Should Britain decide to leave both the EU and EEA as a result of a “Brexit” vote on 23 June 2016, the impact on UK and EU financial services firms could be significant.
The City of London is Europe’s key financial centre and one of the world’s leading financial centres. As such, asset managers, investment banks, retail banks, broker-dealers, corporate finance firms, and insurers choose the United Kingdom to headquarter their businesses, anchoring themselves in a convenient time zone and location from which to access the European and global markets.
A central plank of the European Union’s vision for a single market in financial services is that financial services firms authorised by their local member state regulators may carry on business in any other member state by establishing a local branch or by providing services on a cross-border basis without the need for separate authorisation in every host state. UK-based regulated asset managers (e.g., long-only, hedge fund, and private equity), banks, broker-dealers, insurers, Undertakings for Collective Investment in Transferable Securities Directive (UCITS) funds, UCITS management companies, and investment managers of non-UCITS (known as alternative investment funds or AIFs) have a passporting right to carry on business in any other state in the European Economic Area (EEA) in which they establish a branch or into which they provide cross-border services, without the need for further local registration. Passporting also facilitates the marketing of UCITS and AIFs established in the EEA (EEA AIFs) into other member states.
Members of the EEA (which comprises the 28 EU member states and Norway, Liechtenstein, and Iceland) are subject to the benefits and burdens of the financial services single market directives and regulations, including passporting rights. One outcome of a vote to leave the European Union in the UK referendum to be held on 23 June 2016, would be that the UK leaves the EU but decides to remain in the EEA (with a similar status to, say, Norway)—in which case the impact of a “Brexit” on the financial sector would likely be minimal. Another outcome would be that the UK finds it unpalatable politically to leave the EU whilst remaining in the EEA and therefore decides to leave both the EU and the EEA; it is this scenario that would have significant impact on both UK and EU financial services firms.
This LawFlash assumes the latter outcome, save where otherwise indicated.
Effect on Passporting for UK Financial Services Firms
According to figures released by the European Banking Authority (EBA) in December 2015, more than 2,000 UK investment firms carrying on Markets in Financial Instruments Directive (MiFID) business (e.g., portfolio managers, investment advisers, and broker dealers) benefit from an outbound MiFID passport, and nearly 75% of all MiFID outbound passporting by firms across the EEA is undertaken by UK firms into the EEA. Notably, according to the EBA, 2,079 UK firms use the MiFID passport to access markets in other EEA countries, and the next two highest totals in the EBA list are Cyprus (148 firms) followed by Luxembourg (79 firms). EEA-wide, there are around 6,500 investment firms authorised under MiFID. The United Kingdom, Germany, and France are the main jurisdictions for more than 70% of the MiFID investment firm population of the EU; more than 50% are based in the UK.
We consider that these figures suggest that Continental consumers potentially stand to lose more than UK consumers in terms of the cross-border provision of financial services in the event of a Brexit, which could be a driver for the UK being given a special deal to permit access to continue, although this needs to be weighed against the political imperative that the remaining EU countries would likely feel against being seen as being too accommodating to a country leaving the EU.
In the event of a Brexit where the United Kingdom leaves the EEA, unless special arrangements for the UK were to be agreed between the UK and the EU, and subject to the more detailed comments below, UK firms would cease to be eligible for a passport to provide services cross-border into, or establish branches in, the remaining EEA countries (rEEA) and to market UCITS and AIFs across the rEEA. Instead, local licences would be required, and the use of relatively low-cost branches in multiple member states may have to be reassessed. UK-authorised firms no longer able to passport into the rEEA but wishing to do so would need to consider moving sufficient of their main operations to an rEEA jurisdiction in order to qualify for a passport.
