Brexit: Outsider Trading

Clarity over prospects for the UK's service sector post-Brexit could still be many months away.

"I am always optimistic until I am pessimistic, and that line has not been crossed. While it is all to play for, we should play for it and secure it ... Economic logic must win through somewhere and therefore we have a very good chance of securing something.”

John McFarlane, Chair of TheCityUK, 25 July 2018

Mrs May advances…

It is now over two years since the UK electorate voted (narrowly) in favour of leaving the European Union (EU), an exit which is due to take place on 29 March 2019. But, to all intents and purposes, the starting pistol on serious negotiations between the government of UK Prime Minister Theresa May (HMG, ie ‘Her Majesty’s Government’) and the EU was only really fired with the publication on 12 July by the former of a White Paper on its objectives for the post-exit relationship. The (highly ambitious) stated (see below) aim now is to negotiate an agreement between the two parties by the time of the European Council meeting due to be held on 18/19 October thereby allowing sufficient time for ratification of the deal by the EU27 (including, where applicable, sub-federal entities) and, of course, the UK parliament in Westminster.

The 104-page paper is divided into four main sections, ie economic partnership, security, cooperation and institutional arrangements. Arguably the most important of these is the first, ie economic partnership, in which is embedded widely different approaches for goods on the one hand and services on the other, as follows.

  • On goods, the White Paper attempts to address not only the concerns of business looking for ‘frictionless’ trade with Europe but also the thorny issue of the Irish border (see my 25 November 2017 article) which remains, arguably, the single most difficult circle to square both politically and practically. It proposes what it calls a “free trade area”; but this looks remarkably like membership of the single market albeit without the European Court of Justice (ECJ), the ultimate arbiter of EU rules, having any say in the event of disputes which would be dealt with under new institutional arrangements. It also calls for a new Facilitated Customs Arrangement (FCA) under which the UK would be able to pursue an otherwise independent trade policy while collecting import tariffs (where applicable) on behalf of the EU at the UK border; this would be phased in, strongly suggesting that it would not be ready when the proposed transition period is currently due to end in December 2020. Critically, with or without the involvement of the ECJ and/or a new FCA, if the basic proposal is agreed the UK will either have to accept rules being handed down by Brussels like the proverbial tablets of stone or see any prospect of frictionless trade rapidly dissolve.
  • On services (the main focus of this article), on the other hand, a much looser relationship is proposed. Not only does the current passporting system, which gives automatic access to the EU to around 5,500 firms according to the UK’s Financial Conduct Authority, go out of the window but HMG has also abandoned its original plan to press for a mutual recognition arrangement following its outright rejection by the EU. Instead, the White Paper argues in favour of an expanded version of the equivalence regime which the EU has with a significant number of third countries, basing the case for expansion on the importance of the UK financial services sector to the single market as a whole — more on which below.

…but remains in no-man’s land

Inevitably, the White Paper has not been universally well-received — to put it mildly.

In the UK it triggered — even before it was published — the resignation of a number of pro-Brexit ministers including then Brexit Secretary of State David Davis and Foreign Secretary Boris Johnson. They and other hardline Brexiteers are particularly incensed by the free trade area proposal which Mr Johnson claimed (with some justification, in my view) in his letter of resignation would reduce the UK to “the status of colony” (a variation on his earlier claims that such an arrangement would make Britain a vassal state). They are also strongly opposed to the FCA proposal which (in common with Brussels) they believe to be far too complex — as well as, very likely, because it would mean extending the transition period (some fear indefinitely).

Post-publication, Mrs May’s government only survived the 16/17 July parliamentary debate by making four concessions to the hardline Brexiteers, the so-called European Research Group (ERG) believed to comprise between 60 and 80 MPs, within her Conservative Party. Furthermore, Mrs May struggled to see off a rebellion by pro-EU Conservatives, defeating their amendment by just 307 votes to 301. Nevertheless, she dodged the threat of a vote of no confidence before the summer parliamentary recess which began on 24 July — the ERG claiming to have at least 40 of the required 48 signatures. Then, as MPs headed off for their summer break, she announced that she was taking personal control of the Brexit negotiations from hereon, with the new Brexit Secretary Dominic Raab (a pro-Brexiteer) officially acting as her deputy but, in all probability, an increasing amount of the responsibility resting on the shoulders of her chief Brexit advisor, Oliver Robbins (who has told Parliament that Mrs May is actually unlikely to negotiate directly with the chief EU negotiator Michel Barnier despite assuming charge).

