Most discussions surrounding trade tend to focus on the trade of goods. Physical items, whether primary or manufactured products, are inherently tradeable. Services, restricted as they are by their personal nature and therefore by the bounds of language, custom, culture and local regulation or licensing, used to be less tradeable, but this has changed as a result of technological, regulatory and market developments.

The services sector is increasingly the largest sector of any economy. Services currently account for approximately 70% of the European Union’s (EU) gross domestic product (GDP), and make an equivalent contribution to employment in the EU. Accelerating since the policies implemented under Margret Thatcher in the 1980s, the UK’s economy is even more services focused. In 2018, about 81% of UK’s economic output was made up of services.

As the services sector has grown, so too have opportunities to specialise in specific types of services and to trade these services across several jurisdictions. So, while the UK runs a consistent trade deficit in respect of goods, in services, it runs a surplus both with the EU and the rest of the world.

The UK has been able to develop its financial services sector to the point that London has vied with New York as being the foremost financial centre in the world. A big part of the competitiveness of London as a financial centre has to do with the UK’s participation, through EU membership, in the single market.

The development of the financial services sub-sector has benefited both the UK and the EU. London and its surrounding areas have become one of the most prosperous regions within the EU. EU countries have benefitted from the “deep capital markets” based in London, themselves a function of the scale and the number of market participants in the financial services sector ecosystem.

The increasingly important role of services and services trade is well recognised in global trade. Services featured in the Uruguay Round of negotiations which culminated in establishment of the World Trade Organisation. The first multilateral agreement on services trade – General Agreement on the Trade in Services (GATS) came into force in 1995. GATS sought to replicate what had already been achieved over many years, starting from 1948, with the General Agreement on Tariffs and Trade (GATT) in respect of goods.

GATS identifies four “modes” of supply of services, namely Mode 1 – Cross-border services mostly supplied via the internet; Mode 2 – consumption abroad such as tourism; Mode 3 – Commercial presence, such as local subsidiaries of foreign-owned companies; and Mode 4 – delivery of services of a national of one country within the borders of another country.

Of some interest, is the recognition of Mode 5: the embodiment of services in goods. Smartphones are the obvious example. The physical product is the device we hold in our hands, but the value of the product is via the software or applications (apps) either embedded or specifically downloaded on the device. Mode 5 services is the services content embodied in goods exports. The way we consume is being dramatically altered; software and software updates are increasingly key differentiators in products like the cars we drive.

Indeed, the combination of physical product and embedded software raises the question of whether one really owns a software enabled device. Until recently, after purchase and delivery of a product, it was yours to do with it as you pleased: use it in its intended purpose or any other purpose. Take it apart, repair it, modify it, improve it, use its parts in another device and so on. Now, these rights are not so clear. The embedded software has its own copyright and the vendor can limit the ways you can use the device including who is entitled to repair or service it. Already this has given rise to a “Right to Repair” movement .

The EU we know today is much less about a customs union and more about the so-called single market underpinned by the indivisible “Four Freedoms”. These are the freedoms of movement for goods, capital, services and labour. Three of these four freedoms are essentially about the trade services.

Ironically, it was a British official, Lord Arthur Cockfield, delegated by Margret Thatcher’s government, who was the principal architect of the single market that finally found expression in the Maastricht Treaty of 1992.

Still, most financial sector and prudential regulation has remained a national competence. Indeed, one of the weaknesses of the Euro single currency has been blamed on the relative weakness of the European Central Bank, and that the Euro currency would need a deeper banking union which would regulate all banks in the Euro area.

So while financial sector regulation is national, the single market has meant that UK financial services firms have had what is commonly known as “passporting rights.” What this has meant is that financial services can be provided from the United Kingdom to the EU (and the other way around) with a single local authorisation or ‘passport’ per relevant financial services area. On 1 January 2021, this will cease to apply.

While this change will have obvious negative consequences for the UK’s financial services sector, it will also have negative consequences for the EU and companies operating in the EU which use and benefit from the various financial services provided from the UK. The extent of the potential disruption was the subject of a study by the European Central Bank (ECB) in March 2020.

What the study found is that reliance on UK based financial firms in derivatives clearing is very pronounced. Almost 80 per cent of all euro area clearing members’ Over the Counter (OTC) derivatives positions were cleared through UK based Central Clearing Party platforms. UK based merchant banks also play a significant role in euro area bilateral OTC derivatives markets. The study notes that these institutions play an important role in the provision of liquidity to euro area markets. The UK is also host to a significant insurance sector and leads jurisdiction in asset management.

The ECB study also notes that UK based merchant banks are key providers of financial services to firms based in the EU and that many global investment banks located themselves in London and access the EU from there. These banks are important both in facilitating access to capital markets and providing a number of services such as debt and equity issuance, mergers and acquisitions, and structuring/arranging syndicated loans.

The European Central Bank’s study makes the point that while the loss of these passporting rights would not create financial or prudential risks, the EU would, over time, have to build the equivalent capacity lost through the departure of the UK from within the EU itself.

