Why free trade and open markets in financial services matter

Speaker: Andrew Bailey, Chief Executive
Event: Reuters Newsmaker, London
Delivered: 6 July 2017
Note: this is the speech as drafted and may differ from the delivered version

Highlights

• Andrew Bailey gives an overview of the work that the FCA is doing on Brexit and the impact of Brexit on financial services.
• Open markets in financial services, freedom of location and free trade are important to the functioning of the global economy.
• Firms should be able to take their own decisions on where they locate, subject to appropriate regulatory arrangements being in place which preserve the public interest.
• Restricting trade is not an inevitable or necessary response to Brexit. 

A lot can happen in a year. Last June, I was preparing to move to the FCA to take up the role of Chief Executive on 1 July. It was the week before I moved that I realised how much of my time in my new job would be taken up by Brexit.

Quite simply, our job at the FCA is to get on with it, to roll our sleeves up and play our part in implementing the decision made by the people of this country to leave the European Union (EU), and what goes with it.

I can’t deny that Brexit is a lot of work, and it did not feature in our business planning as a reality until a year or so ago, so a lot of sleeves have had to be rolled up.

Today, I am going to talk about Brexit. I am going to start with a brief overview of what we are doing at the FCA. Then I want to tackle a big and important question.

Some of the commentary on Brexit suggests that it must inevitably lead to restrictions on trade, on the location of activity in financial services and on open markets.

My question is therefore whether restricting trade is an inevitable or necessary response to Brexit and in the interests of anyone? I hope you will not be surprised to hear that my answer to these is ‘No’.

Open markets in financial services, freedom of location and free trade are important to the functioning of the global economy.

Well integrated financial markets support economic growth and employment. They reduce the cost of access to financial services by encouraging competition. It is important to always have in mind the commitment of G20 leaders, at the Pittsburgh Summit in 2009, to avoid fragmentation of markets, protectionism and regulatory arbitrage.

But we cannot take open markets, freedom of location and free trade for granted. Firms should be able to take their own decisions on where they locate, subject to appropriate regulatory arrangements being in place which preserve the public interest.

Authorities should not dictate the location of firms; rather, we should allow open markets to shape those choices, always subject to our public interest objectives.

There is ample evidence that open markets in financial services and free trade can exist safely without common detailed rules and shared regulatory institutions. Consistent outcomes of regulation are what matters.

In sum, open markets, freedom of location and free trade in financial services matter a lot and should be preserved.

The FCA’s work on Brexit

Open markets, freedom of location and free trade in financial services matter a lot and should be preserved.

Let me give you a brief description of what the FCA is doing on Brexit. First, we are ready to provide whatever technical advice is needed to support the Government in the negotiations ahead.

Second, we are working with authorised firms to understand their plans for the future of their cross-border operations into the EU, and from the EU to the UK.

Third, we are working with the Government on the Repeal legislation.

In terms of our workload, the legislation is the most significant task, involving a line-by-line analysis of each piece of EU legislation and rulemaking for which the FCA is the lead regulator.

Our objective in this work is, with Government, to create a clear and functioning regulatory regime on the day that the UK ceases to be a member of the EU, and thus to give certainty to all interested parties.

In doing so, we will continue to advance our statutory objectives and thus maintain high conduct standards and robust proportionate and sustainable regulation.

As we have set out in our budget for this year – while we have sought to absorb as much as possible of the additional cost of putting Brexit into effect by re-prioritising within our established budget – we have levied an additional sum to cover the unavoidable extra costs of the resources needed, largely attached to the Repeal legislation work.

Last, but by no means least, immediately after the referendum we took a couple of important decisions: first, that as long as the UK remains a member of the EU, we will engage constructively in our work with, and as part of, the European institutions – which for us is primarily the European Securities and Markets Authority (ESMA), and we will continue to implement EU legislation during this period; and second, that it is vital that we continue to be an outward-looking regulator heavily engaged with broader global bodies including the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO).

The FCA gains significant benefit from our co-operation with other regulators in Europe and internationally. This allows us to share information, intelligence and best practice – and to deliver as effective supervisors day-to-day.