As for the EU27, in public at least Mr Barnier has been careful not to reject the UK’s proposals outright (contrary to what is being at least implied by some of the media, eg the pro-Brexit Daily Express). However, at a 20 July meeting in Brussels of European Affairs ministers from EU members states, he reportedly spoke out strongly against the services provisions in the White Paper in particular. Top of his list of objections appeared to be the fact that, if accepted, the UK’s proposal would undermine the EU’s “decision-making autonomy”, ie the principle (and current practice vis à vis third countries) that right of access to the EU’s financial services market should be determined by Brussels and Brussels alone. He coupled this with questioning how the UK could leave the single market for services while effectively remaining in it for goods — something which was always likely to be seen as “cherry-picking” by Brussels, making it a hard sell.

Why services matter so much

My very firm impression is that the importance of services to the UK economy is not understood by the vast majority of the country’s electorate (or, in all probability, many of its politicians). Certainly, throughout the post-referendum Brexit debate so far, services seem barely to have registered with the wider public relative to trade in goods and, of course, freedom of movement (which, the White Paper insists, will come to an end while implying — much to the concern of the Brexiteers — that HMG is ready to make significant concessions, euphemistically referred to as “labour mobility”, to secure better terms relative to the single market). And where services have registered, it may be that thinking has been limited largely to the banking sector, which is unlikely to attract much sympathy from the proverbial ‘(wo)man on the street’ even a decade after Lehman went under.

It is, therefore, worth recalling here some of the key data, as follows:

  • According to the Office of National Statistics (ONS), services, which have seen the most growth overall since the crash of 2008, account today for around 80% of the UK’s gross domestic product [Note: An opinion poll taken in 2016 found that, on average, those polled thought services accounted for just 46% of GDP**]**;
  • Although the importance of financial services has gone down since 2008 — the sector has shrunk by around 10% — it alone still accounts for around 12% of the UK’s GDP;
  • The resultant ‘gap’ has been filled by a wide range of IT and professional service activity ranging from law to architecture to management consultancy to security;
  • According to the ONS, in 2016 UK exports in services to the EU (plus EFTA) were worth over GBP105bn (as against GBP158bn in goods), with imports standing at GBP81bn (as against GBP266bn).

But even this presents only part of the picture as it fails to make clear the very tight relationship between goods and services. A recent article by Chris Morris of the BBC quotes as an example Rolls Royce which generates 48% of its revenue “by what it calls original equipment (goods), [while] 52% was generated by services”. He notes that Rolls Royce even makes an average loss of around GBP1.5m on the sale price of a large civil aircraft engine but it then more than makes this good on post-sale services.

Broadening out to the economy as a whole, he goes on as follows:

“…if you add up all the small service companies around the country that are part of manufacturing supply chains of one kind or another, they make up a bigger slice of the UK economy than financial services in the City of London”.

My personal view is that this is a very important point indeed.

It is, perhaps, understandable that in order to protect the interests of the City from ‘Brussels’ without a voice at the table there, HMG would want to detach the UK’s financial services sector from the single market along the lines proposed in the White Paper. However, detaching services as a whole appears to be completely unworkable relative to how modern manufacturing trade in goods actually operates — suggesting that Mr Morris is correct when he notes that small service companies “have much less influence [than the City], and usually receive far less attention in the Brexit debate”.

The interests of small service companies may be largely lost to the UK's politicians; but the EU's Mr Barnier at least understands the generic point about the relationship between goods and services, as he made clear to the press after the 20 July ministerial meeting as follows:

“In products that you use every day, like your telephone, between 20 and 40 percent of the value of the product is linked to services. How [under the proposals set out in the White Paper] do we avoid unfair competition in services?”

In looking after the interests of the EU27, the EU may therefore end up doing more to protect the interests of the UK services sector post-Brexit than Britain's politicians have to date at least.

Where does this leave the City?

At the start of this article, I offered a quote from the current chairman of TheCityUK, the main lobbying organisation in the UK for financial and related professional services, John McFarlane. In saying “it is all to play for” still he is, in my view, broadly correct — although (as I hope will become clear) I am more cautious over his suggestion that “economic logic must win through somewhere”, at least over its doing so in a timely manner. But what exactly does “all” mean in this context?

I think it is probably easiest to answer this question by starting with what it most likely does NOT mean. Notably, I think we can rule out definitely passporting from outside the single market and almost certainly mutual recognition which the EU strongly sees as too close to the single market passport.

