Authors: Tamasin Little
Options for Brexit
The difficulty in describing the potential implications of Brexit lies in the fact that there are several conceivable options, and we do not yet have visibility as to what Brexit would look like or what possible benefits might be achieved. Therefore, the issue is not a simple question of “in" or “out”.
In the event of a vote to leave the EU, the terms of the UK’s exit would need to be negotiated (as would its future relationship with the EU) and it seems inevitable that there would be a period of uncertainty during the two years (or longer) this would take. It is not yet known how favourable an exit the UK would be able to secure or what the terms of any future relationship might be, and it is likely that any future relationship would need to be voted on and approved by all Member States. Outcomes in relation to key matters that would fundamentally shape the UK financial services industry would be likely to remain unresolved for some time following a vote to leave. These matters would include:
- the UK’s access to the EU “single market” (and the potential need for the UK to maintain measures which are “equivalent” or identical to EU rules in order to be able to do so);
- more specifically, the ability of UK financial services firms to provide certain services into other EU jurisdictions without needing to set up a fully authorised subsidiary in each jurisdiction (passporting rights); and
- the continuing impact of EU legislation on the UK (and the UK’s level of influence over such legislation).
As there is no precedent for a Member State leaving the EU, the UK would need to carve its own path. Certain relationships between non-members and the EU are being cited by commentators as potential models for the UK-EU relationship in the event of a Brexit and so it is worth briefly considering these. However, it is worth also bearing in mind that not all of these options may be open (or desirable) to the UK.
The most commonly cited options for Brexit include:
The Norwegian model – membership of the European Economic Area (EEA) (the EU Member States, plus Norway, Iceland and Liechtenstein) and the European Free Trade Association (EFTA). Theoretically this would enable full access to the EU single market (including passporting) in exchange for implementing the single market rules, although the UK would have no direct influence on those rules. Although the incorporation of various pieces of post-financial crisis financial services legislation into the EEA agreement has been delayed, it is expected that this would be resolved by the time that a Brexit would actually take place.
The Swiss model – a combination of EFTA membership and the negotiation of bilateral agreements on a sector-by-sector basis which would govern the UK’s access to the single market (rather than the UK being obliged to implement all single market rules). This could potentially provide access to the EU single market in financial services, although Switzerland does not currently have such access (or related passporting rights). The UK would not have influence over the single market rules.
The Turkish model – a customs union with the EU. This would cover goods but not services and so there would not be access to the EU single market in financial services nor any passporting rights.
Free Trade Agreement – negotiation of a free trade agreement with the EU. This could cover both goods and services, but would likely take a long time to negotiate. It would be unprecedented for it to allow access to the EU single market in financial services or any passporting rights.
World Trade Organisation – reliance on World Trade Organisation membership as a basis for trade with the EU. It would not allow access to the EU single market in financial services or any passporting rights.
Of course, the UK is likely to want to negotiate its own bespoke relationship with the EU, preferably cherry picking benefits such as single market access and passporting rights, whilst maintaining relative freedom over policy-making. However, any agreement which allowed the UK full passporting rights would be unprecedented and unlikely to be achieved, particularly if the UK did not maintain regulation which is suitably equivalent or identical to EU standards.
Why does EU membership matter for UK financial services?
The UK has a very strong financial services industry, which is an important part of the economy. It is for this reason that the UK has had quite considerable influence in shaping EU financial services regulation. Although not every result favours UK interests, the UK does have relatively strong bargaining power.
Financial services is also one of the sectors most heavily affected by EU legislation. Post-financial crisis there has been a deluge of new and amended legislation, with firms spending more and more time on implementation and compliance projects. So many pieces of the regulatory framework were created at such speed in the wake of the crisis that they often do not fit together properly. Increasingly the legislation in the financial services sector has taken the form of regulations which are directly applicable in EU Member States rather than requiring implementation into domestic law. The European Commission has launched a project to review new legislation, gauge its effectiveness and examine any unintended consequences, but it is unclear how effective this will be.
Despite the obvious discontent with “red tape” from Brussels and frustration at elements which are seen as damaging, such as the EU rules around what financial institutions can pay their staff, the question is really whether Brexit would pave the way for improvements in the way the UK financial services sector is regulated (any hopes for a wave of wholesale deregulation would seem overly optimistic) or whether it would simply cause the loss of key benefits without much real change to the substance.
There is concern among some that if the UK were to leave the EU, depending on the model of the future UK-EU relationship, it could end up needing to maintain EU, or equivalent, standards, whilst no longer having a say on the content of those standards. As the UK has such an active market and strong industry bodies, it has often voiced the interests of industry during the legislative process. This industry-focused input could be lost if the UK were to lose its say in EU rules, which could lead to the legislation emanating from Brussels becoming ever less practical to implement.
Further, the UK has been one of the leading Member States arguing for “third country” access to the EU (i.e. access by non-EEA jurisdictions) and so if the UK were to lose its vote on EU legislation, there is a risk that the EU could take a more protectionist approach and seek to restrict further third country access or impose new requirements on dealings with the EU. This would not just be a consequence for the UK, but also for other third country jurisdictions.
