Private equity and the trade and cooperation agreement
The Trade and Cooperation Agreement (TCA) between the UK and the EU, as has very quickly become clear, does very little for financial services. In formal legal terms, the difference between no deal and this deal for financial services is small, although in political terms the difference is crucial: an orderly, cooperative relationship rather than a disorderly and uncooperative one.
The services chapter is a conventional FTA chapter. It is largely based around confirming a range of existing terms of access for third countries to the EU and UK and carving out a range of discriminatory or non-conforming behaviours on both sides for preservation. In this it closely follows the EU’s trade deals with Canada and Japan.
The Treaty is structured as a negative list, meaning that in general, discrimination and other prohibited measures are not permitted in future, unless they are explicitly protected by the Treaty. Both sides have carved out a wide range of existing measures and future prerogatives, such as the prudential carve out for financial services. There is also a full Most Favoured Nation (MFN) provision for services commitments, requiring that both sides are in principle obliged to extend any for preferential terms granted to another state to the other party to this treaty.
Importantly, the UK has secured the prohibition of a requirement for UK businesses to establish a local presence in the EU as a precondition of being permitted to sell into the EU cross-border, although this does not prevent the EU or the UK disallowing cross-border supply.
More specifically, there are basic and relatively conventional sectoral chapters on telecommunications, delivery services, financial services and maritime transportation services, all of which focus on basic principles of fair treatment in licensing or market structure.
The main means of opening up market access in the UK/EU relationship will be through equivalence. Equivalence is a unilateral decision by one side which, in the EU’s case, can be withdrawn with only 30 days’ notice. This means that any market access created by equivalence is, in theory, precarious. And where the overall political relationship is troubled, as it has been between the EU and Switzerland, it can be in practice as well, as the withdrawal of equivalence for Switzerland’s stock market showed. Equivalence decisions are not broad market access commitments but are confined to a particular sector or function.
So far the EU has not made any lasting commitment to market access. Two decisions are time-limited to avoid financial instability, while three others are for public sector bodies.
There has been considerable attention on the commitment in a side declaration to the TCA to develop a Memorandum of Understanding (MoU) on regulatory cooperation in financial services. This MoU is meant to be agreed by the end of March. An agreement would not itself open up more market access but would put a structure around equivalence decisions and regulatory dialogue, potentially opening up room for them and making them more predictable and stable.
However, the EU’s priority thus far has been to onshore financial services business, and until that policy change on equivalence decisions in significant areas, such as on derivatives or third country investment firms under MiFIR, cannot be relied on. The European Commission’s claim that the UK’s future regulatory regime is a “moving target” provides it with an ostensible reason to delay such decisions for months more.
Despite limitations such as these, the TCA as a whole is likely to be macro-stable. Both sides preferred an agreement to no deal for major economic, political and geo-political reasons. But we should expect microinstability: the TCA permits a range of retaliatory measures if one side’s standards on level playing field issues – subsidy control, employment and environmental standards – get out of line with the other’s. That is quite likely: to take two examples, the UK is reviewing its inherited EU legislation on working time and will almost certainly not follow the EU in the provisions of two employment law directives due to be implemented next year. What is to be discovered is how hawkish the EU will be in policing such divergence.
What form any retaliation might take is for now necessarily speculative: both sides have yet to fully think these issues through. But the most politically sensitive sectors, such as agriculture and automotive, are likely to be avoided. Something painful but more niche, like bicycles, would be a more natural target.
For now, the news is full of stories of businesses trading with the EU trying to overcome the new barriers to trade introduced by the UK’s departure from the EU’s customs union and single market. New stories will appear when the UK enforces full controls on its side of the border at the end of June. Some of these are teething problems which will disappear as businesses become used to the new regime and official systems are fully in place to manage them.
But this should not disguise the permanent shift in the terms of trade that has now happened. The UK and the EU are not about to decide a host of mitigations to the barriers to trade they have just agreed to put up. The question for private equity is what this disruption means for assets and potential targets. Some companies will have had business models which were fundamentally dependent on the UK’s membership of the single market. They have a difficult future.
Others now face the challenge of getting ahead of this moment of disruption. Many will need to reconfigure their supply chains. The natural consequence of new trade barriers is local sourcing. This will open up opportunities for some. Further questions for companies are how relatively disrupted an asset is compared to its competitors in the same field and how quickly it can reconfigure its supply chain compared to those competitors.
We have had political Brexit for a year. This is now economic Brexit. The immediate effect will be to make business harder for firms trading with the EU, but there are opportunities for those that can adapt fastest or help them adapt faster than others.
And Brexit will create some absolute gains for British firms. In the longer run there will be different kinds of opportunities as the British government uses its new regulatory autonomy to innovate in areas like gene editing. They will be politically controversial and will bear close watching.