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    A New European Financial Landscape Is Emerging

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    The United Kingdom’s exit from the European single market on January 1 has sent trade in goods plummeting amid much confusion. By contrast, Brexit was carried out in an orderly manner in the financial sector, despite significant movement of trading in shares and derivatives away from the City of London.

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    After five years of radical uncertainty, it has become clear that the European Union and the United Kingdom will be taking separate paths on financial regulations — a financial “decoupling” that means a significant loss of business for the City. Whether the EU financial sector can gain much of what London loses will depend on the EU’s willingness to embrace further financial market integration.

    Smart Sequencing Ensured an Orderly Brexit

    As with the Y2K problem, the Brexit transition could have gone worse. It took more than luck to avoid financial instability along the way.

    First, financial firms on both sides of the English Channel (and of the Irish Sea) worked hard and were able to preempt most of the operational challenges.

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    Second, despite all the recurring high-stakes drama between the UK government and the European Commission, the technical cooperation between the authorities actually in charge of financial stability, primarily the Bank of England and the European Central Bank (ECB), appears to have run smoothly.

    Third, the negotiators phased the process in a smart way. The Brexit Withdrawal Agreement of January 2020 helped reduce uncertainty by ensuring that the UK government would meet its financial obligations to the EU, avoiding what would have been akin to selective default. That agreement kept the United Kingdom in the single market during the transition period beyond the country’s formal exit from the European Union on January 31, 2020. It also set a late-June deadline for the British government to extend the transition period beyond December 31, 2020. As London decided not to do so, that left six months of effective preparation.

    To be sure, whether an EU-UK Trade and Cooperation Agreement (TCA) would be concluded remained unknown until late December. But that mattered comparatively little for financial services, since trade agreements typically do not cover them much. By one count, the 1,259-page TCA (which is still unratified by the European Union) contains only six pages relevant for the financial sector.

    The resulting legal environment for financial services between the European Union and the United Kingdom is unlikely to change much any time soon. Contrary to occasional portrayals in the United Kingdom, no bilateral negotiations on financial services are going on, except for a memorandum of understanding expected this month that is not expected to bind the parties on substance.

    From the EU perspective, the United Kingdom is now a “third country,” in other words an offshore financial center, following decades of onshore status. UK-registered financial firms have lost the right, or “passport,” to offer their services seamlessly anywhere in the EU single market. From a regulatory standpoint, they have no better access to that market than their peers in other third nations such as Japan, Singapore or the United States.

    Equivalence Status for UK Financial Market Segments

    Some segments of the financial sector in these other third countries actually have better single market access than British ones, because they are covered by a category in EU law allowing direct service provision by firms under a regulatory framework deemed “equivalent” to that in the European Union. The equivalence decision is at the European Commission’s discretion, even though it is based on a technical assessment. As a privilege and not a right, equivalence can be revoked on short notice.

    So far, the European Commission has not granted the UK any such segment-specific equivalence, except in a time-limited manner for securities depositories until mid-2021 and clearing services until mid-2022. For the moment, the commission appears to be leaning against making the latter permanent. In most other market segments, the commission will not likely grant equivalence to the United Kingdom in the foreseeable future. This may appear inconsistent with the fact that almost all current UK regulations stem from the existing EU body of law. But the UK authorities (including the Bank of England) have declined to commit to keeping that alignment intact.

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    The commission’s inclination to reduce EU dependence on the City of London is understandable. No comparable dependence on an offshore financial center has existed anywhere in recent financial history. Such dependence entails financial stability risk. In a crisis, UK authorities would not necessarily respond in a way that preserves vital EU interests. Think of the Icelandic crisis of 2008, when Reykjavik protected the failing banks’ domestic depositors but not foreign ones. It is hardly absurd for the European Union to try to reduce such a risk, even if — as appears to happen with derivatives — some of the activity migrates from the United Kingdom to the United States or other third countries as a consequence, and not to the European Union.

    At the same time, the argument that keeping EU liquidity pooled in London is more efficient than any alternative is unpersuasive given the European Union’s own vast size. In addition, the European Commission also follows mercantilist impulses to lure activity away from London, even though these generally do not make economic sense. Added up, these factors provide little incentive for the commission to grant equivalence status to more UK financial market segments, unless some other high-level political motives come into play. None are apparent right now.

    The UK Is Unlikely to Regain Lost Advantage

    How the European Union and the United Kingdom will decouple will not be uniform across all parts of the financial system. Regulatory competition between them may become a “race to the bottom” or “to the top,” depending on market segments and the circumstances of the moment, without a uniform pattern. In any case, such labels are more a matter of judgment in financial regulation than in, say, tax competition.

