The dust has just about settled after the referendum, and firms have had some time to reflect on the result and what it might mean. This is of course a time of uncertainty, and we expect that uncertainty to prevail for some time, but this does not mean it is not possible for firms to undertake some measured forward planning.
What we do know at the moment is that:
- despite the political upheaval of recent weeks, nothing has changed from a legal perspective – for now, things will continue as they were; and
- the direction of travel will start to become clearer once some of the known unknowns are settled – when exactly will Article 50 be triggered, what will be the UK’s stance in negotiations, will the UK be able to negotiate its future relationship with the EU at the same time as its withdrawal?
Consequently, firms need to be getting on with things as usual to an extent, whilst also keeping an eye on developments and starting to plan ahead as matters progress. Nothing is going to change immediately, so there is no need for panic. Equally, though, there will be change ahead and whilst the shape of that change will not be known for some time, there are steps that firms usefully can be taking now not only to prepare themselves but also to seek to influence the direction of travel.
As things stand, the financial services regulatory framework remains as it was before the referendum, including the Capital Requirements framework for banks and investment firms and Solvency II for insurers. Moreover, the changes that are due to come into effect prior to the UK’s withdrawal from the EU, such as the Market Abuse Regulation (which came into effect on 3 July 2016), the Packaged Retail Investment and Insurance Products Regulation - PRIIPS (31 December 2016), the complete rewriting of the rule book for investment businesses under the recast Markets in Financial Instruments package - MiFID II (3 January 2018) and the Insurance Distribution Directive - IDD (23 February 2018) will still have to be implemented.
The FCA made this quite clear in its short statement issued on 24 June:
“Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament.
Firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect…
The longer term impacts of the decision to leave the EU on the overall regulatory framework for the UK will depend, in part, on the relationship that the UK seeks with the EU in the future. We will work closely with the Government as it confirms the arrangements for the UK’s future relationship with the EU.”
The same view was reiterated by Mark Carney in a speech on 30 June 2016:
“Nothing in financial regulation has changed as a result of last week’s referendum. It will not change until the process of the UK’s withdrawal from the European Union is complete, until the UK is no longer a member of the EU and until EU law ceases to have effect in the UK. The law is the law. Rules are rules. The Bank is continuing to implement the current regulatory framework until any new arrangements with the EU take effect.”
Although the subtle difference between the FCA's reference to the Government and Parliament making changes and the Bank of England's stress on the completion of withdrawal from the EU is interesting for those who like to read between the lines, these statements do not give firms much to work with when deliberating what they can and should be doing now.
The FCA’s Chairman, John Griffith-Jones, made an unusual plea for more industry lobbying, or at least rapid constructive engagement with the process of designing Brexit, in a speech he delivered on 30 June.
Whilst he emphasised that UK financial regulation has not changed, Mr Griffith-Jones also called on firms to spend the summer months identifying “at least the broad brush strokes, if not all the technical details, of alternative plans. The position is uncertain and it will not be settled for some time. But it is important for firms to resist the temptation to cite chicken and egg - 'we cannot design a strategy without knowing the rules'.” His aim is for “an industry led 'collective' strategy view” to emerge, and for firms to be able to, at the appropriate moment “inform the Government where your major opportunities and risks lie, along with other industries, as it forms its plans for the negotiation of our exit”.
So, what can firms take from this? Well, now is certainly not the time to scrap or delay existing projects, but equally firms must be prepared for change – perhaps not immediately but in the longer term – and should also, directly or through industry bodies, work out as quickly as possible not only what the best, or "least worst", solution would be for them, but also what the pros and cons are of the other options. These are not necessarily the same for all firms, so it is important not to leave the whole battle to others.
As Mr Griffith-Jones suggests, firms should be informing themselves about the potential models for the future UK-EU relationship, forming views about which elements of these models would help, and which hinder, their business, lobbying for the best outcome and ultimately deciding whether any of these outcomes would have such serious implications for their business that they also need to be planning strategically for the worst outcome.
What are the main options?
By way of reminder, the options broadly fall into three categories:
- Membership of the European Economic Area and the European Free Trade Association. Broadly, this would mean having to implement EU law in many areas, including financial services, without having more than formal lobbying rights in relation to formulating future law and regulations. It would also mean accepting the free movement of people (subject to limitations justified on grounds of public policy, public security or public health) and contributing to the EU budget. In principle, this option allows full access to the single market in financial services and full passporting rights (although there is at present something of a backlog of recent EU financial services legislation that has not been rolled out yet, which affects some passporting rights).