The extent of the changes will only to a very limited extent depend on whether the UK and the EU can agree on a trade in services deal before the end of the year. It is inconceivable that any trade deal that might be able cover the trade in services and especially financial services which replicate the existing passporting rights within the current single market.

As expected, UK negotiators have sought to retain access to the EU market. Access to the EU market in services, particularly financial services, is based on the concept of “equivalence.” Financial services providers from third countries may gain access to EU based customers if the EU recognises that the regulatory or supervisory regime of that non-EU country is equivalent to the corresponding EU regime. The problem, as some argue, is that the rights of access apply to very specific defined services and that at present, there is a patchwork of different regulatory requirements and supervisory procedures for each defined service.

The trouble is that just as equivalence can be granted, the EU institutions granting such equivalence can withdraw it. Given that the whole purpose of leaving the single market is to allow the UK to diverge from EU regulation, the question of continued equivalence recognition comes into sharper focus. In its negotiations covering financial services, the UK seeks to have “clear and coherent” structures in place in the event equivalence is withdrawn by either party. The EU is not inclined to have its discretion in this area circumscribed by any third country.

A 2018 paper by trade specialist Sam Lowe of the London-headquartered Centre for European Reform asks the question, following Brexit, how deep can the UK-EU relationship go. Lowe points to the recent Free Trade Agreement with Japan to show how much openness in services the EU is willing to tolerate without the rules and institutions of the single market. One of the difficulties in the negotiations should there be a narrower agreement limited to an enhanced equivalence regime for financial services is that the EU’s current third country equivalence regime is open to all countries that meet the qualification criteria consistent with the EU’s GATS commitments (GATS Article VII and paragraph 3 of its Annex on Financial Services). Expanding the scope of equivalence simply to accommodate the UK would require a broader internal discussion of the EU’s offer to the rest of the world.

At present, talks between the UK and EU negotiators appear to have stalled once again. The European Commission’s 9 July communication provides an update. It states that the EU’s equivalence frameworks do provide the basis for facilitating specific interactions between the Union and UK financial systems, and that the Political Declaration that accompanied the Withdrawal Agreement adopted by Council decision on 30 January 2020 stated that both the EU and the UK will endeavour to conclude their respective equivalence assessments before the end of June 2020.

However, while the Commission had shared questionnaires covering 28 equivalence areas, by the end of June 2020, only 4 completed questionnaires had been returned. On that basis, the Commission could not conclude its equivalence assessments. In addition, while it would continue the process of undertaking assessments, it was non-committal on the outcome of these. On this basis it advises insurance operators, banks, investment firms, trading venues and other financial services providers to finalise and implement their preparatory measures by 31 December 2020 including that there will be no equivalence decisions taken by the EU or the UK.

To underscore the rather discordant nature of the negotiations, a few days previously, work was continuing with the EU to assess equivalence, and given that successfully concluding equivalence assessments would be in the UK and EU’s mutual interest, the UK’s Treasury could “see no reason why the UK and EU will not be able to find each other equivalent across all existing equivalence regimes”.

It is not unfair to say that the financial services sector does not wait to see how matters will unfold. Driven by the loss of passporting rights, UK based financial services firms can pursue three options namely: setting up subsidiaries in the EU; setting up new branches; and expanding existing subsidiaries/branches. In essence, UK headquartered firms are relocating parts of their activities into the EU. Most of these are relocating to Germany, Ireland, the Netherlands and France.

There are several additional implications of the move out of London. For many, the City of London has been a one-stop place to access a number of financial services and access capital markets whether for the UK, the EU or indeed, the rest of the world. London’s singular advantage, namely the deep and liquid capital markets operating from there, will shift but to several other EU based financial centres. The EU will seek to complete its capital markets union (CMU) to ensure strengthened capacity in areas where the EU financial system has relied on London. This covers markets for equity capital/financing, private equity and venture capital.

A multi-centred financial sector may well require regulation to promote the efficient interaction of different EU financial hubs and perhaps more centralised oversight and supervision of markets. Whether these efforts will result in an outcome that can match or narrow the comparative advantage that the UK presently has in a range of financial services and access to capital markets, remains to be seen.

How the UK responds also remains to be seen. On the one hand, the rise of London as the EU’s financial services hub was partially a consequence of the single market rules. London has long been a magnet for people and firms from the EU and around the world wanting to make it in finance and the ecosystem that developed around it from corporate lawyers to high-end restaurateurs and a myriad of other ancillary services. But it also made London a place where many were, in the words of ex-Prime Minister Theresa May, “Citizens of the World”, and consequently, “Citizens of Nowhere”.

Two options present themselves: The UK’s financial services sector can seek to achieve maximum conformity with EU rules and to use the weight of its current market advantages and know-how to both informally shape those rules and defend its market share. The other option is to go it alone, double down on the “Citizen of Nowhere” theme, bet against the ability of EU regulated firms to replicate or compete with London and try to become a Singapore-on-the-Thames by remaining an indispensable source of capital to European customers.

With just five months remaining until the UK is no longer part of the EU, so much remains to be done and it is far from clear how it will all turn out.