regulation, for example the EU approach to the ‘output floor’.
• A potentially more flexible approach to ESG regulation in the UK, largely linked to the fundamental differences in rule-making styles between the UK and the EU referred to above.

Divergence is giving rise to significant practical issues for in-house legal and compliance functions, including:

• How to design systems and policies to secure compliance in both the UK and the EU as the two regimes diverge.
• Coping with the UK as a ‘third country’ facing 27 EU member states with varying third country regimes, and the consequent need for local advice in those member states. Relationships with local counsel in relevant member states have become more important.
• Keeping in touch with reform proposals and developments. Trade associations have arguably never been more important, and should be supported where they do good work.
• Finding relevant law, regulation and guidance, now a particular challenge in the UK despite a proliferation of platforms that purport to consolidate searchable legislation and rules. It is worth using some of these platforms, but developing and maintaining internal know-how is more important than ever.
• Recruiting and retaining suitably qualified EU lawyers and compliance professionals.
• Communicating proposals for positive reform to the regulators.