This effectively brings us back to the question of enhanced equivalence. But, as noted, this also looks to be a hard sell, even putting to one side the wider issue of the future relationship across the services sector as a whole, for reasons neatly summed by the The Economist in a 19 July article (subscriber access only) as follows.

“Existing provisions in various EU laws allow access to financial firms from outside the bloc if their home country’s regulatory regime is deemed equivalent. Touted by City bosses as an alternate access route to Europe since the first days after the referendum in 2016, and favoured by Michel Barnier, the EU’s Brexit negotiator, equivalence might seem a shoo-in.

But its shortcomings, particularly from a British perspective, have long been obvious, too. Only some regulations, notably one governing clearing-houses, as well as another for trading, brokerage and underwriting services to institutional clients, contain equivalence provisions. Much of finance, notably bank lending and insurance, is not covered. Even where the provisions exist, applying them is up to the European Commission, which has discretion to apply the status or withdraw it at just a month’s notice.

Little surprise, then, that the British government wishes to modify the arrangement considerably. Its proposal would entail formalised supervisory co-operation between British and EU regulators, procedures to discuss changes to rules on either side, and a dispute-settlement mechanism for when one party threatens to withdraw equivalence. A charitable interpretation is that this provides a useful starting point for improving the equivalence system—after all, even the EU is unhappy with parts of the regime, such as its reliance on foreign regulators, with no role for EU oversight.

But in a world where Europe wants, if anything, to tighten the rules on equivalence, it is hard to see why it would agree to such a system. Britain could always threaten to cut off access to EU firms. But such tactics would work only if Europe saw value in accessing London’s deep markets. At least in some countries, the focus seems to be more on forcing companies to relocate. France, for instance, has recently taken the position that certain types of firm should have to set up a branch or subsidiary within the EU, even under an equivalence regime. (France is among those trying hard to woo businesses away from London.)”

This probably does not rule out totally financial services access to the single market under existing (ie non-enhanced) equivalence arrangements. But that would fall a long way short of what the City believes it needs. And it certainly would not address the difficulties inherent in trying to split goods and services in the manner proposed in the White Paper, a potentially key consideration on which I very much hope TheCityUK is quietly liaising with manufacturing and other relevant service sectors to try to establish a common position. After all, why speak for ‘just’ 12% of the UK’s economy when, in theory at least, one could be speaking for pretty much the whole of it?

If I am correct, this basically leaves us with two options (discounting Brexit being abandoned altogether), ie:

  • A no deal/hard Brexit; or
  • A somewhat softer Brexit than the White Paper envisages, in which both goods and services would effectively be inside the single market.

[Note: This being said, in an article by Chris Giles and Alex Barker published on 11 July which is worth reading if you have subscriber access, the FT comes up with five scenarios, ie:

  • “No deal” whereby the UK crashes out of the single market on 29 March 2019;
  • “Hard Brexit after transition”, ie detailed negotiations after the UK’s 29 March 2019 exit fail to secure a frictionless goods-only agreement;
  • “Customs union after transition” which, by and large, would probably be acceptable for trade in goods despite increased border frictions but which would fall well short of what the City’s hopes;
  • “Goods-only single market access”, ie something pretty close to the proposals in the 12 July White Paper, ie again falling well short of the City’s aspirations even though the UK would have better access for services than other third countries; and,
  • “Norway plus plus”, under which the UK ends up signing an EEA-type agreement ensuring frictionless trade in goods with services trade continuing as at present.

However, the first and second of these both amount to a hard Brexit with the only difference being one of timing — more on which below. And, for reasons previously set out, I do not personally see the third and fourth scenarios as likely. Thus, I stick with my two options to all intents and purposes.]

What next?

One of the most difficult questions to address confidently during the whole Brexit process to date has been when a crunch point would be reached which would not allow Mrs May to continue to paper over the Grand Canyon-wide cracks within her Conservative Party. To all intents and purposes, she succeeded — just — in doing this again this month, at least to the extent of keeping the show on the road. Furthermore, I think she will probably avoid reaching this point not only around the time of the 18/19 October European Council meeting but also until after the UK leaves the EU on 29 March 2019. A very good article by Bruno Waterfield in the 18 July edition of The Times (another pro-Brexit newspaper) explains why as follows.

“The EU’s focus on the withdrawal agreement and Ireland, rather than the Chequers white paper, dominates the timetable for the talks in Brussels….

