The Future of the City

Speaker: Andrew Bailey[2], Chief Executive
Event: Future of the City dinner, London
Delivered: 19:30, 5 February 2018
Note: this is the speech as drafted and may differ from the delivered version

Highlights

• We are treating Brexit as a high priority and will do our utmost to make it work in the interests of the people of this country.
• There is a range of operational issues arising from Brexit which, if not tackled, will create financial stability risks and issues for both the UK and the European Union (EU).
• We are working with the Government to take action to ensure we have a functioning regulatory regime from day one by implementing the EU withdrawal bill.

It is a great pleasure to be here this evening and to have the opportunity to discuss the Future of the City.

I would imagine you will be unsurprised to know that I am going to talk about Brexit. So, I need to begin with some important disclaimers. The Financial Conduct Authority (FCA) takes no position on the issue of whether Brexit is a good thing or not. Appropriately, that decision has been taken by the electorate of this country. It is our job to roll up our sleeves – though if you don’t mind, at this time of year, I will treat this as a metaphor – and do our duty, which is to serve the public interest. We are giving it the highest priority, and we will do our utmost to make it work in the interests of the people of this country.

I want to start with something that I know at other times would have been regarded as a statement of the blindingly obvious, bordering on a platitude. London is a global financial centre, just as it has been for several centuries. The world of finance has changed beyond recognition in this time, but London has remained a global financial centre, indeed the pre-eminent one. This is no longer a platitude, as I will explain.

The second important opening comment is that global financial markets are, as the term indicates, open. Free trade in financial services means open markets, and most particularly for wholesale markets which are at the heart of the City. What does this mean in reality? For wholesale markets, it means that a firm operating in the UK – whatever its legal entity status here – can trade with a professional counterparty in any other country. It's that simple on the surface.

But, of course, it isn’t that simple under the surface. What underpins that freedom to trade is not a trade agreement of the long-established sort – it's not about the World Trade Organisation (WTO), very important though the WTO is in other spheres of activity. It's not about tariffs or import quotas or licensing agreements. No. It’s about mutual recognition of regulatory standards which appropriately protect the public interest.

The public interest is paramount in terms of the framework for open markets. We can date much of the foundations of free trade back to the seminal work of Adam Smith and David Ricardo. It was Smith in 'The Wealth of Nations' who wrote that the business interest is 'always in some respects different from, and even opposite to, that of the public'. It is the role of regulation to reconcile these differences while preserving the public interest. And, in doing so, it provides the foundations and framework for open markets and thus free trade in finance.

If as a response to Brexit the European Union wishes to change the status quo, it would amount to a decision to close market access, not a decision about whether to open it. It would also be a decision to disconnect the EU from the benefits of global markets.

The big point here is that if as a response to Brexit the European Union (EU) wishes to change the status quo, it would amount to a decision to close market access, not a decision about whether to open it. It would also be a decision to disconnect the EU from the benefits of global markets. As I will come onto, in my view this would have serious adverse consequences, and by no means just for the UK. It would only be justifiable if the UK was derelict in its protection of the public interest through its regulatory standards. You will be unsurprised to hear that I would oppose this strongly. I strongly endorse the view of the European Commission as set out by Vice-President Dombrovskis, that the lesson of the financial crisis is that financial stability is best protected by co-ordinating rules and supervision. And, I would add that this is the way to preserve open financial markets. 

I want now to tackle the issues facing us in the two by now familiar parts: issues around the transition; and issues around the future steady state.

Phase One: The Transition to Brexit

There is a range of operational issues arising from Brexit which, if not tackled, will create financial stability risks and issues for both the UK and the European Union. These issues have been discussed at length in recent months, and have been set out by the Financial Policy Committee. Just as they are symmetric in impact, so they are in the mutual interest of the UK and the EU to tackle. I think this point is increasingly understood on both sides. It is not a matter of scaremongering to get negotiating advantage.

Let me briefly set out a number of them, starting with so-called contract continuity. When the UK departs from the EU, unless action is taken, a wide range of financial contracts between UK and EU counterparts could cease to be serviceable, in particular in insurance and derivatives. This could affect up to £26 trillion notional of derivative contracts (of which £12 trillion extend beyond the end of March next year) and at least 30 million EU and 6 million UK insurance policyholders. It would affect individuals, businesses, economies and financial stability.

The issue arises where services provided each way in an existing contract between UK and EU counterparties may only be provided by an entity which is either authorised in the local market or passported under the Single Market rules. Thus, when the UK leaves the EU, those relying on a passport which at that point falls away, may be in breach of local law. In most EU member states and the UK, servicing an insurance contract includes collecting premiums and paying claims. In derivatives, the same definition can include trade compression, rolling an open position or exercising an option. These actions are critical to effectively managing the risk of derivative positions, cash flow, margins and capital requirements.

