August 1 marked Switzerland's national holiday to celebrate its independence from what was then the pan-European Holy Roman Empire. While Switzerland has since then carved out a clear set of rules on what, when, how and to whom it permits access to its financial markets, its bilateral relations with the European Union have been very much in the spotlight over the first half of 2019. In July, a standstill in negotiations concerning a new framework agreement between the EU and Switzerland culminated in tit-for-tat moves that saw the EU withdraw Switzerland's status of financial equivalence i.e. permitting Swiss and EU financial market participants relative freedom to access each other's markets and infrastructure. The move comes against the backdrop of Brexit negotiations and several other recent EU decisions on equivalence. Until now, no negative side effects for Switzerland have arisen, but it is unclear whether this will remain the case. This loss of equivalence status is not only of relevance to two key financial markets but also represents a proxy for the future relationship between the EU and other, what it terms "third countries".
Since 2014, Switzerland and the EU have been attempting to hash out a common institutional framework intended to replace more than 100 bilateral agreements relating to matters as varied as agriculture, labor and air transport.1 A draft agreement was published towards the end of 20182 , but no final deal was struck as the Swiss people and parliament (which is facing a general election this October) refused to concede on issues such as state subsidies, wage protection for Swiss workers, and EU citizens' right to free movement. Somewhat irked, pressured by the fear of setting a negative precedent for Brexit, and feeling pushed to finalize the framework (as its term ends on October 31), the EU Commission (the Commission) let its provisional financial equivalence agreement with Switzerland – which was contingent upon progress made towards the framework - expire at the end of June.34
On July 1, therefore, financial equivalence stopped applying to Swiss financial market rules, resulting in Swiss equity securities no longer being able to trade on EU platforms.5; Up to that date, Switzerland's primary stock exchange, SIX, had a market share of approximately 70% of trading in Swiss large cap stocks and a turnover of around CHF1,361 billion (€1,238 billion; £1,128 billion) in Swiss shares in 2018.6The Swiss stock market is Europe's fourth largest7, and several big-league Swiss companies (such as Nestlé, Glencore and Roche) are included in every major investors' portfolio around Europe. To avoid EU investors no longer being able to trade Swiss stocks on Swiss exchanges, Switzerland swiftly implemented their retaliation that same day, banning any Swiss stock listed or traded in Switzerland from being traded in the EU. This resulted in the restrictions under Article 23(1) of the Markets in Financial Instruments Regulation (MiFIR)8 no longer applying to Swiss stocks, enabling EU investment firms to trade Swiss shares on the Swiss stock exchange or exchanges in other non-EU countries. In the short term, this has led to additional inflows of capital and SIX's market share of trading in Swiss stocks increasing, as Swiss companies previously only listed in the EU returned to the motherland, aided by SIX's fast-track process.9
Breaking it down
The loss of share trading equivalence does not mean that Swiss investment firms lose the right to trade in Europe, or vice versa. Rather, it means that Swiss shares tradeable in Europe (the majority of which are also traded in Switzerland) cannot be traded in Switzerland by EU investment firms, as Switzerland no longer benefits from equivalence under Article 23 of MiFIR, which prescribes that European investment firms must trade shares on an EU or an equivalent third-country venue and applies to all shares trading on a trading venue (regulated market or a multilateral trading facility (MTF) such as the "open market" (Freiverkehr) of the Frankfurt Stock Exchange) in the EU, which was the case for a lot of Swiss stocks. This led Switzerland to prohibit the trading of Swiss stocks in the EU. Because Swiss-issued shares are now no longer being traded in the EU, Article 23 of MiFIR no longer applies to EU investment firms. This allows for EU investment firms to continue trading in Switzerland despite it no longer being deemed "equivalent" by the EU.
The EU's rationale
Whilst the EU was within its rights not to renew the equivalence agreement, it was also certainly an easily accessible bargaining chip to pressure Switzerland into ratifying the framework agreement: on the face of it, the decision had nothing to do with any technical qualities of Switzerland's exchange. Beyond the framework agreement negotiations, a number of other factors may also have influenced the EU's decision:
The Brexit perspective
The move may partially have come as a warning to the UK that equivalence, or anything else for that matter, is not guaranteed. As the UK is unlikely to reach any favorable deal with the EU regarding access to financial markets prior to October 31, it will most probably have to rely on financial equivalence10, an increasingly uncertain concept. However, not granting financial equivalence to the UK will likely lead to a response similar to that of Switzerland but with worse consequences – EU issuers could lose direct access to Europe's second-largest exchange and EU market participants subject to the European Market Infrastructure Regulation's clearing obligation could lose access to some of Europe's key clearing houses.11 Liquidnet, a global institutional investment network, even goes so far as to state that mutual lack of recognition would damage EU funds more than those in the UK, holding that at European trading venues "1% of activity is European to European, under a quarter is European to UK and international trading" and more than three quarters of activity occurs "without interaction with an EU member".12
Additionally, the suspension of Switzerland's equivalence may simultaneously be an attempt by the EU to discourage UK financial service providers from relocating to Switzerland, rather than an EU member state, post-Brexit. However, an alienated Switzerland and UK may find themselves being drawn together. A substantial amount of Swiss stock that, until June 30, was traded on European platforms was done so at venues headquartered in London.13 It is possible that Switzerland and the UK may enter into a post-Brexit bilateral agreement that is unfavorable to the EU and further reduces its leverage. This seems especially likely given that Switzerland and the UK recently struck a deal regarding their citizens' right to work in each other's countries in the event of a no-deal Brexit14, as well as a memorandum of understanding aimed at close cooperation in various areas.15
The EU's recent approach to equivalence
The EU's decision also comes against the backdrop of a flurry of activity around financial equivalence. In a recent communication, the Commission announced that new legislation on EU equivalence in the context of the European Supervisory Authorities, European market infrastructures and the prudential treatment of investment firms was to enter the "EU rulebook" shortly.16 The communication also stated that the EU, for the first time ever, stripped five countries (Canada, Brazil, Singapore, Argentina and Australia) of some of their market access rights for not having credit rating agency standards of a sufficiently high caliber for European banks to rely on.17 Whilst this highlights the EU's resolute attitude, it is neither comparable to Switzerland's situation nor indicative of the UK's fate. The withdrawal of equivalence was in response to the five countries not meeting EU Credit Rating Agencies Regulation standards, despite having had six years to amend their legislation. Furthermore, rating agencies can alternatively use "endorsement" to access the EU market by means of an EU-based group member endorsing a rating issued by a non-EU member, making the withdrawal of equivalence less critical and the EU's measure less harsh.