Effect on UK Financial Services Regulatory Law
The EU is a major source of UK financial services regulatory law. Recent UK parliamentary research estimates that EU-related law constitutes one-sixth of the UK statute book. That figure does not include the deposit of more than 12,000 EU “regulations” which take direct effect in each member country (including the UK) in contrast to EU “directives” which must be implemented or “transposed” in local law by each country; EU regulations would cease to apply in the UK post-Brexit. In addition, it would be necessary for the UK to renegotiate or reconfirm a series of EU negotiated free-trade deals that would not automatically be inherited by the UK upon Brexit. Post-Brexit, the UK would need to legislate to “renationalise” voluminous laws rooted in the EU and fill any regulatory gaps in UK legislation once the EU treaties ceased to apply.
It would be open to the UK merely to incorporate directly applicable EU regulations into UK law. This might be the easiest course of action, given the volume and breadth of issues which would need to be addressed by the UK government in the event of a vote to leave the EU.
Accordingly, in contrast to the impact that the UK leaving the EEA would have on passporting, the UK regulatory environment for financial services firms may not change dramatically in the event of a Brexit, at least in the short-term. Furthermore, any subsequent changes to the UK regime are more likely than not to be deregulatory in nature and therefore favourable to UK firms. In relation to the AIFMD, to take one example, the UK government would have the option to introduce a more tailored and proportionate regime for fund managers managing AIFs with lower risk profiles.
Planning for a Brexit is difficult without knowing what a post-Brexit landscape would look like (as yet, this is a “known unknown”). However, in the run up to the UK referendum, it seems prudent for UK financial institutions to consider the impact of a Brexit on the terms of any new contracts being entered into and, if relevant, seek to make provision for a Brexit (e.g., by including Brexit in a force majeure provision; providing for termination rights in the event of a Brexit and adapting references to the EEA to continue to cover the UK, if appropriate).
Passporting aside, UK firms will also need to assess the practical issues that would arise in the event of a Brexit. For instance, investment strategies that permit investments in the EEA may need to be amended in order for investments in the UK to continue to be permitted. Similarly, a Brexit may impact the terms of product distribution agreements and other service agreements.
Alternative Investment Fund Managers Directive (AIFMD)
If the UK were to leave the EEA, then, potentially: UK AIFMs would be treated as non-rEEA AIFMs, marketing by UK AIFMs of AIFs to rEEA investors would have to be undertaken on the basis of member state private placement regimes, and UK AIFMs would no longer be able to manage (from the UK) an AIF established in an rEEA member state without being locally authorised in that member state to do so. Further, UK AIFMs that utilise AIFMD passports for MiFID investment services to provide segregated client portfolio management and/or advisory services on a cross-border basis would cease to be able to use those passports. Conversely, rEEA AIFMs that seek to manage or market AIFs in the UK or provide MiFID investment services to clients in the UK in reliance on AIFMD passports would no longer be able to do so.
However, unlike other single-market directives, the AIFMD provides for its regime to be extended to non-EEA managers, and this offers a potential “third way” should the UK not remain in the EEA. If the UK were to leave its current AIFMD compliant regime in place, it ought to be technically straightforward, following a Brexit, for the AIFMD to be extended to the UK. In this scenario, UK AIFMs could continue to be authorised under the regime and be entitled to use the AIF marketing and management passports (a non-rEEA manager passport). This possibility may influence the UK government to leave the current UK regime unchanged in the event of a vote to leave the EU. However, any such extension of the AIFMD would require a positive opinion from the European Securities and Markets Authority (ESMA) and a decision by the EU Commission, so there would be a political dimension to it that would likely introduce uncertainty.