    In some areas, the European Union will be laxer, while in others, it will be the United Kingdom, as is presently the case between the EU and the US. For example, the European Union is more demanding than the United States on curbing bankers’ compensation but easier when it comes to enforcing securities laws or setting capital requirements for banks. At least some forthcoming UK financial regulatory decisions may be aimed at keeping or attracting financial institutions in London, but they are still not likely to offset the loss of passport to the EU single market.

    All these permutations suggest that the medium-term outlook for the City of London is unpromising, although the COVID-19 situation makes all quantitative observations more difficult to interpret. Once an onshore financial center for the entire EU single market, and a competitive offshore center for the rest of the world, the City has been reduced to an onshore center for the United Kingdom only and has become offshore for the European Union. That implies a different, in all likelihood less powerful, set of synergies across the City of London’s financial activities.

    The few relevant quantitative data points available reinforce this bleak view. Job offerings in British finance, as tracked by consultancy Morgan McKinley, have declined alarmingly since the 2016 Brexit referendum. The ECB (as bank supervisor) and national securities regulators coordinated by the European Securities and Markets Authority are tightening requirements for key personnel to reside mainly on EU territory rather than in the United Kingdom.

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    As noted by Financial Times columnist Simon Kuper, many financial firms’ Brexit policy until this year had been to “sit tight and do nothing until post-Brexit arrangements for finance forced [their] hand.” That phase has ended. Firms that drag their feet face regulatory disruption, as happened to broker TP ICAP in late January. Tussles between regulators and regulated entities, rather than between the European Commission and the UK government, are where most of the financial-sector Brexit action is likely to be in 2021. These disputes typically happen behind closed doors, and the regulators typically hold most of the cards.

    For all the optimistic talk in London of “Big Bang 2.0 or whatever,” the United Kingdom’s comparative advantage as the best location for financial business in the European time zone is unlikely to recover to its pre-Brexit level. The macroeconomic losses could be moderated or offset by cheaper currency and less expensive real estate in London, making the city a more attractive place to do nonfinancial business. Even so, a gap will likely remain for the UK government, which has for years depended heavily on financial sector–related tax revenue.

    The European Union stands to gain financial activity as a consequence of Brexit. How much and where is not clear yet. As some analysts had predicted, Amsterdam, Dublin, Frankfurt, Luxembourg and Paris are the leaders for the relocation of international (non-EU) firms. Dublin and Luxembourg specialize in asset management, Frankfurt in investment banking and Amsterdam in trading. But EU success in terms of financial services competitiveness and stability will depend on further market integration, the pace of which remains hard to predict.

    The European banking union is still only half-built because it lacks a consistent framework for bank crisis management and deposit insurance. The grand EU rhetoric on “capital markets union” has yielded little actual reform since its start in 2014. Events like the still-unfolding Wirecard saga may force additional steps toward market integration, even though a proactive approach would be preferable.

    The one near certainty is that London’s position in the European financial sector will be less than it used to be.

    *[This article was originally published by Bruegel and the Peterson Institute.]

    The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy. More

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      Failing to Protect the Independence of the European Commission

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      I have always believed that the independence of members of the European Commission (EC) was a keystone of successful European integration. Commissioners are obliged by their oath of office to seek a European solution to problems, rather than just seek a balance between conflicting national interests. They have done so ever since 1958. This is why European integration has succeeded, while integration efforts on other continents have failed under the weight of national egoism.

      As the European Union grows, the independence of commissioners from national politics has become ever more important. Some believe the European Commission is too large. From an efficiency point of view, they have a point. But Ireland, among others, has insisted that despite this, each member state should have one of its nationals as a member of the commission at all times.

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      But if the one-commissioner-per-member-state rule is to be upheld as the EU enlarges, commissioners from all states — large and small — must demonstrate that they put European interest first and are not subject to the vagaries and passions of politics in their country of origin. In other words, European commissioners must be independent. All member states must be seen to respect this.

      This is why I am deeply troubled by the attitude taken by the Irish government, and then by President Ursula von der Leyen of the European Commission, to call for Phil Hogan to resign as EU trade commissioner. Both of them failed in their understanding of the European Union and of one of its vital interests — namely the visible independence of members of the European Commission from the politics of any EU state, large or small.

      I was genuinely shocked by what happened. Late in the evening of August 22, leaders of the Irish government called on Hogan to “consider his position.” That means to resign. They piled on the pressure thereafter, with a further statement on August 23 containing a political determination that he had broken the government’s quarantine rules to combat the spread of COVID-19 after returning to Ireland from Belgium. Hogan resigned on August 26. That was his decision and one he was entitled to make.

