As the dust clears from the result of the UK’s referendum on EU membership, new Prime Minister Theresa May and her team must begin serious consideration of the options open to the UK. Two issues are likely to sit at the heart of the UK’s negotiation.

First, there is an economic imperative to preserve the operation of the financial services sector. UK-authorised financial firms currently enjoy a ‘passport’ to operate throughout the EU without additional authorisation. Loss of the EU ‘passport’ would damage not only intra-EU financial services exports, but also reduce the willingness of third country (especially US) firms to base European operations in the UK. According to TheCityUK, financial and related professional services account for 7% of domestic employment (two-thirds of whom work outside London), 12% of UK GDP and 12% of UK tax revenues. The EU is the largest export market for UK financial services. Its loss could be an economic disaster for the UK.

Second, in light of the significance attached to concerns about immigration in the referendum campaigning, there is a political imperative to secure a change to the terms on which immigrants are able to enter the UK. These two desiderata are widely thought to be incompatible: EU officials and senior politicians in other Member States have publicly opined that the EU’s framework is not available a la carte: we must take free movement or leave financial services. What, then, are the options for the UK?

To date, consideration of alternatives to the EU has revolved around three possibilities popularly known as the ‘Norway’, ‘Swiss’ and ‘Canada’ models. The so-called ‘Norway model’ would involve re-joining the European Free Trade Association (EFTA) and becoming a party to the European Economic Area (EEA). Ironically, EFTA membership would be a round-trip for the UK, which was the prime mover behind the establishment of EFTA in 1960 as an economically-oriented framework for trade liberalisation between European countries, in contrast to the EEC’s more politically-oriented approach. Yet over the years, EFTA increasingly became seen as a ‘waiting room’ for EU membership, from which most of its original member states subsequently graduated. Today there are just four EFTA members: Iceland, Liechtenstein, Norway, and Switzerland.

A key difference from the EU is that EFTA is not a customs union. This means that, while EFTA members agree to waive tariffs on goods and services amongst themselves, they do not agree a common policy in relation to trade with third countries. This would open the possibility, for example, to more favourable trade terms with Commonwealth countries, as was the case prior to the UK’s accession to the EEC in 1973. Nevertheless, EFTA does negotiate shared free trade agreements with third countries on behalf of its members, which the UK would be free to join or not as it wished. 

The most important such agreement is the 1994 European Economic Area (‘EEA’) Agreement, which governs relations between three EFTA members (Switzerland opted out) and the EU. The EEA entails acceptance of the EU’s four freedoms: goods, persons, services and capital. Moreover, the EEA requires contracting parties to implement as part of their ‘internal legal order’ the vast majority of the EU’s acquis (as set out in the 22 Annexes to the EEA Agreement), save for the Common Agricultural Policy, the Customs Union, the Common Trade Policy, the Common Foreign and Security Policy, Justice and Home Affairs, and the European Monetary Union.

As regards financial services, the EEA-relevant EU measures include those pertaining to company law and financial services. As a result, were the UK to become a party to the EEA, UK-authorised financial services firms would keep their ‘passport’ to market products and services throughout the EU. Moreover, UK-registered companies founded by entrepreneurs in other EU member states (of which there may be upwards of 100,000) would continue to have their existence recognised by other EU jurisdictions.

However, there are two significant drawbacks to an EEA version of the ‘passport’, as opposed to the EU version. First, the UK would no longer get any say over the content of the rules. As a member of the EU, the UK has been a highly influential participant in the legislative process. In particular, the EU’s early 21st century reforms on securities markets owed much to UK thinking, and the UK has been a vocal opponent of some post-crisis measures it views as overkill. 

Second, the ‘transplantation’ of EU legislation into the laws of EEA members is not automatic; rather, members must each consent to enact it into their domestic laws. This can lead to a lag between the enactment of EU laws and their EEA adoption. There have been particular problems with post-crisis EU financial regulation. The new European System of Financial Supervision (‘ESFS’), introduced in 2010, established EU-level agencies with delegated authority to write binding rules. Implementing this creates constitutional difficulties for some EEA members, and although the matter is a priority for the EFTA Standing Committee, it has not yet been resolved. Because the ESFS is embedded in all subsequent financial services regulations produced by the EU, virtually none of the EU’s post-crisis financial regulation is yet applicable in non-EU EEA signatories. Indeed, the majority of the EU legislation in the ‘holding pattern’ status of ‘identified as EEA-relevant but not yet adopted’ consists of financial services measures.

Financial services regulation in the EU has moved quickly since the financial crisis. If UK firms have no say in the direction of that process, and cannot be guaranteed the application of the latest measures, then the current EEA model will not be suitable for the fast-changing regulatory challenges of the financial sector. This means that if the UK seeks to sign up to the EEA, it would need to ensure at least some mechanism to improve implementation speed for financial services measures and ideally some process for securing UK input to the rules. This would be in both sides’ interests, because regardless of EU membership, their financial sectors will continue to be interwoven as a practical matter, posing a mutual source of potential systemic risk.

The EEA therefore does not look a promising avenue for the UK. Straightforwardly applied, it would involve no additional immigration control and a greatly enfeebled version of the financial services passport. Of course, the UK might try to negotiate exceptions to the EEA’s free movement parameters: Liechtenstein, for example, obtained a five-year transitional period. However, the UK’s prospects for such an ‘EEA minus’ deal seem distinctly unpromising, given the risk to the EU of setting a precedent that other member states might follow. More concerning for the UK is the risk that other EU member states, jealous of London’s success in financial services, might offer an ‘EEA minus’ version that permitted the UK to opt out of free movement but tore up the passport for financial services.

What, then, of the other options? The ‘Swiss’ and ‘Canadian’ models each refer to bilateral agreements between these countries and the EU, which could provide templates for a bilateral UK-EU deal. The bundle of bilateral measures between Switzerland and the EU cover free trade in goods, but not services, and also require Switzerland to accept the free movement of EU citizens. This configuration would clearly be unappealing to UK voters, as indeed it now appears to be to the Swiss. In contrast, the recently-negotiated Comprehensive Economic and Trade Agreement (‘CETA’) between Canada and the EU, encompasses not only goods but a wide range of services, and does not entail any commitment on Canada’s part to free movement of persons. However, its provisions on financial services (Chapter 13) do not extend anywhere near the ‘passport’ recognition enjoyed by firms authorised within the EU. Brexit optimists might argue that the UK might be in a stronger negotiating position even than Canada and so able to achieve an even better result. Yet it should be remembered that CETA has taken seven years to negotiate, that any bespoke agreement with the UK would be at least as complex, and that EU member states would have concerns about precedent-setting which would not have applied to Canada. Uncertainty blights investment, and uncertainty of the extent and duration entailed by such a negotiation could easily be fatal for much of the UK’s financial services sector.

John Armour is the Hogan Lovells Professor of Law and Finance at the University of Oxford.