If we turn to central counterparties (CCPs), if the UK leaves the EU without mitigating action on both sides, EU and UK CCPs could find they are in breach of regulation by providing clearing services in the other’s jurisdiction. This would apply to maintaining existing positions as well as taking on new positions. This would require abrupt close-out of positions, with attendant financial stability risks and costs to real economies. I would add that this risk is more acute for EU users because of the volume of activity conducted in UK CCPs.

The last issue I will set out concerns data. EU and UK firms hold and share a very large amount of data about each other’s citizens. It is thought that around three quarters of cross-border data flows involving the UK are with EU member states. The UK is a major exporter of digital data services such as data hosting and processing, and is the entry point to Europe for many global data-dependent businesses. The FCA itself is a major exporter of data on trading activity, helping other European regulators oversee firms and markets. In fact, in an average month we export over 250 million trade reports, compared with the 12 million we receive. If the UK was to leave the EU without mitigating actions on both sides, holding and sharing each other’s data may be in breach of national law.

We are working with the Government to take action to ensure we have a functioning regulatory regime from day one by implementing the EU withdrawal bill.

What is to be done about all this? We are working with the Government to take action to ensure we have a functioning regulatory regime from day one by implementing the EU withdrawal bill. The aim of the work is to ensure that, so far as possible, the same rules and laws will apply on the day after exit as on the day before and provide certainty and confidence to business. On its own, the legislation does not solve the operational issues I have just described, because they are symmetric in the sense that they affect both sides, and in important areas they result from the loss of the passport regime which goes with exit. But, there are solutions for all these issues. 

The least good – in fact bad – solutions are to leave them to firms to sort out. These solutions would be expensive, messy and prone to risk, and would take much longer to enact. The second best – but distinctly inferior – approach would be for each of the UK and EU authorities to enact solutions at the official level but independently.

The best solutions are mutually agreed and enacted so that they are consistent. And to achieve this, we need by the end of March a joint commitment by the political authorities to a well-defined Implementation or Transition Period which will create the space and support for the regulators to work with firms and political authorities to put practical solutions into place. The benefits of a transitional period go beyond the need for time to deal effectively with these operational issues, but the latter are nonetheless important. 

It can be done, and I think there is a growing consensus on both sides that it must be done. I sense this view increasingly taking hold from my discussions around Europe. But it needs support in the form of a timely commitment to a transition agreement which will allow the regulators to get on and tackle these issues. A joint agreement to get on with this is in the interest of everyone involved. And, it will give much needed assurance to firms and markets as well as regulators. As the International Monetary Fund (IMF) set out in December, a solution would be most efficiently achieved through co-ordinated official action.

We need by the end of March a joint commitment by the political authorities to a well-defined Implementation or Transition Period.

As an important step in this direction, I welcome the announcement by the UK Government and the EU in December that there should be a transitional arrangement. I also welcome the announcement by the UK Government that it is prepared to bring forward secondary legislation to ensure that contractual obligations can continue to be met in the UK. These provide important safeguards on the UK side, but do not mean that we should forsake the better outcome of a co-ordinated solution.

As part of this co-ordinated solution, I hope that the respective regulators can put in place a Memorandum of Understanding (MoU) to give effect to a stable and orderly transition which would acknowledge that firms are planning for a transition period to be in place. An MoU would be a means for the regulators to be transparent in the more practical issues around implementation, and thus that we are committed to such a period of time being available. 

We have taken an important step in the direction of contingency arrangements by introducing the plan that we would use interim permissions as a means to deal with the risk that firms are left without authorisations without due warning. We think this is an important safeguard and a sensible way to underpin financial stability. I am grateful to the Government for committing to introduce the secondary legislation needed to put such an arrangement in place.

Phase Two: The Steady State Future

Let me now move on to what the future could look like after transition. I said earlier that for me a commitment to continued open markets is at the heart of the future, and that regulatory standards operating in the public interest underpin open markets. At the heart of such an arrangement is mutual recognition of regulatory standards. This is quite different from passporting. Let me conclude on transition. As an impartial technician, I cannot stress too much that we need these arrangements in place, and co-ordinated solutions are in the best interests of both sides. We are ready with sleeves rolled up to get on and put these arrangements in place.

