London/Madrid: A gap in EU financial rules is allowing member countries to compete to host the trading operations of London-based investment banks after Brexit by offering looser regulatory standards.
The European Central Bank (ECB) is the euro zone's banking supervisor but, under EU law, does not have direct responsibility for the divisions of banks that conduct most of their market trading — broker-dealers — even though they are some of the most complex and riskiest parts of their businesses.
This is largely because when the ECB became responsible for euro zone supervision in 2014 the bulk of broker-dealers were in London and therefore not under its purview.
This means banks now looking to relocate these operations, to continue to trade continental securities after Britain leaves the EU, will have businesses approved and supervised by the national markets regulator of whichever country they move to.
Countries hoping to lure banks to their financial centres after Brexit are offering differing regulatory standards, raising fears at the ECB that they could be subject to light touch supervision and undermining its aim of making financial regulation consistent across the bloc.
Such inconsistencies mean broker-dealers trading the same markets in Europe could be subject to different regulatory requirements and raise the prospect that some would take on more risks than other regulators would deem appropriate.
"Regardless of balance sheet size, it's currently the national regulators who will have the authority to approve and regulate the broker-dealers. That is raising concerns of inconsistencies emerging," said Vishal Vedi a partner at Deloitte who is advising banks on how they will need to reorganise as a result of Brexit.
Across the euro zone, the likes of Frankfurt, Dublin, Luxembourg and Madrid are vying to lure banks, hoping to benefit from the tax revenues and jobs they would bring.
Regulation is one way to differentiate themselves.
One area in focus is the extent to which national regulators will allow broker-dealers to conduct "back-to-back" trading. This is where a bank would conduct trades - for example, buying European securities — out of its EU base but process and risk manage the transactions at its London office.
This would minimise the and number of people a bank would have to move to Europe after Brexit as much of the trading and risk could continue to be overseen in London.
But it would mean regulators in that country and the wider euro zone would not have supervisory control over the people and units that are conducting the trading and managing the risks, with minimal amounts of capital held locally at the EU unit.
Spain's markets regulator CNMV has said it wants to make Madrid "the most appealing option for investment firms considering a move from the UK to another EU country".
According to people advising investment banks on where to move, CNMV has said it would consider allowing broker-dealers to back-to-back 100 per cent of their trades. Other regulators have also said they would allow some back-to-back trading, although will require a portion of the trades to be managed locally, those people said.
"We can look into it, but we will see how this plays out and what the regulatory framework will look like in two years' time," a CNMV spokesman said when asked whether it would allow 100 percent back-to-back trading.
CNMV said in December that while it wanted to be the most welcoming place in Europe for UK financial firms, it would not accept "totally empty shells" or breaches to EU securities rules.
Germany's regulator Bafin has meanwhile said it would consider the limited and temporary use of back-back arrangements, according to an official there, but has indicated that it would expect banks to eventually establish a substantial operation in the country.
The approach by some regulators to Brexit has created resentment among some countries. Last month Ireland complained to the European Commission that it was being undercut by rival cities competing to host financial firms looking for a European Union base outside London after Brexit.
The EU's European Securities and Markets Authority (ESMA) has been studying ways to limit unfair competition among the bloc's national securities regulators.
It declined to comment for this article.
So far, banks are showing no signs of flocking to Madrid, citing other factors such as Spain's relatively low sovereign credit rating as a reason not to go there.
Countries are also diverging in how banks' risk models for their broker dealers would be assessed, with some saying they would be approved immediately if they were to use the same model to the one they use in Britain.
"Regulators differ in their approach to risk models — particularly around the level of reliance that they will be prepared to place on models which have already been approved in the existing UK entity and the amount of pre-assessment they will do themselves," said Deloitte's Vedi.
Most banks — publicly at least — have yet to make a final decision on where they plan to set up their broker dealers after Brexit, and executives say they are sceptical about whether they will be allowed to use workarounds like back-to-back in the long term.
"We do suspect that following Brexit, there will be constant pressure by the EU not to 'outsource' services to the United Kingdom but to continue to move people and capabilities into EU subsidiaries," JPMorgan Chief Executive Jamie Dimon said in his annual letter to shareholders on Tuesday.
The ECB has warned banks that if they try to cut corners by asking for back-to-back deals, they will be disappointed. But currently it does not have the legal authority to oversee broker-dealers, though sources say it is quietly trying to put pressure on countries they think are offering lower standards.
The ECB declined to comment on Spain or 'back-to-back' arrangements more broadly, but instead pointed to previous comments by its officials.
Sabine Lautenschlaeger, an ECB executive board member, expressed her concerns on the issue in March when she said there could be changes to EU laws to bring broker-dealers under the ECB's supervision.
"Needless to say that I would certainly not accept banks booking all exposures with the euro area entity while having their risk management and internal control systems outside the euro area," she said.
Regulators like CNMV are currently free to cut deals as long as they don't breach EU securities rules, but the bloc's regulatory landscape could change within a year or two and cast a shadow over any deals on regulation agreed now.
The EU's executive European Commission has proposed that non-EU banking firms with banking and broker-dealer operations with total assets of more than 30 billion euros in the EU, should set up an intermediate holding company inside the bloc.
An intermediate holding company would come under direct ECB supervision in euro zone countries.