      Lessons From This Precedent

      But there are profound lessons to be learned by President von der Leyen — and by the European Commission as a whole — as to how and to whom commissioners should be held accountable, and a need to understand what this precedent means for the future political independence of commissioners from their home governments. Separately, there are also questions to be asked about the internal management of and the collegiality of the EC.

      I will set out my concerns here, drawing on the words of the EU treaty, which I helped draft as a member of the Convention on the Future of Europe.

      On August 26, von der Leyen clearly withdrew any active support from Commissioner Hogan and unquestioningly accepted the line of the Irish government. This influenced him to resign from his position. In this action, I contend that the president did not fulfill all of her responsibilities under the treaties. I know she faced genuine political difficulty. But the treaties were framed to deal with fraught political situations while preserving the independence of the EC and due process.

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      The European Commission is the guardian of EU treaties and should be seen to defend the rules laid down in the treaties under all circumstances, even when it is politically difficult. Article 245 of the treaty requires member states to respect the independence of commissioners. Ireland is bound by that article, after having ratified it in a referendum. One should note that Article 245 refers to respecting the independence of commissioners individually, not just to the EC as a whole.

      It is for the Irish government to say whether publicly demanding a commissioner’s resignation for an alleged breach of Irish rules is compatible with the Irish government’s treaty obligation under Article 245. But it had other options,

      If a commissioner is visiting a member state for any reason, he or she is subject to the laws of that state on the same basis as any other citizen. A visiting commissioner would not be above the law, nor would they be below it either. If they breached the law, due process in the courts ought to be applied — as with any citizen. This is what would have happened if the visiting commissioner was from any country other than Ireland and had experienced the difficulties that Hogan did, and due process would have been followed.

      The statements of the Irish government, and the unsatisfactory explanations by Hogan, created political problems for von der Leyen. She had to do something, but not necessarily what she did. Yet there were options available to her, which she inexplicably failed to use or consider.

      Rules Ignored

      Commissioners are subject to a code of conduct. Under that code, there is an ethics committee to determine if its guidelines have been breached. If the matter is urgent, there is provision for a time limit to be set for a report by the committee. Nonetheless, a reference to the ethics committee would have allowed for due process and a calm and fair hearing. More importantly, using this process would also have asserted the independence of the European Commission as an institution.

      The code says that it is to be applied “in good faith and with due consideration of the proportionality principle,” and it allows for a reprimand that does not warrant asking the commissioner to resign. Due to the course followed, we will never know if there was any breach of the code at all by Hogan.

      President von der Leyen’s failure to use these mechanisms seems to be a serious failure to defend due process and proportionality and to protect the independence of individual commissioners, as was required by the treaty. The EC and the European Parliament should inquire into why she did not do so. There are consequences now for the viability of the code of conduct if it is not to be used in a case like this.

      Criteria Not Applied

      Was what Phil Hogan did a resigning matter anyway? Article 247 allows for only two grounds for asking a commissioner to resign. These are that he or she is “no longer being able to fulfil the conditions for the performance of [their] duties” or “has been guilty of serious misconduct.” I do not think either condition was met in Hogan’s case.

      Hogan would have been fully capable of carrying out his duties while the ethics committee did its work. Instead, his position is now effectively vacant.

      Most people I have spoken to do not think the breaches committed by Hogan — while foolish — amounted to “serious misconduct” within the meaning of Article 247. Failure to recollect all the details of a private visit over two weeks, or to issue a sufficient apology quickly enough, may be political failing, but they hardly rise to the level of “serious misconduct.” Any deliberate and knowing breach of quarantine measures should have been dealt with in Irish courts without fuss.

      In any event, von der Leyen would have been far wiser to have gotten an objective view on all of this from the ethics committee before allowing Hogan to resign.

      Why Did the European Commission Not Meet?

      Another issue is the president’s failure to call an EC meeting if she was considering that a commissioner should resign. Under Article 247, it is the EC — not the president alone — that can make a commissioner resign, and even then it must be approved by the European Court of Justice. These safeguards were put in the treaty to protect the independence of the European Commission. They were ignored in this case.

      The subsequent weakening of the institutional independence of the commission is very damaging to European integration and to the interests of smaller EU states. This should be of concern to the European Parliament.

      The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy. More

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      The CO2 Border Adjustment for the EU

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      The heads of state and government of the European Union propose introducing a “carbon border adjustment mechanism” from 2023, to charge imported goods according to the CO2 emitted during their production. At their recent summit, they decided to use the ensuing revenues to boost the EU’s budget. This gives a fiscal twist to an instrument actually designed for climate policy.

