ESMA has published three sectorspecific opinions to promote supervisory convergence in connection with the likely relocation of many financial services providers currently based in the UK to the other EU Member States (the EU27) in advance of Brexit.
These sector-specific opinions were signposted by ESMA in its Opinion: General principles to support supervisory convergence in the context of the United Kingdom withdrawing from the European Union, published on 31 May 2017.
For further information on that opinion, please read our June 2017 Client Briefing: Brexit: ESMA highlights importance of supervisory convergence.
OPINIONS
The following three sector-specific opinions published on 13 July 2017 were addressed to national competent authorities (NCAs):
Sector-specific opinion: investment management
Sector-specific opinion: investment firms
Sector-specific opinion: secondary markets
Each opinion assumes that the UK will become a third country on Brexit.
The opinions relating to investment management and investment firms focus on how NCAs should deal with MiFID investment firms, UCITS management companies, self-managed investment companies and authorised AIFMs that are currently based in the UK and are looking to relocate to within the EU27. The third opinion addresses the perceived regulatory and supervisory arbitrage risks arising from third country trading venues relocating to the EU27 and looking to outsource activities back to their jurisdictions of origin.
Noting that the EU27 have a "shared interest in building a common approach" to relocations, ESMA reiterated in its related press release that relocating firms must be "subject to the same standards of authorisation and ongoing supervision across the EU27 in order to avoid competition on regulatory and supervisory practices between Member States".
This briefing is a high-level overview of the opinions' key themes. In the coming days, we will be issuing more detailed briefings on each of the three opinions.
COMMON THEMES
Regarding the authorisation of MiFID investment firms, UCITS management companies, self-managed investment companies and AIFMs, certain key principles are common to the first two opinions:
» NCAs should seek a complete set of information under the relevant legislation and should not put in place any "fast-track authorisation processes".
» NCAs should not rely on existing authorisations from other Member States or third countries. Instead, they should look for detailed information on the applicant's organisational structure and business operations to check compliance with the relevant legal framework.
NCAs should examine applications closely to ensure that they are not motivated by regulatory arbitrage.
In light of the important roles played by board members and senior management, NCAs should pay special attention to individuals with a significant number of its size (i.e. the value of assets other executive or non-executive roles.
Reiterating its previous concerns about the number of (sub-)funds and organisation and is consulted before Brexit-related relocations leading to a prevalence of "letter-box entities", ESMA has cautioned that this is not just the complexity of investment out its activities on a continuous basis a risk that may arise from strategies pursued; and report regularly to the delegation/outsourcing, but also from governing/management body. situations in which EU authorised the type and range of asset classes entities use non-EU branches for the invested in; White-label business performance of certain functions. If relocating entities propose to establish the geographical spread of NCAs must pay particular attention to or maintain non-EU branches, NCAs investments;entities engaged in white-label must be satisfied that this is based on businesses. Those entities are likely to objective reasons linked to services the use of leverage; see a significant increase in business provided in the non-EU jurisdiction. levels when Brexit takes place, and this NCAs must also look for detailed the use of efficient portfolio will create further operational risks. information on the activities (and their management techniques; NCAs should assess whether the geographical distribution) to be structures put in place by those entities, performed by the branch, its the frequency of investment and the resources they employ, remain organisational structure and the persons activities; appropriate or whether they should be responsible for the management of the enhanced. branch and ensure that they can its cross-border management or effectively supervise the non-EU marketing activities; Delegation branch.