The Times understands that Michel Barnier, the EU’s lead negotiator, is not convinced that the white paper will be the basis of final agreement on a customs, economic and trade relationship.

'No one sees this as a real landing zone, apart from the Brits,' a source said. 'The priority is Ireland and getting the withdrawal agreement over the line for autumn.'

Although European governments are divided over giving Britain access to the EU single market for goods, as set out in the Chequers plan, there is firm opposition to the proposal on customs. The Brussels strategy, diplomatic sources said, would be to fudge a separate political deal on the future, using elements of the white paper but pushing Britain towards a customs union.

'It will be a balancing act. To push for more evolution in Britain’s position without further destabilising the prime minister,' a European ambassador said.

The real substance of negotiations would then be parked until a 21-month, or longer, standstill transition period after Brexit on March 29 next year.

'The priority is to nail down the withdrawal agreement and deal with Chequers stuff after Brexit,' a source said.

Mr Barnier will redraft the text of a withdrawal treaty tabled in March, which proposed a new border in the Irish Sea by giving Northern Ireland a special status to avoid customs checks on its border with the Irish Republic. The new text would still be specific to Northern Ireland but would emphasise that checks at entry points to Northern Ireland would be technical, in an attempt to 'de-dramatise' the issue.

Changes to the language, alongside the government’s move to create a UK-wide 'combined customs territory', could, EU officials hope, paper over divisions this summer.”

[Update 1 August: Readers with access to the FT may wish to check out an article by Alex Barker published today which basically echoes The Times, ie arguing that Mr Barnier's event softer tone — see footnote below — is consistent with Brussels' immediate focus on the withdrawal terms alone, effectively pushing off decisions about the future relationship until after 29 March 2019; and with the EU's desire to help Mrs May to survive in office when she is beset by dissatisfaction with the White Paper proposals on both sides. The FT believes that German Chancellor Angela Merkel is on board with this approach; but it suggests that question marks remain over France's stance, underlining the potential importance of Mrs May's meeting this weekend with French President Emmanuel Macron. Some elements of the British press are presenting this as an attempt to "bypass Brussels" but I think this is a misreading and that, in fact, France needs to be won round to a 'kick the can further down the road' approach which is broadly acceptable to the other major players. Inevitably, such an approach will mean that Brussels will have to soft-pedal on objections to the White Paper's proposals; but it would be unwise to read this as ultimate acceptance of what could be described as the 'half-pregnant' approach of goods in the single market and services outside.]

Mrs May retreats!

I am certainly not alone among the commentariat in thinking that this approach would suit Mrs May very well. Insofar as one would use the word, as I wrote in my 22 February article, her central ‘strategy’ since last year’s disastrous general election if not since she first became Prime Minister on 13 July 2016 seems to have revolved around playing it long while trying to keep her party together and in government (as well as herself in No 10). Increasingly, it looks like this is coupled with an acknowledgement that the only way to avoid a hard Brexit is to be prepared to retreat from previously stated 'red lines', a pattern which I expect her to be looking to continue, even if only reluctantly, in the face of Brussels' pushback.

This is not to say that she — and Brussels — can definitely carry this off. Again as I noted on 22 February, one of the Brexiteers’ clear concerns is that the longer this process drags out the less likely it is that they will achieve the clean break with the EU which they are seeking. Unless Mr Rees-Mogg is as confident as he certainly tried to sound in a 21 July interview of a “no deal exit” in any case, he may well feel that he has to make a move to try to force this well before 29 March 2019 and possibly even before the 18/19 October European Council meeting. But I think the FT did James Blitz something of a disservice when it headlined his 18 July article (subscriber access only) “Jacob Rees-Mogg in the driving seat”, for the text of the piece is a good deal more nuanced as follows:

“…one returns to the question: will the Brexit hardliners dare to vote a final Brexit deal down, even if it contains a high dose of Chequers compromise? It’s hard to believe they would.

If Mrs May were to lose such a vote, the entire Brexit process would be derailed and parliament would enter a no man’s land. As the pro-European Tory Dominic Grieve argued on Newsnight last night, it’s unthinkable that the Commons would allow the country to default to the catastrophe of a no deal outcome.

Instead, momentum would flow behind the call for a second referendum (raised this week by Justine Greening). And Mr Rees-Mogg and the ERG will not want that.