- A form of bilateral agreement, which appears to be the approach favoured by the new Government. Models range from the arrangement between Switzerland and the EU (membership of the European Free Trade Association, plus a series of bilateral agreements negotiated on a sector-by-sector basis), to the customs union the EU has with Turkey and the freshly-negotiated free trade agreement with Canada (which has yet to be approved by each individual EU Member State). Whilst none of these models currently allows for full single market access or full access to the financial services market, there may be scope to negotiate some access for financial services. However, this would almost certainly require the UK to implement or maintain most EU rules in this area. If anything approaching full single market access was involved there are likely to be questions over how far it would be offered without budget contributions and acceptance of freedom of movement of people as well as of goods, services and capital (a conundrum with which Switzerland is currently wrestling, having recently had its own referendum on immigration).
- Relying on World Trade Organisation membership. The UK would be a “third country” and would not have access to the EU single market in financial services or the associated passporting rights. However, if it maintained “equivalent” regulation it might be able to benefit from regimes for third country firms in certain of the more recent EU legislation that allow some access to EU markets, in particular under the Alternative Investment Fund Managers Directive (AIFMD) and MiFID II. Many other more recent pieces of EU legislation contain equivalence provisions that, for example, may allow for exposures by EU firms to third country entities to be treated in the same way as exposures to other EU firms for prudential purposes.
It should be pointed out that the absence of access to the single market or of a third country equivalence regime in EU legislation does not necessarily mean it is impossible to provide services to any EU customer. It may mean no more than that access by third country firms is a matter of Member State discretion. Some EU countries are very restrictive, but others are significantly more liberal in relation to the ability of third country firms to access their markets, particularly at a professional, rather than retail, level. However, there is an increasing tendency for new EU financial services regulation to seek to reduce Member State discretion over the level of access given to third country firms. It is also worth noting that the UK has been the principal Member State arguing for third country access provisions in the past which may mean that a more protectionist approach is taken by the EU in future.
Is equivalence enough?
Third country equivalence assessments of the kind provided for under MiFID II and not provided for but nevertheless being carried out under the AIFMD may prove a useful model for future co-operation and the provision of services into the EU. However, it is important to note the limitations in the current regimes, notably that:
- The only significant equivalence-based passporting regimes for financial services covering the whole of the EU without individual Member State discretion relate to: (i) the cross-border management, and marketing to professional clients, of alternative investment funds under the AIFMD; and (ii) the provision of investment services to eligible counterparties and “per se” professional clients (not to others who elect to “opt up” to professional status) under MiFID II.
- Neither of these AIFMD and MIFID II third country regimes is yet in effect, so there is no experience of how easy or difficult they will be to operate.
- Of the two principal current EU-wide third country equivalence regimes, the MiFID II structure seems more likely to be practical at the wholesale level. It depends on the European Commission’s assessment of equivalence of the relevant third country (on which no rulings at all have yet been given) and ESMA registration of individual firms, following which services can be provided cross-border to per se professional clients in the EU on the basis of the relevant third country rules plus some extra disclosures.
- The AIFMD third country structure as originally drafted necessitates not only an ESMA assessment of equivalence (not required under the Directive but this is the approach ESMA is taking, having ruled so far on Guernsey, Jersey, Switzerland, Canada, and Japan and, subject to caveats, the US, Hong Kong, Singapore, and Australia) but also a full scale application to an EU Member State for authorisation, with a number of difficulties surrounding selection of that jurisdiction. Following this, third country fund managers must comply on an ongoing basis with all of the AIFMD requirements, in addition to their home regulator’s requirements. It is doubtful how far this dual authorisation regime will prove attractive to third country fund managers. Those with a sufficiently large EU investor base to be reluctant to rely solely on national private placement regimes may well continue to establish an EU alternative investment fund manager of their own or work by delegation from an external EU alternative investment fund manager.
- MiFID II also has an option available to individual Member States to authorise branches of third country firms in their jurisdictions. Such branches could provide services to retail and elective professional clients, but full compliance with MiFID would be required, i.e. a dual authorisation regime for the EU branch. However, even if the Commission gives a positive equivalence ruling in respect of their home country, such branches would have no automatic passporting right to provide cross-border services to clients elsewhere in the EU other than eligible counterparties and per se professional clients. The timing of any potential equivalence decisions, and in particular whether the Commission would be willing to make any assessment prior to the UK leaving the EU, is uncertain.