A retreat from international engagement would be a big mistake, and we are not doing that.

Implementing Brexit and the impact on financial services

Let me now move on to the impact of Brexit on financial services. When I hear people say that firms need to re-locate in order to continue to benefit from access to EU financial markets, I start to seriously wonder.

Does Brexit have to mean abandoning the benefits of free trade and open markets in financial services? It should not.

Does it require membership of the Single Market to get the benefits of free trade with the EU? No.

Does Brexit mean abandoning the use of regulatory co-operation to ensure sufficient alignment of standards and outcomes so that open markets can prevail? It should not.

Does Brexit mean we are now saying that – even with such alignment – economic welfare, market integrity and the interests of consumers would be so damaged by open markets that the only way to be safe is to resort to policies to make sure firms are on your patch? The answer should be no.

Brexit should not be conflated with whether or not to have open global financial markets and trade in financial services. The economic and financial cost of losing open markets is too great to be justified and is not a necessary response to the choice of Brexit.

And, to be clear, this is highly relevant to the FCA’s objectives. Amongst other benefits of open markets and free trade is the enabling of healthy competition, an important objective of the FCA.

I want to put this into the context of the history of the last 10 years. The correct and determined response to the global financial crisis was to build a strong framework of global standards. The aim of the framework has been to create the institutional and regulatory foundation of financial stability and financial conduct.

The G20 and the Financial Stability Board have led the way internationally to embed this new approach, and it is to their great credit that so much has been achieved as this provides firm underpinnings for financial stability.

In doing so, the institutional structures that can provide the assurance for international trade in financial services have been strengthened. These structures are not yet complete, but it is not an easy task and it was always envisaged to take time.

With these institutional structures being built, it makes little sense to abandon them and seek refuge in restrictions in the name of responding to Brexit.

A good example of the scope for international agreement to facilitate open financial markets is the agreement between the US and the EU regarding clearing house equivalence. It was, in many ways, quite ground breaking when it was agreed a year ago.

The process to put it into place took time, but the signs are that it has worked effectively and has demonstrated that cross-border regulatory co-operation is perfectly possible. This type of agreement can be backed up by effective joint supervisory oversight, something that is very clearly preferable to the cost and risk that is introduced by a location based policy.

Firms should be able to take their own decisions on where they locate.

I quite often have it put to me that the UK is a different case from other non-EU countries because it has large and nearby financial markets, and therefore there needs to be a more restrictive outcome for the UK. I don't accept this proposition. Our markets have developed together on the basis of the same rules. It would be a departure from the sound regulatory approach of ‘same risk, same requirements’, and in a world of increasingly strong global standards of regulation, it is not the right approach.

I think it is important also to put this line of argument into some longer historical context, because it is such a crucial point. There is a fundamental question which has been around for more than 200 years – whether people want to live in an open commercial system and thereby gain from free trade with the rest of the world?

The approach in Britain shifted decisively in 1846 with the repeal of the Corn Laws which led – not quite seamlessly – to Britain being the strongest advocate and practitioner of unilateral free trade in the late nineteenth and early twentieth century.

This was a period in which the benefits of free markets were assumed to prevail without question. It was the same story in monetary policy with the classical gold standard, operating without an underpinning of institutional support in the modern sense of the term.

This came to an end after the First World War as the issue of how to reconcile international forces with domestic public interests came to the forefront. This created a larger role for the state as representing the public interest, with choices then made about the precise form of the institutional structure of the state. Here I use the word ‘institutional’ broadly to mean the place in which the rules and constraints of the game of political, economic and social interaction are made and enforced.

That shift in approach has continued until today – with some fluctuations in intensity from time to time – so that institutions of state matter in representing the public interest.

The FCA is an example of this process at work, representing the public interest in financial conduct. Our role, alongside the Bank of England and the Prudential Regulation Authority, is to build and maintain public trust in the stability, safety and soundness and fairness of the financial system.