At the same time, the cost to the ERG of signing up to Chequers may not be as great as it seems. After all, it is not clear how much the future UK-EU trade relationship will actually be hard wired into the Article 50 deal.”

On the issue of a second referendum, this is not, in my view, totally out of the question. But, as Professor Kenneth Armstrong made clear in a 17 July article in The Conversation following Ms Greening’s intervention, the barriers to this are far from negligible. More likely, in my view, would be another general election especially since some of the sheen appears to have come off Labour leader Jeremy Corbyn in recent weeks; but I doubt that the Brexiteers would want to risk that at this stage either, other than if they are confronted with a deal on the post-exit relationship which effectively forces their hand.

Taking all of the above into account, my base case is that we shall probably see a political fudge emerge in October which will settle the exit terms and take the UK into a post-29 March 2019 transition period with the hard issues still left to be decided.

Not great news for the City but...

Although it could be worse (eg an early hard Brexit), this is not particularly great news for the UK financial services sector. First, it leaves open the possibility of a downstream hard Brexit. Second, in principle at least the UK would still be aiming for the decidedly sub-optimal (from the perspective of the City) outcome of an equivalence-based regime in services where enhancement would remain a hard sell. Third, consequent continuing uncertainty even if the eventual outcome was indeed an EU/UK relationship under which both goods and services had full access to the single market.

In the such circumstances, it is very likely that the next few months will see more business (see, eg, recent reports of Deutsche Bank moving around half its euro clearing business to Frankfurt) and more personnel moving out of the UK and into the eurozone. This being said, I am very hesitant to speculate on job losses, credible 'best case' estimates of which by authoritative bodies such as TheCityUK, the City of London Corporation and the Bank of England range from around 5,000 to 12,000 (with much higher numbers being quoted in the event of a hard Brexit). And I am not personally clear how Brexit-related losses compare to job losses from other causes, eg post-2008 shrinkage in the banking sector, the longer-term impact of MiFID II and the growth of electronic trading.

Nevertheless, overall, even though I do not entirely share Mr McFarlane’s optimism, this does not sound anything close to the death knell of the City. And especially not if the eventual outcome is indeed a deal which gives UK services, as well as goods, full access to the single market, which I see as an increasing possibility if not yet a better than 50% probability.


No sooner had I published this article than the FT (subscriber access only) reported that Messrs Barnier and Raab agreed last week that Brussels would have ultimate control over the City's access to the single market, rather than there being an independent arbiter in the event of disputes. This runs completely contrary to the consensus interpretation (including by Brussels) of the 12 July White Paper, which HMG certainly did nothing to counter before today. In effect, this abandons any attempt to secure a special non-member status for the UK financial services sector and would place in it the same circumstances as, say, Singapore's or the United States. On the face of it, this sounds like further capitulation by the May government.

However, other reporting — almost certainly influenced by Downing Street 'spin' — is presenting what sounds remarkably like a retreat as a confrontation where the May government is threatening to block the access to European financial institutions to the City unless the UK's financial services sector continues to enjoy its present level of access to the single market. This strikes me as a high risk approach which could seriously backfire and which, again, is driven primarily by the Conservative Party's internal politics rather than by any reasonable interpretation of how best to protect the City. It is to be hoped that it is yet another 'red line' from which Mrs May will retreat in due course.

Footnote/Update 2: 3 August

The plot thickens! The British press is picking up on reports (confirmed by several individuals) of a private dinner held on 25 June of largely pro-European Conservative MPs and peers at which arch-Brexiteer Michael Gove openly discussed the idea of the UK remaining in the European Economic Area (EEA) after 29 March 2019 if no deal was reached with the EU by then, rather than hard Brexit. This would mean the UK's assuming a relationship with the EU similar to that of Norway for a period while negotiating a deal on a more detached relationship downstream (presumably during the transition period due to end in December 2020). Admittedly, this dinner took place before Mrs May sold her White Paper proposals to her cabinet (and Mr Gove's allies recently have been claiming that he is solidly with the Prime Minister in backing the White Paper proposals); but I think it should still be taken seriously. I had the pleasure of discussing Brexit with Mr Gove at a private dinner a few weeks before the referendum and I am in no doubt that he is a true believer. But I also don't doubt his personal ambition and that he is, as today's FT suggests (subscriber access only), setting himself up as the senior Conservative who could unite the party in the event that Mrs May's plan fails, eg that she secures a deal with Brussels by mid-October but fails to garner the requisite support in Parliament.

Alastair Newton