Back in June 2016, we questioned the need to make any immediate decisions in response to the referendum result given the inherent uncertainty as regards likely timing and the EU/UK relationship post the negotiation period. Although the countdown to Brexit has commenced following the triggering of Article 50, the industry is no clearer on what is likely to be the eventual outcome of the negotiations.

Nevertheless, with less than two years until the UK is set to leave the EU, firms will need to be considering their options now. Indeed, it has been reported that the FCA has written to 20 asset managers and other firms, requesting detailed information about their Brexit contingency planning.

So what more do we now know about how the regulatory landscape might look post-Brexit? In this article we consider those areas that have become clearer since the referendum vote and address some of the questions we are being asked by our clients.

Will EU law-based regimes continue to apply once Brexit occurs?

Much of the UK’s regulatory regime implements, or is based on, EU legislation and regulation. We know that the current government’s intention is to preserve that regime, and indeed all EU-derived law, at least temporarily following Brexit. The government has set out how it intends to do this, in its Great Repeal Bill white paper.

Exactly how this will work will depend on the form that current areas of regulation take. Many EU Directives have been implemented in the UK through amendments to primary legislation (for example, the Financial Services and Markets Act 2000), through new secondary legislation and through rules made by the FCA and the PRA. The UK authorities also currently take account of guidelines issued by the European Supervisory Authorities (ESAs) in relation to specific regimes. In addition UK firms must comply with delegated and implementing regulations made under the Level 1 directives: as these regulations are directly applicable, no additional UK legislation or regulation was needed to bring them into effect. This is also the case for Level 1 regulations such as the capital requirements regulation.

In theory, the UK may choose to use the opportunity of Brexit to change its regulatory regime for financial services: for example, by removing some of the measures that it did not support when they were developed by the EU legislators, such as the much disputed bonus cap.

In reality though, this would be a huge undertaking especially given the competing demands on legislative time and complex nature of the financial services regulatory regime. In practice, there are compelling reasons to suggest that the UK may be unwilling to make major changes to its financial services regulatory regime, at least in the short to medium term:

  • The UK regime reflects international policy objectives (at G20/FSB/IAIS/IOSCO/BCBS level) that are supported by the UK government and regulators.
  • The UK was heavily involved in negotiating the legislation at EU level and, in many cases, this resulted in existing UK standards being replicated across the rest of the EU.
  • UK financial services regulation will need to be sufficiently similar to EU regulation for the UK to be deemed to be equivalent by the European Commission for UK financial institutions to obtain market access in certain areas.
  • The UK wants to remain a world-leading, competitive financial services hub and consequently it is likely to want to be recognised as having “equivalent” regulatory standards to the EU and other leading financial centres.

In order to maintain existing EU frameworks post-Brexit, the UK will need to:

  • Review the implementing law and regulation to ensure that it reflects the outcome of Brexit negotiations. This will include amending any references in statute to European institutions or concepts that will no longer be applicable when the UK leaves the EU, so that existing UK law still ‘works’ post-Brexit
  • Introduce legislation or regulation that reflects level 1 regulations and/or the provisions of delegated and implementing regulations relating to the level 1 framework.
  • Introduce measures, presumably guidance or rules from the FCA and the PRA, reflecting the guidelines issued by the ESAs.

The UK authorities will need to undertake this exercise for every piece of EU legislation affecting the financial services sector. In a press conference in April 2017, Andrew Bailey, FCA Chief Executive, described the work that the FCA was undertaking to transpose EU legislation into UK legislation:

The government has asked us to assist on this for that body of European legislation that is within our ambit, as it were and there is a lot, we are having to have lawyers go through page by page to say … which elements of that, as they are currently written in European legislation, would be inoperable if you just lifted them and dumped them into a UK piece of legislation because obviously they relate to a different institutional organisational structure“.

The House of Commons library has published reports on the work needed to transplant existing EU law into UK law and to revise law that has already been transposed to make it effective post-Brexit.

What is equivalence and is it relevant to your business?

Certain EU legislation provides for ‘third country‘ regimes which allow non-EU based firms to offer a limited number of services into the EU if their home country regulatory regime is accepted by the EU as being ‘equivalent’ to EU standards. The UK will become a ‘third country’ once Brexit takes place.

These regimes are only available in relation to certain services and activities, and are much more limited in scope and in general much less secure than the current passporting regime.

Equivalence is the concept that the regulatory regime of a third country relating to a particular sector is of an equivalent standard to that which applies under EU law. In financial services legislation, the assessment that a third country’s regulatory regime is equivalent will typically be made by the European Commission, based on advice given by one of the European Supervisory Authorities. The factors that the Commission will have regard to when assessing equivalence will vary between sectors and the corresponding legislative acts. They may include whether the third country’s regime:

  • Is broadly similar to that of the EU and is applied consistently.
  • Adequately implements internationally agreed standards, such as those reflecting G20 initiatives.
  • Allows EEA financial institutions access to the third country’s markets.
  • Does not contain obstacles relating to investor protection, market disruption, competition or the monitoring of systemic risk.

There are three main disadvantages to the use of third country regimes (as they currently exist or as are contemplated) as a substitute for existing passporting arrangements:

  • Third country regimes are not available for all financial services sectors. In particular, they are not available for deposit-taking, lending, mortgage lending, insurance mediation and activities relating to UCITS nor for payment services or electronic money.
  • It is at the discretion of the Commission to determine whether a third country is equivalent, which in practice may mean that political considerations affect the outcome of any determination and its timings. It is also at the Commission’s discretion whether to withdraw an equivalence determination.
  • Relying on equivalence would likely require the UK to keep its regulatory regime broadly in line with that of the EU. This might cause problems if the UK wished to adopt a significantly different regulatory policy to the EU, such as deregulating certain financial markets.