It is important to note, though, that the use by a UK AIFM of a non-rEEA manager passport would be subject to a number of conditions prescribed by the AIFMD that would have material practical implications. In particular,
- a UK AIFM would need to be authorised by the regulator in its rEEA “member state of reference” (this would be determined in accordance with the AIFMD by reference to where in the rEEA the manager is proposing to manage and/or market funds). This regulator could not be the Financial Conduct Authority (FCA), so the use of a non-rEEA manager passport would involve dual regulation and supervision—by the FCA in the UK and by a regulator in an rEEA country in relation to compliance with the directive for funds managed or marketed in rEEA countries (the guidance and approach to application and interpretation of the directive by the regulator and local rules in the member state of reference may well differ from that of the FCA);
- it would be necessary to establish a legal representative in the member state of reference in order to be the contact point between the manager and rEEA regulators, and the manager and rEEA investors. The legal representative would be required to perform the compliance function relating to funds managed or marketed in rEEA countries; and
- disputes with rEEA investors in a fund managed/marketed by a manager using a non-rEEA manager passport would need to be “settled in accordance with the law of and subject to the jurisdiction of a Member State”—this would preclude the use of UK courts as a forum for disputes with investors.
UK AIFMs should also note that the AIFMD does not provide for a non-rEEA manager passport to cover the provision of MiFID investment services on a cross-border basis. Accordingly, even if the AIFMD were to be extended to the UK so that UK AIFMs could use a non-rEEA manager passport to manage and/or market AIFs in the rEEA, in the event of the UK not remaining in the EEA, UK AIFMs providing cross-border MiFID investment services within the rEEA (e.g. discretionary management/advisory services for separate account clients) may need to think about where the services are in fact being provided and whether local authorisation would be required to continue the provision of those services. For the provision of MiFID investment services, this would re-establish the position prior to the implementation of the Investment Services Directive (the precursor of MiFID) in the mid-1990s.
Undertakings for Collective Investment in Transferable Securities Directive (UCITS)
A UCITS fund must by definition be EEA domiciled, as must its management company. Currently, both UCITS funds and their EEA managers benefit from the passport. UCITS funds are passportable into any other member state for the purposes of being marketed locally to the public and management companies can set up branches and/or provide services cross-border into other member states (e.g., a UK-based management company can provide management services to a UCITS fund based in any other EEA country such as, for example, Ireland or Luxembourg). UK UCITS funds and management companies established pre-Brexit would no longer qualify as UCITS post-Brexit. UK-based UCITS funds would no longer be automatically marketable to the public in the rEEA and would therefore become subject to local private placement regimes. Conversely, a UCITS fund established, say, in Ireland or Luxembourg, would no longer be marketable in the UK to the general public, and a management company based in Ireland or Dublin would no longer be entitled to provide management services to a UK-based UCITS fund.
Accordingly, consideration would need to be given to migrating UK UCITS funds to an rEEA country. Otherwise, UK UCITS funds would become subject to the AIFMD regime instead of the UCITS regime and would be subject to additional restrictions and unavailable to most types of retail investor. UK UCITS management companies would have to migrate to rEEA in order to continue to benefit from the passport.
The Markets in Financial Instruments Directive (MiFID)
MiFID gives EEA investment firms authorised in their home EEA country a passport to conduct cross-border business and to establish branches in other EEA countries, free from additional local authorisation requirements. MiFID prohibits member states from imposing any additional requirements in respect of MiFID-scope business on incoming firms that provide cross-border services within their territory, but does allow host territory regulators to regulate passported branches in areas such as conduct of business.
UK-regulated firms that undertake MiFID business would no longer be able to rely on the passport to undertake MiFID business in rEEA and might have to restructure accordingly. Conversely, rEEA firms that seek to undertake MiFID business in the UK would no longer be able to do so and might also have to restructure. However, in contrast to UCITS, that outcome is potentially leavened by the new third-country regime indicated by the recast Markets in Financial Instruments Directive (MiFID II).
The impact on the provision of cross-border MiFID investment services might be diluted by the regime under MiFID II permitting non-EEA firms to provide investment services to professional clients on a pan-EEA basis upon registration with ESMA, but this would not be an immediate solution, as it would be subject to ESMA making an equivalence determination under MiFID II in relation to the UK, and the timing would be highly uncertain (in particular, MiFID II seems unlikely to come into effect until January 2018, which will be 18 months after the UK referendum). The UK could implement an equivalent regime (in practice, largely by not repealing or amending its EU-generated legislative inheritance and “renationalising” it) to secure its status as an “equivalent” third country with which EEA firms can do business. However, it seems unlikely, given the technical difficulties and delays being experienced generally by ESMA in relation to MiFID II implementation, that an equivalence determination for any non-EEA firms will be high on the agenda until sometime following January 2018.