From the First World War onwards, the development of institutions of state representing the public interest has produced another long-running issue, namely - what is the correct balance of international and domestic institutions?

The most important international institutional structures grew out of the Bretton Woods Agreement and the treaties that created the European Union.

These were agreements about how to interpret and put into practice the role of the state in terms of the balance of national, regional and global institutional structures.

They interpreted the meaning of state sovereignty and, in doing so, sought to resolve the tension between the economic interdependence of states and national determination. As part of that outcome, the EU has over time been a strong proponent of free trade.

Brexit does not need to lead to calling into question the fundamental principles of free trade and open markets. Brexit is undoubtedly a very big development, but it should sit within the overall scope of how to arrange the institutions of state to enable trade to happen while maintaining the public interest in stable, safe and fair financial services.

Moreover, we should recognise that this public interest is not limited to the UK public interest. Why? This is probably best summed up by the IMF in its Financial System Stability Assessment of the UK published last year, namely that financial stability in the UK is a global public good.

This means that the institutional structures that underpin and preserve the public interest in order to enable open financial markets and free trade should, as they do now, represent the global as well as domestic interest. That’s what it means to have the world’s leading financial centre here in London.

This brings me to the last part of my remarks. What sort of institutional structure of regulatory co-operation do we need to preserve open markets and free trade alongside Brexit? It is worth starting on this issue with a broad reflection on differences of approach to regulation between the UK and the EU.

A retreat from international engagement would be a big mistake, and we are not doing that.

In my experience, the UK approach at its best is rooted in strong principles which reflect clear public interest objectives. These principles are then put into practice as rules which allow for the use of supervisory judgement by the relevant authority. I would describe this as using judgement against a framework of rules.

It can work well: it is focused on outcomes but depends on a very clear articulation by the regulator of the meaning of the principles that are established out of the public interest objectives given by Parliament.

It can work less well when the wrong principles are embedded, which was the case in the run up to the financial crisis.

The problem there was not principles-based regulation per se, but rather that the governing principles appear with the benefit of hindsight to have been inadequate in terms of prudential requirements, firm governance and (in some areas) fair outcomes for consumers.

In response, we have had to construct a fresh system with stronger principles as reflected in the FCA’s recent Mission.

I would describe the EU approach to regulation as far more one of detailed rule-making as the means to create harmonisation. The challenge is different in a union of 28 countries where there is a risk of divergence among the various authorities.

The rules-based approach was no better at dealing with the pre-financial crisis build up excesses than the principles-based approach.

The existence of these two approaches obviously begs the question, in the context of Brexit, of what institutional framework of regulation could preserve open markets and free trade in financial services? It will require a strong co-ordination of regulatory institutions across the UK and the EU.

The current system is one of common rules which underpin market access, but where the UK has been able to exercise an influence over the form of the rules, and conduct largely independent supervision to put those rules into effect.

Over the years, we have argued consistently and successfully that the application of rules through supervision should not follow rulemaking in terms of centralisation, something that is not a necessary condition of stable open markets. Recently, we have seen some movement of EU oversight into the application of rules.

There is already a basis for the sensible use of equivalence as the basis for market access between the EU and the UK in the future. It is the basis that the EU uses for a growing number of other countries.

Brexit should not be conflated with whether or not to have open global financial markets and trade in financial services.

A key area is investment services, shortly to be governed by the new framework under MiFID II and MIFIR. Here a firm from outside the European Economic Area (EEA) will be able to provide cross-border services from outside the EU to professional clients and eligible counterparties within the EU without the need to establish in relevant EEA jurisdictions, provided that the regulatory regime of the other state is deemed to be equivalent and in some respects reciprocity exists. For retail clients, there is some scope to require establishment in some form (including branches), which is a sensible recognition of the wholesale-retail difference.

This is an obvious basis for coming up with a general approach to equivalence and mutual recognition across financial services, something that would treat the UK in the same way as other non-members. As an example, it would not be the best outcome to adopt a special treatment for the oversight of outsourced service provision arrangements involving the UK and EU when there are already arrangements in place which can form the basis of an equivalence arrangement.