OPINION ON INVESTMENT MANAGEMENT The opinion on investment management covers UCITS management companies, self-managed investment companies and authorised AIFMs. Authorisation ESMA has emphasised that UK-based applicants for authorisation should not receive either more or less favourable treatment than other, non-UK-based, applicants. Governance and internal control ESMA has asked NCAs to consider the possibility of publishing guidance on appropriate thresholds (in terms of aggregate time commitment) for directorships. It’s worth noting that the Central Bank of Ireland has already published such guidance on time commitments for directors. ESMA reiterated that NCAs should assess each applicant on a case-by-case basis, having particular regard to: » its size (i.e. the value of assets under management); » the number of (sub-)funds and share classes; » the complexity of investment strategies pursued; » the type and range of asset classes invested in; » the geographical spread of investments; » the use of leverage; » the use of efficient portfolio management techniques; » the frequency of investment activities; » its cross-border management or marketing activities; » the type and range of functions that will be performed internally; » the functions that will be subject to delegation monitoring; » the provision of additional MiFID services; » the number and type of investors; » the frequency of investor subscriptions and redemptions; and » the geographical distribution of marketing activities. While the relocating entity must have at least two senior managers, ESMA’s view is that NCAs should examine the size of the entity’s business and/or the complexity, nature and range of its activities before deciding whether that minimum number is acceptable. It’s important to note that the requirement to have at least two senior managers is not a new requirement and simply repeats the existing requirements in Article 8(1)(c) of AIFMD and Article 7(1)(b) of the UCITS Directive. These requirements are also reflected in the existing authorisation regime applied by the Central Bank. The NCA must be satisfied that the entity’s internal control function plays a key role within the organisation and is consulted before significant strategic decisions are taken. The internal control function must carry out its activities on a continuous basis and report regularly to the governing/management body. White-label business NCAs must pay particular attention to entities engaged in white-label businesses. Those entities are likely to see a significant increase in business levels when Brexit takes place, and this will create further operational risks. NCAs should assess whether the structures put in place by those entities, and the resources they employ, remain appropriate or whether they should be enhanced. Delegation As with the other sector-specific opinions, delegation is a key theme. While this will be covered in more detail in our forthcoming opinionspecific briefings, key points to note are: » NCAs should carry out a case-bycase analysis of any proposed delegations, and the due diligence carried out by the relocating firm, taking into account the materiality of the delegated activity. » NCAs should pay particular attention to proposals to delegate functions to non-EU entities or to use delegation structures that involve complex operational chains or large numbers of parties. Substance The opinion states that NCAs should apply “additional scrutiny” to situations where relocating entities, even small relocating entities that have simple investment strategies and a limited range of activities, do not dedicate at least 3 locally-based full-time employees (FTEs) (including time commitments at both senior GROUP BRIEFING: JULY 2017 management and staff level) to the performance of portfolio management and/or risk management functions and/or monitoring of delegates. In this regard, it is important to note that the opinion refers specifically to relocating entities. Furthermore, the opinion does not say that having less than 3 locallybased FTEs is prohibited; it says that in such cases NCAs need to give the applications “additional scrutiny” and have regard to the nature, scale and complexity of the proposed business. (See the criteria referred to above under “Governance and internal control”.) The Fund Management Company Guidance issued by the Central Bank of Ireland following the CP86 consultation process is a comprehensive regime detailing how firms establishing in Ireland need to address the allocation of managerial functions, the location of the persons carrying out those functions and the oversight of delegation arrangements. It should be possible to reconcile those requirements with the “additional scrutiny” mentioned above where a relocating firm has less than 3 locally-based FTEs. Internal control functions ESMA reiterated that, as internal control functions carry out ongoing desk-based and on-site controls, a local presence is usually necessary. Where this is not the case, the relocating entity must demonstrate to the relevant NCA that this will not impair the effectiveness of those functions. OPINION ON INVESTMENT FIRMS This opinion covers MiFID investment firms. Substance To avoid authorising “letter-box entities”, NCAs should examine the relocation of human and technical resources, any outsourcing proposals, and planned governance and internal controls for the firm’s day-to-day business to ensure that the applicant’s relocated presence will be one of substance. 