In the context of asset management, the following considerations are relevant:

  • Portfolio management – MiFID II provides that a third country firm, such as a UK portfolio managers, would be entitled to provide portfolio management on a cross-border basis to eligible and per se professional clients in reliance upon the MiFID II third country access regime. However, a precondition is that the firm must be registered by ESMA and the Commission must have made an equivalence determination as regards the UK’s rules.
  • Managing a UCITS – unlike MiFID II, the UCITS Directive does not establish a third country access regime. Management and depositary activities may, however, be possible in accordance with the delegation provisions which are discussed further below.
  • Managing an AIF – the AIFMD contains provisions that will have the effect of extending the AIFMD passport regime to the management and marketing of AIFs by non-EU AIFMs and to the marketing of non-EU AIFs by EU AIFMs. A pre-condition for a non-EU AIFM to take advantage of this passport is that its regulatory regime must be equivalent to the EU’s regime, as set out in the AIFMD. Whilst the Commission has been looking at these provisions, they are not yet in force. Similar to the UCITS Directive, the AIFMD also provides for delegation, the requirements of which are discussed in more detail below.

What is delegation and how could it help me?

Both the UCITS Directive and the AIFMD contain a delegation regime whereby: (i) a company managing an EU-domiciled UCITS; or (ii) an EU AIFM (as appropriate) would be able to delegate certain functions, including the provision of MiFID portfolio management to third parties (including those based in third countries). Subject to regulatory acceptance of such models in the future (which may be scrutinised further in light of Brexit), these structures may enable:

  • EU UCITS management companies to delegate portfolio management of a UCITS to a UK based portfolio manager; and
  • EU AIFs to delegate portfolio management of EU AIFs to a UK manager.

In relation to depositary activities, both regimes require EU depositaries although such entities are allowed to delegate the provision of services to a third-party custodian (including one that is based in a third country).

Under MiFID II, EU investment firms are permitted to outsource management activities to a third party

(including a third-country firm) provided that certain conditions are met. These requirements include that the relevant firm has taken reasonable steps to avoid undue additional operational risks; and that outsourcing of important operational functions is not undertaken in such a way as to materially impair the quality of the firm’s internal controls or the ability of the relevant supervisor to monitor the firm’s compliance with its obligations. Following Brexit, this structure may enable EU investment managers to outsource portfolio management to UK managers but as noted above, this will depend upon the approach taken by member state regulators.

On 31 May 2017, ESMA published on opinion which set out general principles to support supervisory convergence within the EU27 in context of Brexit. ESMA explains that, in the course of the UK withdrawing from the EU, UK-based market participants may seek to relocate entities, activities or functions to the EU27, within a relatively short space of time, to maintain access to EU financial markets. They may seek to minimise the transfer of the effective performance of those activities or functions in the EU27 (for example, by relying on the outsourcing or delegation of certain activities or functions to UK-based entities, including affiliates). As a result, ESMA considers that it is necessary to ensure that the conditions for authorisation, as well as for outsourcing and delegation, do not generate supervisory arbitrage risks. In the opinion, ESMA sets out nine general principles aimed at fostering consistency in authorisation, supervision and enforcement relating to the relocation of entities, activities and functions from the UK.

In relation to outsourcing and delegation, ESMA states that any outsourcing or delegation arrangement from entities authorised in the EU27 to third country entities should be strictly framed and consistently supervised. Outsourcing or delegation arrangements, under which entities confer either a substantial degree of activities or critical functions to other entities, should not result in those entities becoming letter-box entities. National competent authorities are reminded that they should be prudent when determining the extent to which an entity can rely on outsourcing or delegation. Under certain Union legislation, outsourcing or delegation arrangements to a third country entity are conditional on prior cooperation agreements between the EU NCA and third country authority.

When will know more about the future EU/UK relationship?

In her Lancaster House speech of 17 June 2017, Prime Minister Theresa May set out details of the UK government’s approach to Brexit. Key for financial services was the Prime Minister’s confirmation that the UK would not seek to be a member of the single market following its departure (thereby losing passporting rights) and that the UK would seek to agree transitional arrangements in order to allow businesses to plan and prepare for any new arrangements agreed between the UK and the EU. The Government then published its white paper (which provided little additional detail to the statement made in the Lancaster House speech) ahead of triggering the process on 29 March 2017 – the European Council’s guidelines for Brexit negotiations have subsequently confirmed that the two year time frame ends on 29 March 2019.

A snap UK election was then called for 8 June 2017 which means that negotiations with the EU cannot begin until the middle of June at the earliest. If there is a change of UK government, perhaps the incoming administration would want to push that date back whilst it gathers its thoughts and the key statements in relation to UK financial services summarised above could be revised.

The European Commission currently expects that the negotiations themselves will last approximately 18 months (from early June 2017 to October/November 2018) although there are disagreements on the structure of the negotiations. As you might expect, the UK would prefer to negotiate the withdrawal agreement and the future framework governing the relationship in tandem, whereas Europe has made clear that it will only commence talks on the future framework once the withdrawal agreement has been finalised.

Assuming the Conservative party remains in power, negotiations are currently scheduled to start on 19 June. However, it is already clear that this will not be a straightforward process. From an EU perspective, there are 27 governments involved, all with their own internal demons. Compromise is likely to be key – for example, a policy to remove delegation in an asset management context may be preferred by France but this would have a significant impact for the Luxembourg economy.