But clearly, we have to provide comfort to our trading partners that we do uphold the rules and standards in force. And, as I noted earlier when citing the IMF, the UK has every reason to continue to put high standards into practice as our financial markets are an international public good.

This alone should be a source of confidence that we do not intend to create a race to the bottom on deregulation. The stakes are simply too high in terms of the risks to our public interest objectives.

Moreover, the UK has been and continues to be prepared to go further in recognition of the importance of the financial services industry. A very good example of this is the Senior Managers Regime, which establishes a much stronger form of individual accountability.

We also need to preserve close regulatory and supervisory links with the EU. Looking ahead, strong co-ordination is a sensible approach to take in order to demonstrate the strength of the system.

What are the key elements of such co-ordination? I would point to 4 permanent features: comparability of rules, but not exact mirroring; supervisory co-ordination; exchange of information; and a mechanism to deal with differences. I would add to this importance of transitional arrangements being put in place which allow for a smooth path to the new post-Brexit world.

Effective comparability of regulatory standards in financial services is not a new idea. It exists around the world today in various forms. Crucially, with the advent of much stronger international standards in the wake of the financial crisis, we are in a better place than ever before to create a strong platform of co-ordination. Again, this is to recognise just how far we have come in the last decade in terms of the importance of the public interest in financial stability and sound financial conduct.

In banking, we now have robust prudential standards which are being put into effect rigorously.

In financial conduct there is rapid progress in the important area of co-ordinating wholesale market conduct – important because international trade in financial services is concentrated in wholesale markets. An obvious example is the regulation of benchmarks in interest rate, foreign exchange and other markets.

Maintaining open financial markets should be founded on the authorities agreeing that the standards and outcomes should be observable and thus transparent. As authorities we all share an interest in being accountable for robustly protecting the public interest.

Clearly, any such system requires an approach that allows checking and verification that outcomes are equivalent and sustained and that differences can be resolved without recourse to withdrawing market access.

Co-operation needs to be close in ways that not only avoid irreconcilable differences but also thereby make the commitment to sustained market access credible. Disagreements should be escalated to a mechanism that provides reconciliation.

Likewise, we should be prepared to make our supervision more transparent, where appropriate, so that it is always a source of confidence. Exchange of information on an open basis will be important to support this.

Fortunately, we start in a good place in terms of the strength of working relationships between regulatory authorities. We have worked hard on this over the years.

As a Board member of ESMA, I am as committed to its work today as the FCA was before the referendum. I hope we can all commit openly to keep it this way. No good will come from a breakdown of these relationships since we are pursuing common public interests.

We have built effective structures around supervisory colleges in the EU and globally, and at the FCA we have over 100 memorandums of understanding with other regulators around the world. We should continue this work with a strong commitment. This is another lesson of the financial crisis that we should not jettison.

Conclusion

Arguing that Brexit should not mean an end to open financial markets does not amount to special pleading for the financial services industry.

In conclusion, arguing that Brexit should not mean an end to open financial markets does not amount to special pleading for the financial services industry. That is not my job. Rather, my job is to achieve good financial conduct which includes the integrity of markets, the fair treatment of consumers and ensuring effective competition.

My counterparts in other countries have the same objectives. There is nothing that I have seen in Brexit which changes that. Although the Repeal legislation changes the legal basis for important parts of our framework, it does not change our objectives.

In the 10 years since the outbreak of the global financial crisis we have come a very long way in rebuilding financial regulation to serve the public interest of financial stability and good conduct.

The G20 and Financial Stability Board deserve great credit for leading this work internationally. This provides the institutional structure for trade in financial services.

I have no doubt that we can continue to achieve these objectives with Brexit. That sounds bold, but I strongly believe it.

My view is that if there is a commitment on all sides that the UK and the EU maintain substantially equivalent regulatory arrangements in future, that it will not be necessary to restrict open markets and free trade in financial services and therefore not necessary to limit the freedom of firms on location. And therefore, I see no reason why we should sacrifice open financial markets and free trade, as an inevitable response to Brexit.