The European Union has a history of strong commitment to global free trade. After all, like the Bretton Woods institutions, it emerged out of the desire to avoid the horrors of war and the causes of that war, including the breakdown of free trade and the resort to protectionism between the wars. The EU is, of course, a regional trade bloc, but I don’t believe that it has ever been part of the objective of the EU to pursue regional free trade and global protectionism. The EU has a history of high ideals.

I hope that the respective regulators can put in place a Memorandum of Understanding to give effect to a stable and orderly transition.

And, we can see this in practice, in a very important way, in the approach the EU took to the Transatlantic Trade and Investment Partnership (TTIP) negotiations with the US, where the EU pursued a trade agreement which included provision for financial services. The US wasn’t ready for such a move, but this doesn’t take away from the fact that to its credit, the EU proposed such an arrangement. And what this meant was a proposal for close regulatory co-operation which could underpin broad mutual recognition and thus a commitment to ensuring open markets. The European Commission drafted a TTIP chapter on financial services. So, it turns out that it can be done, and moreover there is an extant proposal from the EU which could be a good starting point for UK-EU mutual recognition. The EU has also taken over 200 equivalence decisions on third country jurisdictions in financial services. So, when I hear that there is not a single trade agreement open to financial services, I think, 'really?'. And, it would not have to involve a loss of regulatory autonomy.

When I hear that there is not a single trade agreement open to financial services, I think, 'really?'.

If you don’t mind, I am now going to spend just a few minutes talking about fish. It's a new subject for me, so bear with me. Fish have an annoying habit. They swim across borders. What is the relevance to financial services? Well, I was struck the other day to read a set of slides put forward by the European Commission on how to deal with this annoying habit of fish, which we have to assume they will continue to do post-Brexit. So, the European Commission in its slides suggested a fisheries agreement to maintain the status quo with reciprocal access to waters, fish stocks and markets, with respect for historic rights and quotas, seeking the highest level of convergence in management regimes and a bilateral EU-UK Partnership Agreement on fisheries. It's not for me to opine on fishing policy. But, the key point is that this sounds like the fishing equivalent of open financial markets.

So, the moral of the story, to borrow a quote, 'You can get it if you really want'. And, if it is possible to envisage a partnership agreement on fishing based on convergence of regimes, of course it is possible to have open financial markets and mutual recognition of regulatory regimes, just as the TTIP proposal envisaged.

The principles for mutual recognition would look a lot like the ones we already use to authorise the branches of banks from outside the European Economic Area, namely broad equivalence of regulation in terms of outcomes, supervisory co-operation and good information sharing. We would need to add on a robust dispute resolution arrangement, but this could be done. We are used to working very closely with other regulators, it is a big part of our job given London’s international role.

And let me comment on the negative arguments – ie the arguments against not having mutual recognition. First, it is not sensible to imagine material regulatory divergence, especially in wholesale financial markets. It is a false concept. Markets are global and we cannot in practice diverge much in terms of regulatory outcomes, and regulatory arbitrage is not an allowable ground for competition.

Second, fragmentation of financial markets is not a price worth paying, for either side. Take clearing houses as a case in point; they reap benefits by being multi-currency. Segregating currencies reduces the depth of liquidity pools and increases costs. It is in no one’s interest. Fragmented markets reduce diversification and transparency, thereby increasing risk.

Finally, is it possible to properly assess the quality of regulation across regimes? Yes, and that is what the IMF does every four years in its Financial Sector Assessment Program (FSAP) reviews. So, let me repeat what the IMF said about the UK in the last review in 2016.

Five years ago, the financial system had stabilised but still faced major residual weaknesses. This FSAP found the system to be much stronger and thus better able to save the real economy. Like all systems, the UK financial system is exposed to risks. Given its size, complexity, and global interconnectedness if these risks were to materialise they could have a major impact not only on the UK but also on the global financial system. Financial stability in the UK is thus a global public good. At the same time, understanding, mitigating and staying a step ahead of the evolving risks is such a complex system, as well as a constant analytical and policy challenge for UK policy-makers and regulators. 

Conclusion

Whatever view you take on Brexit, I think we all agree that financial stability comes first as a common objective. It would have been easy in the aftermath of the financial crisis to conclude, wrongly in my view, that the better way to achieve financial stability was to step back from open financial markets. To the great credit of everyone involved, led by the G20 and the Financial Stability Board, that did not happen, and instead regulation has been strengthened to protect financial stability and provide the necessary foundation for open markets.

In the UK, the authorities recognise and take into account the global systemic financial nature of the financial system, and where necessary we enact higher standards to reflect this. In short, of course it is possible to have open financial markets based on mutual recognition of regulatory standards, and of course it is possible to assess the application of those standards to ensure broad equivalence.   

Thank you.