In a detailed report, the House of Lords European Union Committee outlined the potential consequences for businesses and the economy as a whole if no agreement is reached on the terms of future trade.
"In agreeing the relationship between the UK and the EU post-Brexit, both sides should favour an end state allowing mutual market access," the Committee said.
"Fragmentation would lead to costs increasing and to financial stability deteriorating. The dangers of disintegration are already apparent in proposals that envisage the possibility of relocating the clearing activity of central counterparties (CCPs) to the EU, and in the political rather than purely economic calculations emerging in the broader Brexit negotiations," it said.
The Committee said that the UK's exit from the EU would not automatically mean that the UK's approach to financial services regulation would diverge from the EU's. However, it said that the UK government should not accept a future relationship where the UK relies on a designation from the EU that the UK's financial services framework is 'equivalent' to that of the EU.
"We conclude that the current equivalence regime would fail to provide the level of market access for financial services that both sides require, and that it would inhibit the UK from developing an appropriate regulatory framework," the Committee said. "The government should not settle for an agreement based on equivalence without securing substantial changes to that regime."
"There are various possibilities for a future agreement covering financial services. These include a free trade agreement to include services, a standalone mutual recognition regime, and possibly some form of so-called ‘enhanced equivalence’. We do not come to a view on which of these would be preferable, although all would be more satisfactory than equivalence," it said.
The Committee also stressed the importance of an agreement being reached on a transition period before Brexit takes full effect. The transition period should constitute a "three-stage process", it said.
"First, a standstill period, allowing time for the two sides to agree the terms of their future relationship; then, once that relationship (the ultimate destination) is known, a period of adaptation; and, finally, the seamless commencement of trade under the terms of the new relationship," the Committee said.
"Absent all these elements of transition, financial services firms will be forced to activate their worst-case scenario contingency plans, with stark implications for the continued provision of services and for financial stability," it said.
The Committee further stressed that a "nuanced approach" to the transfer of EU rules into UK national law is needed. It said that while some regulations "will need to be enshrined in statute", other EU rules could be implemented in the UK through regulatory guidance or standards.
However, any changes that the UK could make to financial services regulation post-Brexit "will be necessarily constrained by the UK’s continued participation in international fora", it said.
"The government should develop an appropriate architecture for the future domestic regulation of financial services," the report said.
The UK government should also resist any attempts by the EU to set new rules affecting innovation in 'fintech' where it would "threaten the UK’s flexible and adaptive approach", it said.
Tobin Ashby, an expert in financial services regulation at Pinsent Masons, the law firm behind Out-Law.com, said: "This report makes clear, if it wasn’t already, the scale of the Brexit challenge for financial services both in the UK and in the EU. It also stresses the need for agreement on a future framework as part of the post-Brexit deal, despite the unhelpful recent comments from the EU that financial services should not form part of future trade arrangements."
"The effort that has gone into the report highlights the importance of financial services to the UK and it presents a good overview of the issues facing the financial services industry. The suggestions in relation to the structure of a transition period to agree the framework and then adapt to it are particularly useful, as well as the proposals in relation to continuity of cross-border contracts and fintech in the UK," he said.
"However, amongst the proposals there are some important warnings. The report rightly emphasises that as an alternative to an agreed framework, the 'equivalence' regime would simply be an inadequate base for future relations between the UK and the EU," Ashby said.
"The committee has also considered a likely increase in rule-making by UK regulators in line with changing EU laws, in order to maintain the UK’s cross-border business in the sector. Whilst this flexibility could be helpful in maintaining the UK’s competitive position, the report does caution that a suitable structure is needed for the scrutiny of domestic regulation of financial services, and controls in this area will be vital to mitigate the risks of the UK becoming simply a 'rule-taker'," he said.