3 | ARTHUR COX ASSET MANAGEMENT AND INVESTMENT FUNDS FINANCIAL REGULATION undertaking and other group members) could supervise the outsourced functions. The importance of avoiding a prevalence of “letter-box entities” created through the use of outsourcing was also reiterated. As ESMA considers it unlikely that one individual could have the knowledge, experience and time to effectively monitor a wide range of services and functions, NCAs have been urged to engage with relocating firms that intend to allocate the supervision of a number of outsourced functions to a single person and be satisfied that this does not present additional risks. In particular, ESMA’s view is that the outsourcing of key client-facing functions such as website design, trading software, financial promotions, client disclosures, and client on-boarding processes requires more complex controls, and NCAs should consider not authorising firms that cannot demonstrate and ensure effective oversight of outsourced functions to meet their regulatory obligations under the MiFID framework. NCAs must highlight to investment firms that, once Brexit takes place, any outsourcing of portfolio management to UK entities will only be permitted in certain circumstances, and current outsourcing arrangements will need to be reassessed. NCAs should carefully monitor thirdcountry firms that carry out investment activities or services in relation to EU clients, whether those services are provided in accordance with the MiFID II/MiFIR third-country regime or whether such third-country firms misuse the “clients’ own exclusive initiative” exemption. OPINION ON SECONDARY MARKETS Outsourcing Regarding third country trading venues that are considering relocating to the EU27 while outsourcing activities back to their jurisdiction of origin, ESMA is aware that such outsourcing could make the oversight and supervision of the Governance The applicant’s business should be directed by at least two individuals with the required levels of knowledge and expertise who are prepared to dedicate sufficient time to that role. A single senior manager should not be able to decide on the firm’s overall direction without agreement from the other members of the management body. Where the firm is of a significant size, or had a complex business model or broad range of activities, NCAs should require more sophisticated governance and internal control structures (for example, the management body should have more than the minimum of two members). Where the applicant intends to provide cross-border services, NCAs should look at the additional risks arising from the need to manage and oversee that arrangement. If the applicant already uses, or proposes to use, a party based in a third country to place or execute client orders, NCAs should examine this closely. Other close links with non-EU entities should also be considered in detail. Outsourcing Outsourcing is a key focus of this particular opinion, and ESMA has emphasised that NCAs should carefully examine any proposed outsourcing arrangements. An investment firm should not have significantly more of its activities performed on an outsourced basis than it performs directly itself. Outsourcing arrangements which could present an issue could involve outsourcing to non-EU entities, and outsourcing arrangements with complex operational chains. If a relocating investment firm has an outsourcing arrangement already in place that could cause a concern, NCAs should consider requiring that firm to prepare a plan for phasing-out those arrangements. One mitigation measure suggested by ESMA is that a sufficient number of nonexecutive members (that are independent from the parent GROUP BRIEFING: JULY 2017 outsourced activity more difficult. Outsourcing should not involve the delegation of activities to the extent that the relocated trading venue becomes a “letter-box entity” and outsourcing should not facilitate the circumvention of the MiFID framework. Certain activities should not be outsourced by a trading venue. These include the decision-making for the design, control and operational monitoring of the trading system, the admission to trading of financial instruments, the establishment of and any subsequent changes to the rulebook of the trading venue together with the suspension and removal of financial instruments from trading and mechanisms to halt trading. A significant portion of the trading venue’s staff should also be based in the EU27. NCAs should assess outsourcing arrangements with third-country service providers with a view to ensuring that there are no potentially detrimental effects to investor protection, orderly markets or financial stability. If such effects exist, the trading venue should not be allowed to outsource the activity. Outsourcing that would result in the delegation by senior management of its responsibility, alters the relationship and obligations of the trading venue to its members and participants, removes or significantly modifies the conditions subject to which the trading venue’s authorisation was granted, should not be permitted. NCAs should examine any existing as well as any planned outsourcing arrangements and, as this is likely to be a lengthy process, ESMA has recommended that NCAs advise trading venues seeking to relocate to the EU27 to approach them as early as possible. FURTHER INFORMATION As mentioned above, we will be issuing more detailed briefings on each of the three opinions in the coming days. In