Whilst there may be temptation to use Brexit as an opportunity to make adaptations (where this is politically feasible), the UK would also want to maintain its image as a respected centre for financial services. Although so much regulation comes from Brussels, a large proportion derives from G20 commitments or global standards with which the UK would be obliged to comply regardless of its EU membership.
For UK and third country financial services businesses alike, having an entity in the UK which is authorised in accordance with one of the EU single market directives (which include, for example, the Fourth Capital Requirements Directive (CRD IV) for banks, the Markets in Financial Instruments Directive (MiFID) for investment firms, and the Alternative Investment Fund Managers Directive (AIFMD) and Undertakings for Collective Investment in Transferable Securities (UCITS) Directive for fund managers) provides a gateway to the rest of Europe.
Passporting is a major benefit for financial services businesses in the EU, as it essentially means that in respect of certain services only one authorised entity is required in order to access the markets in other EU jurisdictions, either on a cross-border basis or through a branch. This can allow for significant cost savings, in terms of both the initial costs associated with set-up and authorisation, and certain ongoing costs such as regulatory capital requirements. Passporting does not just enable access; it also enables incoming firms to do business on the same terms as local firms. That said, the regulatory environment across the EU is not completely harmonised and firms do still encounter regional variations.
Financial services groups based outside the EU do not benefit from passporting rights. They often choose to use the UK for their EU headquarters, establishing a UK subsidiary that can passport into other Member States. For example, a large number of global banking groups have a UK banking entity with branches set up in various other EU Member States.
Therefore, one key question in the debate is whether the UK would be able to secure passporting rights in the event of a Brexit. An absence of passporting rights could necessitate both UK and third country financial services businesses rethinking their structure, as businesses with any significant presence across the EU would need to establish an EU subsidiary to access EU markets, but would likely also want to maintain a UK entity to do UK business. The issue of passporting is of course less of a concern for businesses which do not have EU-wide operations or for financial services businesses which do not do business under the single market directives (for example, consumer credit firms and certain financial advisers).
Brexit by sector
We now turn to examine the potential impact of Brexit on certain key sectors of the financial services industry. The discussion below is largely dependent on the nature of the UK’s relationship with the EU post-Brexit, and any speculation about what the UK might do should be read subject to the caveat that such action might simply not be possible in light of the terms of any future UK-EU relationship.
The UCITS Directive regime for certain types of open ended retail funds has been one of the success stories of EU financial services regulation but, curiously, may be one of the least affected in practice by Brexit, largely because of the well-trodden path of using Luxembourg or Ireland (with some newer competitors) as the place of establishment for many UCITS funds and, to a lesser extent, their managers.
Managers falling under the UCITS Directive will be most heavily affected if they have established the funds themselves in the UK as UK OEICs or unit trusts and market them across Europe, rather than having established them in Luxembourg or Ireland as is common for funds marketed across Europe. In the event of Brexit such funds may well reorganise and migrate to Luxembourg or Ireland.
However, all UK-based UCITS managers with any business elsewhere in the EU would be affected by the loss of their management passport which allows them to manage funds established in other EU Member States (and potentially provide other services including segregated discretionary management services). If that passport is lost they would need to look at transferring management of relevant funds to a subsidiary or third party manager established in an EU Member State and operating as the delegated investment manager of the fund in the way many third country managers currently do, subject to the controls and restrictions on delegation under the UCITS Directive (and, in due course, the third country provisions of MiFID II referred to below).
As far as all other fund managers are concerned, the advent of the AIFMD, which covers all non-UCITS funds (AIFs), was generally unwelcome and probably contains the greatest volume of regulation which would not necessarily have been introduced by the UK in the absence of its EU obligations. However, the introduction of a pan-European regulatory framework has allowed EU Alternative Investment Fund Managers (AIFMs) to benefit from a marketing passport enabling them to access EU professional (not retail) investors without having to navigate national private placement regimes (NPPRs), as well as a management passport.
EU AIFMs managing non-EU AIFs must comply with substantially the whole of the AIFMD plus, if they want to market the fund in the EU, the applicable NPPR – a less favourable position than non-EU AIFMs marketing non-EU AIFs in the EU, who do not at present need to be authorised under the AIFMD and need comply with comparatively few AIFMD requirements. If the UK were to leave the EU it is quite conceivable that the UK would reduce the burden of the AIFMD requirements, or make full AIFMD compliance an optional regime, in which case UK AIFMs might find managing and marketing non-EU AIFs (which would then include UK AIFs) less burdensome at least at the outset. However, they would lose their passport to manage and market EU AIFs, meaning that, like UCITS managers, they would need to establish a new AIFM (or form a relationship with an existing AIFM) in an EU Member State, switch management of the EU AIF to the new manager and provide delegated investment management or advisory services to it, subject to the delegation restrictions in the AIFMD (and MiFID II provisions in due course).