Are substantial liberalising changes to UK regulation likely?
One point to bear in mind is that it is quite probable under various scenarios that the UK will either be obliged to keep implementing EU law or will need to maintain regulation that is close enough to EU standards to enable the UK to achieve positive equivalence assessments from the EU. Also, in many areas the EU regulatory framework implements internationally agreed standards (e.g. G20 Basel commitments) and/or aligns with UK policy, which also limits the scope for change.
Even if the UK does end up in a position where it can, legally and politically, deviate from EU standards, picking over the swathes of regulation and deciding what to keep and what to adjust will take some time and we cannot expect that changes to the regulatory framework would be made particularly swiftly.
That said, Mr Griffith-Jones did indicate that the FCA has already started to give some thought as to how it might set about deciding what to do with current rules, in case it does need to carry out such a review. There are some areas where the UK has strongly disagreed with the EU regulatory approach in the past. Remuneration policies and the extension of the cap on bonuses beyond the largest banks is the most obvious example. It will clearly be worthwhile for firms to identify and inform the Government as quickly as possible: (i) which EU sourced pieces of regulation are regarded as the most onerous and undesirable for their business and could be removed; and (ii) whether it would be advantageous or not to have a dual system of regulation, with one set of rules applying to UK and other non-EU business and the other, on an opt-in basis, for business seeking EU access.
It is possible that some of the regulatory requirements that the UK regulators never saw as desirable will be relaxed. It is even possible that some future implementation of EU legislation may not happen as swiftly in the UK as has previously been customary. However, it is at least as likely that the UK regulators will be keen to prove their credentials as good, and fully equivalent, neighbours, even on issues that they might previously have argued about as a member of the EU and the European Supervisory Authorities.
It is to be hoped that some clearer policy intentions will emerge now that the new Prime Minister, Theresa May, is in place. With the leadership campaign having been cut short, there has been little opportunity to hear much of Mrs May's thinking on key points, but this should become apparent over the coming weeks and months as we see how the new Department for Exiting the European Union, headed by David Davis, takes shape.
Davis has already made clear his view that there is no rush to trigger Article 50 before the end of 2016 or the beginning of 2017. This is intended to leave time for “some serious consultation” before the negotiating strategy is designed, emphasising again the need for firms to give thought to the options and make their opinions known sooner rather than later. Davis’ intended strategy is that “we need to take a brisk but measured approach to Brexit. This would involve concluding consultations and laying out the detailed plans in the next few months”, so things may start moving quite quickly.
Key questions for firms
Although what is possible will depend heavily on the shape of negotiations and the future UK-EU relationship, firms do need to consider what will be in their best interests and make those views known.
Firms can usefully be asking themselves questions that will help with both industry representations and their own forward planning, such as:
- where are our customers and investors at present?
- are they classified as “retail” or “professional”?
- where do we see the main growth opportunities?
- what passports do we have and are all of these strictly necessary?
- what impact would the removal of passport rights have on the business?
- do we currently have branches or subsidiaries in another EU Member State?
- can the permissions, substance and business of our existing entities elsewhere in the EU be upgraded if in future we wish to shift part of our business?
- can a subsidiary readily be formed and authorised where a branch currently exists, either taking over branch business or running alongside it with some shared resources?
- is the business done elsewhere in the EU likely to fall within “equivalence” access provisions?
- which pieces of legislation most affect the business; do these come from the EU or the UK?
- which bits of regulation are most problematic for the business and what would we change if there was the opportunity for change?
- where do our employees come from?
- where do our employees want to be based?
- do our customers and investors care about our EU status?
- is the firm sufficiently strong to mean that its customers and investors in the EU will seek it out of their own initiative if it ceases to market in the EU?
At later stages in the planning process, if it seems unlikely that the UK will secure sufficient access to the EU market for your business and you decide it is essential to ensure that you have an EU entity (or entities) capable of exercising full EU passporting rights, or if you wish to establish such an entity on a precautionary basis, a much more detailed review will be needed for the choice of location. This will need to cover tax, employment, immigration, property and resources issues and other practicalities, as well as the regulatory and business environment. At that stage care will be needed to review all of the potentially useful locations - not just the quasi-offshore service centres of Luxembourg and Ireland and the more major financial centres of France and Germany. Numerous other EU countries will be - and are already - vying for business, carrying varying advantages and disadvantages attached to the financial services "passports" they offer.