The communication also covers decision making on equivalence, in regard to which the Commission stated that it "will always18 seek to establish an effective technical dialogue with the parties concerned in order to ensure the robustness and accuracy of its underlying technical assessments" and "establish technical contacts with the third country concerned in order to develop its understanding of the third-country framework [...]".19 Whilst this sounds promising, the Commission clarified that meeting all technical requirements does not guarantee that it will grant equivalence.20 This is especially true for "high impact" countries (such as the UK), which require a more careful approach. Clearly then, the EU did not owe Switzerland a duty to keep financial equivalence in place even though Switzerland fulfilled all legal and supervisory arrangement conditions. What differentiates this from the UK's situation, however, is that the Commission made the extension of Switzerland's financial equivalence conditional upon "the current state of progress" regarding framework negotiations21, and no such barriers are in the UK's way. Therefore, Switzerland's situation does not necessarily foreshadow doom and gloom across the channel.
On the surface, the EU's action has not significantly affected the Swiss stock exchange market in terms of price execution or liquidity – if anything, it has benefited. However, the true repercussions may only be visible in the long term. Liquidnet says that reduced competition on the Swiss market provides investors with fewer choices and could therefore drive up costs in the future.22 Furthermore, whilst liquidity may not currently be an issue for SIX, the decline in the range of venues where both EU and Swiss companies may list shares will likely lead to a reduction in these companies' ability to raise capital and therefore their liquidity. More generally, operational uncertainty, market disruption and risk planning will also affect both EU and Swiss firms.
Despite the ramifications discussed above, the EU is unlikely to change its course of action anytime soon, given that it will likely want to appear resolute in the lead up to Brexit. If the Swiss stock market is ultimately not seriously affected, the EU may have other tools up its sleeve. Market participants should therefore increasingly "expect the unexpected". All stakeholders are advised to closely follow regulatory developments and any publications on equivalence by the Commission or other relevant bodies, as well as to consult with professional advisors on how they may be affected.
3 Financial equivalence is a tool introduced by the Markets in Financial Instruments Directive II, allowing the European Commission to recognize the financial regulatory or supervisory regime of a third country as being equal to the relevant EU framework, allowing that third country to participate in the financial markets.↩
4 "Commission Implementing Decision (EU) 2018/2047 of 20 December 2018 on the equivalence of the legal and supervisory framework applicable to stock exchanges in Switzerland in accordance with Directive 2014/65/EU of the European Parliament and of the Council" dated December 20, 2018, available here.↩
5 As equity securities traded in the EU cannot be traded in non-EU locations that have not been granted financial equivalence by the EU. ↩
9 SIX media release "SIX is Ready for the Activation of the Ordinance adopted by the Swiss Federal Council to Safeguard and to Strengthen a Strong Swiss Capital Market" dated June 24, 2019, available here.↩
10 In the broader sense i.e. not just share trading equivalence.↩
15 Memorandum of Understanding between the Department for International Trade of the United Kingdom of Great Britain and Northern Ireland and the State Secretariat for Economic Affairs of the Swiss Confederation, dated January 2019, available here.↩
16 "Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions on equivalence in the area of financial service" dated July 29, 2019, accessible here.↩
18 Emphasis added.↩
19 Page 7 of the "Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions on equivalence in the area of financial service" dated July 29, 2019, accessible here.↩
20 Page 8 of the "Communication from the Commission to the European Parliament, the Council, the European Central Bank, the European Economic and Social Committee and the Committee of the Regions on equivalence in the area of financial service" dated July 29, 2019, accessible here. ("[...] equivalence empowerments do not confer a right on third countries [...] to receive an equivalence determination, even if those third countries are able to demonstrate that their framework fulfils the relevant criteria".)↩
21 Commission Implementing Decision (EU) 2018/2047 of 20 December 2018 on the equivalence of the legal and supervisory framework applicable to stock exchanges in Switzerland in accordance with Directive 2014/65/EU of the European Parliament and of the Council, dated December 20, 2018, available here.↩
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