Moreover, on the marketing front not only are the NPPRs highly restrictive or effectively unavailable in a number of EU countries, but also the marketing regime under the AIFMD has not yet reached its final state.
The AIFMD envisages that a passporting regime will be introduced for authorised AIFMs (including third country AIFMs who have opted into the AIFMD). However this will only apply if both the AIFM and the AIF are located in an approved “equivalent” jurisdiction and the non-EU AIFM goes through full scale authorisation in an EU “Member State of reference”. This is likely to be a slow process - to date the assessment of other jurisdictions has been exceedingly slow and the passport is not yet available even to AIFMs from the very few countries which have so far been assessed as "equivalent".
The plan under the AIFMD is that eventually NPPRs will be removed and non-EU AIFMs will only be able to market into the EU by opting into the AIFMD and using its passport. The result is that even if the AIFMD framework were removed in the UK, UK AIFMs would need to opt in to the AIFMD in order to market into the EU and this would be reliant on the passport having been made available in respect of the UK (which would effectively require the retention of the AIFMD framework at least on an opt-in basis). Given the slow progress to date towards positively assessing jurisdictions and “switching on” the passport this should not be taken as a fait accompli. Moreover, the AIFMD is due to be reviewed and revised in a process starting in 2017 – a process which might well include changes to its third country provisions in an environment in which the UK would be negotiating its exit from the EU, rather than acting as a key member of the EU arguing for third country rights.
For investment firms authorised under MiFID the obvious drawback of Brexit would be the potential loss of passporting rights, which are widely used to access EU markets. Non-MiFID investment firms, which tend to be much smaller and carry on limited activities, may not be greatly affected, although they might hope for relaxations of some of the UK conduct of business rules which are largely derived from MiFID standards.
However, MiFID II (which is currently expected to come into effect on 3 January 2018) will change the position for investment firms outside the EU by introducing a new third country regime which will allow third country firms to provide services into the EU on a cross-border basis in some circumstances, or to passport services from an authorised branch in Member States which choose to permit this branch model, depending on the types of client with which they are dealing. However, the cross-border model will not be available to firms dealing with retail and other less sophisticated clients, and will only be available once an equivalence decision has been made in respect of the relevant jurisdiction, which could take some time. Therefore, it is not yet clear how accessible the new regime will be in practice. Nonetheless, in theory it may be possible that even as “third country” firms, some UK investment firms post-Brexit would be able to access EU markets without needing an EU subsidiary.
Firms wishing to provide investment services and activities across the EU which cannot use (or do not wish to wait for) the new third country regime and do not wish to establish an EU subsidiary, might try to rely on an exemption from MiFID. Some firms may eye the provisions which allow a third country firm to provide investment services and activities to clients on the “exclusive initiative” of the client without needing to be authorised as a potential aid, although such approach would obviously bear a certain risk as these provisions are not clear-cut and may be applied strictly (and differently) in various EU Member States.
Although investment firms might see one major upside of Brexit as not needing to implement MiFID II, it is worth bearing in mind that the MiFID framework is largely based upon the UK regulatory framework and that many of the changes under MiFID II are seen as necessary due to developments in market infrastructure since MiFID was implemented in 2007. Also, on a practical level, it is highly likely that the UK would still be a member of the EU, and so obliged to implement MiFID II, when its implementation date finally arrives (and likely for some time after). Although the UK might in future seek to tinker with certain elements of MiFID II to make them fit more neatly with UK markets, it seems doubtful that the regulation of investment firms would be significantly altered in the event of a Brexit.
For banks in the UK, passporting rights are a key benefit of EU membership, with many overseas banking groups choosing to place their EU subsidiary in the UK and making use of that entity’s passporting rights to access other EU markets.
While much has been made of the UK’s challenges to certain elements of EU banking regulation (in particular the highly-publicised failed bid to challenge the cap on bankers’ bonuses), it is questionable whether, if the UK were to leave the EU, there would be any major relaxation in banking standards. There are several key reasons for this:
- the UK is a major banking centre and a UK banking licence carries a certain cachet; the UK regulators will not want to be seen as watering down standards;
- the UK is still feeling the effects of the financial crisis and public confidence in the banking sector remains weak; the UK will not want to erode trust further by being seen as letting the banks off (recent policy decisions seen as concessionary to banks have sparked a great deal of public criticism);
- many rules do not come from the EU, but rather reflect agreed global standards which the UK would still be required to implement even if it were not a member of the EU; and
- the UK often gold-plates requirements or introduces its own tougher measures; a good example is the recently implemented Senior Managers and Certification Regime which imposes a stricter framework for individuals working in the banking sector.
That said, there may well be some areas where the UK would follow its own approach. Although this would not necessarily be a more relaxed approach (bearing in mind that the UK is often a step ahead, having brought in its own recovery and resolution rules, and created a ring-fencing regime, in advance of EU measures), it could choose to adjust certain areas of regulation with a view to calibrating them more effectively for the UK banking sector. It also seems probable that the UK would choose to take its own approach to the remuneration rules for banks, which would no doubt be a welcome move.