Eurozone’s fate hangs on Brexit deal: Q&A with Barney Reynolds, leading City lawyer

Barney Reynolds is a partner at US law firm Shearman & Sterling, and a leading authority on the UK’s financial services industry and relations with the European Union. Here, Maggie Pagano talks to him about where we are in the Brexit talks, why the UK should leverage its financial muscle and why we should walk away if there is not a deal that works.

Reynolds is also a man with a plan for how best the UK and the EU can continue going about their business with minimum risk to either party in financial services. This is what’s known as “Enhanced Equivalence.”

Under Enhanced Equivalence, the EU would allow UK financial businesses to trade in the EU under UK law, so long as UK regulations meet international standards and outcomes.

Reynolds, whose concept of Enhanced Equivalence is now central to the Brexit talks, also believes that if the UK and the EU cannot agree terms of a deal by the deadline, the UK should tear up the Withdrawal Agreement and the Political Declaration, walk away and not pay any of the remaining money agreed.

He also argues that the UK’s position as a mitigator of risk with regard to the state debt of the Eurozone countries should be used as leverage in negotiations across the continent, and that world powers such as the US should put pressure on the EU because of the systemic risk to the global financial system.

Maggie Pagano: The latest round of negotiations between the Brexit Sherpa, David Frost, and the EU’s chief negotiator, Michel Barnier, has concluded without reaching “an early understanding on the principles” underlying any agreement. Both sides say there is substantial disagreement on the so-called “Level Playing Field” and fisheries, but Frost is hopeful that an outline can be reached in September. How close do you think they are?  

Barney Reynolds: Well I think they’ve done 80% of the agreement, as they have in fact said. I think the EU will end up complying with its best endeavours and good faith obligations to respect UK sovereignty in these negotiations. I think we will get a reasonable deal for goods. I’m bullish on the replacement of the WA and the Protocol with sovereignty-compliant arrangements since the EU have effectively already agreed to this (in article 4 of the Political Declaration) and it reflects the legal realities of Brexit anyway.  I think we won’t bind ourselves into their defence structures in a way that we’re not comfortable with. I think we’ll ultimately get a sovereignty-compliant agreement.

The remaining bit of the jigsaw puzzle that I don’t yet know about is financial services. This is partly a question of political will. There’ll be a moment when the UK will be confronted with the possibility of having to say “this deal’s not good enough because it hasn’t got services, including financial services.” Are we prepared to do that?

Secondly, there’s the Eurozone leverage that I’ve written about before. Are we prepared to use that? And if so, how? To my mind this is the biggest weak point of the EU, because they can’t do anything about it. Not quickly enough, anyway.

This recent escapade (the EU summit which signed off on the Covid recovery fund of grants and loans) has shown that they can make minor adjustments, but they can’t solve the whole thing by mutualising all the existing debt.

They’ve got a problem with the system, which involves the dumping of financial risk on the UK, US and others, which we mitigate. We’re happy to carry on doing so if they play ball. That’s the bit we need to play out, because I don’t think it’s in the public domain yet. I don’t see the EU feeling pressure on that point. And I think the Americans should be concerned about this topic also.

MP: Ok, so on the Level Playing Field and fishing rights, are they anywhere near to an agreement? 

BR: Yes, despite the heels being dug in I believe these points will be dropped by the EU, as they must be because they are incompatible with UK sovereignty and therefore absurd. They will just get dropped at some point and then we’ve more or less done it. But I don’t think we’ve yet got the full Enhanced Equivalence deal for financial services into the mix, and we need to ramp things up on that front. We need to be a little bit more direct in exposing the Eurozone risk situation and what they’re doing. I think that’s going to trigger a sticky moment, because the EU don’t like talking about it, but what else can we do? It’s there, it’s a problem.

MP: Can you give more detail about what you call the dumping of risk and why the UK should use its leverage within the EU over sovereign debt?

BR: Under EU regulations, state debt from Eurozone countries, such as Italy and Greece, is registered as sovereign, and therefore risk-free. But these countries don’t have their own currency. They have adopted the euro. Therefore, their ultimate monetary authority, the pan-Eurozone European Central Bank, is not under the control of their own government. As such, any debt cannot be sovereign. True sovereign debt is like cash – i.e. the best form of liquid asset – since the sovereign issuer need never default. It can always print more money to repay its debts. But no Eurozone member state controls the ECB, so there is a risk of default there which is not present for sovereign debt.

EU financial regulations conceal this financial risk, which is dangerous to the world economy. The Eurozone system has misleadingly treated member-state debt as sovereign for years.

This matters because a crash caused by unmanaged Eurozone risk could unleash financial and economic carnage, greater in scale than 2007. In truth, the problems go even deeper still, as perilous and opaque accounting practices further mask systemic problems in the EU.

The UK currently protects the world system (plus the UK itself) and mitigates Eurozone risk through its application of top-up requirements to banks based in the City of London.  But this protection will not automatically continue on the current basis after Brexit, unless the two parties can put their heads together and agree a mutually beneficial trade deal on financial services, such as Enhanced Equivalence, which is now the preferred outcome for the government.

Failure to foster a deal could lead to disaster for the Eurozone and the world’s savers and investors who are all indirectly exposed to the Eurozone problem. A small spark in a minor bank could set off a meltdown of the global financial system. This would work in ways similar to the 2007-8 financial crisis that arose because central banks globally had under-appreciated the (then much smaller) systemic risk arising from California, Florida, Nevada and other US state sub-prime mortgages.

If the 19 Eurozone countries were to try and build a similarly robust system to that comparable today with the City of London, albeit on a smaller scale reflecting the domestic rather than global nature of the Eurozone’s markets, this could take decades and hundreds of billions (if not trillions) of euros of liability.

MP: Can you explain your solution in more detail?  

BR: Actually you summarised it nicely at the outset. The proposition is for an agreement based on an enhanced version of the EU’s existing concept of equivalence which would enable UK-based financial trade and services provision to continue to take place from London across the EU, under UK law and regulation, and for the UK to continue to safeguard the world economy from Eurozone risk, as it has done now for many years. UK standards would be recognised so long as they met international standards, particularly the Basel Rules (which they do anyway). This approach is one which I have called Enhanced Equivalence, and I set it out in detail a few years ago. The UK government adopted it in the post-Chequers White Paper (and onwards) as our proposed model for trade in financial services post-Brexit.

Such an arrangement is in the EU’s own interests as well as ours, so that the Eurozone is not polluting the whole world, putting investors at risk, and that the risk they create is mitigated.

Barnabas Reynolds is a partner at Shearman & Sterling LLP and Global Head of the Financial Services Industry Group. He is the author of numerous reports on financial services and Brexit for the think tank Politeia. His most recent publication – “Non, non, M. Barnier!” – lays out his proposals for a deal on financial services in the wider context of the UK-EU negotiation.