Now on to the difficult stuff

When the European leaders established that “sufficient progress” had been made on phase 1 of the Brexit negotiations, it marked the end of the beginning of the British withdrawal from the EU. The commitments set out in the Joint Report now have to be fleshed out in the Withdrawal Agreement. While not yet legally binding, the commitments are – of course – politically impossible to walk away from. Hence, phase 1 is not concluded yet, and the devil could very well be in the detail when commitments to citizens’ rights and the Irish border are put in writing. Many questions remain – both more systemic and practical.


“Divergers” and “Aligners”

Phase 2 of the negotiations is about the long-term relationship. The hardcore Brexiteers (the divergers) want to break free of EU laws and rules and establish an independent way – to diverge. They believe that the alternative – regulatory convergence – would make Britain a “vassal state” of the EU. The opposite view is held by the group around Chancellor Hammond (the aligners), who want to align British rulemaking as closely as possible to the EU to assure maximum access to the European market. The disagreement relates to both the transition/implementation period from 29 March 2019 to probably end 2020 (when the current EU budget period expires) and the long-term arrangement.


Although the UK will leave the customs union and single market on 29 March 2019, Hammond has stated that the UK should maintain the status quo during transition and implement whatever EU law is adopted. Divergers have already thrown tantrums, but this is the only practical way of assuring “business as usual” during transition, so that the economy only has to adapt to a changed framework once. The EU-Commission has made the same assessment. The principles for the transition period can probably be agreed upon in March, but “nothing is agreed until everything is agreed” means that even transition arrangements would have to wait for the final agreement late in 2018.


The pre-Christmas British cabinet meetings seem to have settled on seeking a free-trade agreement that allows for regulatory divergence, but encompasses financial services. To quote from the meeting readout: “a deal which secures the best possible trading terms with the EU, enables the UK to set rules that are right for our situation, and facilitates ambitious third country trade deals.” Sounds a lot like a “have your cake and eat it”-approach, which invites renewed British frustration in 2018.


All about the banks

The EU-countries now also have to set out a common position about the long run, and this is not going to as easy as agreeing on the demands in phase 1. Basically, the UK and the EU will be negotiating a trade agreement akin to the process other third-countries have been through, and the usual topics are likely to become hurdles. The EU has proposed using the free-trade agreement with Canada (CETA) as the masterplan, although all trade agreements are bespoke or unique in the sense that specific issues (e.g. soft border on Ireland) are dealt with in different ways. As CETA has already been ratified in the EU, this would be the easiest way of getting things done. Quite conveniently, CETA covers goods, the main export articles from the EU to the UK.


The EU-negotiators have not yet received instructions from the European leaders, but Chief Negotiator Barnier and his senior advisor De Rynck have made waves in the British media with statements on what is achievable on transition issues and the longer term – seen from the European side. And it all comes down to financial services; a sector that has never before been comprehensively covered in a trade agreement. It is also by far the strongest part of the British economy and the envy of many other European countries.


While the customs union is important to goods, the single market is everything to financial services. The single market establishes “passporting” rights, allowing financial intermediaries to do businesses across the EU (and EEA-countries Norway, Iceland and Liechtenstein) no matter where they are located. Switzerland, which has negotiated extensive access to the single market, does not have passporting rights for financial services, but have tried to gain those rights for years. It would be very difficult for the EU to grant access to British banks, while keeping Swiss out. However, there is no appetite for granting Switzerland further access; the EU is already annoyed by the myriad of bilateral deals that bind the two parties together.


The message from the EU’s chief negotiator on 20 November was that “The legal consequence of Brexit is that the UK financial service providers lose their EU passport.” and that “On financial services, UK voices suggest that Brexit does not mean Brexit. Brexit means Brexit, everywhere.” London does not see it that way. PM May stated on 20 December that “The City of London is … a significant provider of capital finance for Europe. There will be greater recognition for the role that the City plays.” She was joined by Mark Carney, Governor of the Bank of England, who dismissed the argument that it cannot be done, because it has not been done before.


Convergence or Canada

The discussion about the future starts with the red lines set out by PM May: taking back control of the movement of labor and leaving the jurisdiction of the European Court of Justice. The EU insists that the red lines are not compatible with a deep and special long-term relationship – all rights and obligations come together. While a typical European compromise (allow divergence, do convergence) is theoretically feasible, the statements from Foreign Secretary Johnson and other Brexiteers make it perfectly clear that part of the Brexit movement views regulatory divergence and independence as the very essence of Brexit.


On the European side, Northern European countries are viewed as more favorable to forging a compromise with the UK, but they will not tolerate any divergence (easing) of labor and environmental rules, if British goods are to have free access to the EU market. Agriculture and fishery could prove particularly tricky. France will adamantly oppose a free-trade deal that allows the UK to lower the corporate tax rate after Brexit – and will not allow financial services into the EU unless they continuously live up to at least as strict regulations as the EU.


Financial regulatory equivalence, convergence or alignment is easy enough in the short run, but the memory of the financial crisis and its causes seems to fading quickly – and global regulatory divergence for financial services is likely after the recent Basel III (or IV) hit European banks particularly hard, while the US is now rolling back financial regulation. When European authorities talk about “financial stability” in the context of Brexit, it means forcing banks to move operations to the EU27.


In the end, the UK most likely will have to make the choice between a “deep and special” relationship with a committed (long-term) regulatory convergence or a Canada-like free-trade agreement with the freedom to diverge on topics not specified in the agreement. To quote Barnier (from The Guardian) “They have to realize there won’t be any cherry picking. We won’t mix up the various scenarios to create a specific one and accommodate their wishes, mixing, for instance, the advantages of the Norwegian model, member of the single market, with the simple requirements of the Canadian one. No way. They have to face the consequences of their own decision.”


Take your pick. And with the latest parliamentary votes on amendments to the Withdrawal Bill, the British parliament will also have a say in the outcome.