UK financial institutions would need to consider the regulatory perimeter in each rEEA country in which a financial institution wishes to undertake business. Conversely, rEEA financial institutions would need to consider the UK perimeter to identify what activities by them in the UK would engage a registration requirement locally in the UK.
On the other hand, equivalency considerations aside, the proposals under MiFID II for the unbundling of research and trading fees would fall away in the UK and remain in the rEEA. The unpopular cap on bonuses for systemically important banks and investment firms brought in by the Capital Requirements Directive (CRD) would also fall away in the UK but remain in the rEEA. Notably, the EBA has recently indicated that the bonus cap should be imposed on all firms subject to the CRD, which would implicate a huge increase in the number of banks and investment firms subject to the cap. On 29 February, it was announced that FCA and the Prudential Regulation Authority had decided to reject that advice on the basis of proportionality. Accordingly, even without a Brexit, the UK is already implementing a policy which should put it at a competitive advantage to other EEA countries that decide to follow the EBA's guidelines.
Under MiFID, EEA countries must permit investment firms from other EEA countries to access regulated markets, clearing and settlement systems established in their country. Post-Brexit, UK investment firms would no longer be able to rely on those provisions, but nor would rEEA firms looking to access the UK. It is precisely this possibility of “mutually assured destruction”—combined with the UK’s status as Europe’s leading financial centre—that could drive some hard bargaining post-Brexit by both sides towards a constructive outcome in favour of continuing integrated financial markets and services.
The European Market Infrastructure Regulation (EMIR)
EMIR applies to undertakings established in the EEA (except in the case of AIFs, wherever established, where it is the regulatory status of the manager under AIFMD which is key) that qualify as “financial counterparties” or “non-financial counterparties.” Since, post-Brexit, a UK undertaking would no longer be established in the EEA, under EMIR, UK undertakings that are currently financial counterparties or non-financial counterparties would become third-country entities (TCEs) for EMIR purposes.
Post-Brexit, UK undertakings—along with other TCEs—would not be able to avoid EMIR altogether, as a number of its provisions have extraterritorial effect, including in relation to key requirements such as margin for uncleared trades and mandatory clearing. The trade reporting obligation, however, does not apply to TCEs. The UK government would need to consider whether to introduce similar reporting requirements domestically, particularly given the size and importance of the UK derivatives market. If UK undertakings became TCEs, they would be required to determine whether they would be financial counterparties or non-financial counterparties if they were established in the rEEA, an exercise which would be straightforward.
In any event, UK undertakings subject to the clearing and margin requirements of EMIR pre-Brexit would remain subject to such requirements when entering into derivatives transactions with rEEA firms post-Brexit. Importantly, the exemption from the forthcoming mandatory clearing requirement for UK pension scheme trustees would cease to apply post-Brexit. Accordingly, a UK pension scheme would no longer be able to rely on the EMIR exemption when entering an OTC derivative contract with an rEEA counterparty.
The City of London boasts some of the world’s largest clearing houses, and at least three of them are currently permitted under EMIR to provide clearing services to clearing members and trading venues throughout the EEA in their capacity as ESMA-authorised central counterparties (CCPs). Post-Brexit, however, a UK CCP would become a third-country CCP. Under EMIR, a third-country CCP can only provide clearing services to clearing members or trading venues established in the EEA where that CCP is specifically recognised by ESMA. This would require, among other things, clearing houses operating out of London to apply to ESMA for recognition, the European Commission to pass an implementing act on the equivalence of the UK’s regime to EMIR, and relevant cooperation arrangements to be put in place between the rEEA and the UK—a lengthy process overall. Financial institutions based in rEEA will certainly want to continue to access UK regulated markets and CCPs.