      Ursula von der Leyen, the president of the European Commission, had already announced in 2019 that she would like to introduce a “carbon border tax” as part of her European Green Deal. In spring 2020, the commission launched a roadmap process to prepare concrete legislative proposals by 2021. Its proposal also responds to fears that higher European CO2 costs caused by EU emissions trading (EU ETS) could cause companies to relocate activities outside the union, causing carbon leakage.

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      Outsourcing would contribute to reducing European emissions, but not to tackling the global problem. To date, the European Union has addressed the risk of relocation by allocating free emission allowances to sectors at risk of carbon leakage. A CO2 border adjustment could create an alternative with a global impact.

      There is rising support for the idea, after years of resistance from many EU member states and business associations. And the pressure is set to grow, with an increase in the EU’s climate target for 2030 — and anticipated higher CO2 costs for EU businesses — expected this fall. Furthermore, a CO2 border adjustment for foreign products will be widely interpreted as a clear message, especially to Washington and Beijing, that the EU intends to implement the 2015 Paris Agreement. When designing the instrument, it will be important to comply with World Trade Organization (WTO) rules and to get important trading partners on board. 

      WTO-Compatible Design

      The European Commission proposes three ways in which a “carbon border adjustment mechanism” could be implemented: “a carbon tax on selected products, a new carbon customs duty or the extension of the EU ETS to imports.” From a trade law perspective, any of these options could be designed in accordance with WTO rules. The crucial aspect is the principle of non-discrimination: that a CO2 border adjustment must not differentiate among like products or between WTO members. If it were necessary to depart from the principle, for example, where a trading partner or individual company is able to demonstrate that it is already taking care of emissions reductions, the rules for exceptions would need to be observed.

      An EU-wide CO2 “product tax” and its implementation by the EU member states would be the most straightforward approach from a trade law perspective. To do this, the EU would first have to levy a CO2 tax on goods manufactured in the European Union. Then, it would be unproblematic to apply this tax to imports as well — the value-added tax, for example, follows this approach. Imported “like” products would be treated the same way as domestic products, which is WTO-compliant.

      Extending the EU ETS to industrial imports would be more complex. The task for the European. Commission would be to demonstrate that under trade law, the CO2 allowance price is ultimately equivalent to a “product tax.” Failing that, the commission could argue that it was acting to protect a global resource, i.e., that avoiding carbon leakage was the central aim of the EU legislation. The “conservation of exhaustible natural resources,” which includes the Earth’s atmosphere, is a valid ground for violating WTO principles, subject to certain conditions. Such an exemption would also have to be claimed for a new CO2 customs duty.

      However, the European Council decision has exacerbated the risk that WTO dispute settlement panels will regard the new instrument as a means of generating income, rather than a means to protect the climate. This would make a difference if trading partners challenged the new tool. The climate focus, which would be taken into account in WTO rulings, is currently slipping into the background.

      Don’t Underestimate the Diplomatic Effort

      A CO2 border adjustment mechanism will need extensive explanation given the many open details, and it can only promote international climate policy cooperation if trade partners are informed at an early stage and regularly consulted. For this, the European Union should use WTO forums and the climate regime as well as other international organizations. In 2012, the European Commission was made painfully aware of the difficulties involved in going it alone, after seeking to include international aviation in the EU ETS. Major partners put political pressure on the EU, even threatening sanctions, and the union decided to backtrack and reduce the coverage of the ETS to flights within the European Economic Area.

      Trust can only arise if the EU adheres to multilateral climate and trade agreements — i.e., supports the Paris Agreement and the troubled WTO and expresses this clearly and often. This task has probably become much more difficult after the European Council decision because a fiscally-motivated border adjustment cannot be convincingly attributed to these multilateral concerns — especially as the revenues would flow to the EU rather than to funds supporting climate protection, for example, in poorer countries. If a CO2 border adjustment specifically targeted cement, steel and other energy-intensive industries, as has already been discussed, producers from emerging and industrialized countries would be especially affected.

      The union should start discussions with these countries without delay. A good opportunity will arise at the meeting of G20 finance ministers in Saudi Arabia toward the end of the year. In addition, the EU should insist to the US that this initiative is not intended as a provocation in the smoldering customs dispute. Ultimately, the climate policy success of a CO2 border adjustment will depend on how the world’s major economies react to it.

      *[This article was originally published by the German Institute for International and Security Affairs (SWP), which advises the German government and Bundestag on all questions relating to foreign and security policy.]

      The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy. More