Brexit: Its impact on Financial Services Regulation

by Claudio Caruana

On 24 June it was confirmed that the UK had voted for a British exit of the European Union ushering in a period of uncertainty and instability for the UK financial services sector.

The Brexit vote gives the UK government a mandate to leave the EU by application of article 50 of the Lisbon Treaty. However, expectations are that such process will not be triggered until Prime Minister David Cameron officially leaves office in October and a new Prime Minister is appointed. Once Article 50 is invoked, it could take Britain up to two years to actually leave the EU, during which period EU laws would still apply to the UK. The full extent of the impact upon the financial services sector depends on the arrangements which will be put in place during the transitional period that would need to occur while negotiations are undertaken between the UK and the EU and just how and how far those negotiations shall preserve access for UK firms to EU clients. A wide range of scenarios are possible, ranging from no special relationship, to membership of the European Economic Area (EEA), to a broad trade agreement, to a Swiss style arrangement which is based on many sectoral bilateral agreements between Switzerland and the EU.

The directives that have been put in place since 1999 created a single market by enabling financial services firms authorised in one Member State, their home state, to carry on business in any other Member State, a host state, without the need for a separate host state authorisation either by establishing a local branch or on a cross-border basis. This is referred to as the “passport”.

Within the framework of the EU authorised asset managers, banks and insurers continue to have the ability to use passport rights to conduct their business throughout the EU single market.

The directives also establish the respective responsibilities of home and host state regulators for business with a cross-border element and provide a framework for regulators to cooperate with each other, both in relation to routine supervisory activities and in special cases such as changes of control, recovery and resolution planning and investigations.

As things stand, provisions do exist in various EU directives for the recognition of third country firms. It is expected that the UK government will push for recognition of the UK as an equivalent regulatory regime to support continued acknowledgement under passporting agreements.

In reality the impact of Brexit on fund managers would depend on the extent to which they are UK, EU or non-EU focused and the types of products they offer to investors. The main EU asset management regime is contained in the Markets in Financial Instruments Directive (MiFID), the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings for Collective Investment in Transferable Securities Directive (UCITS).

Undertakings for Collective Investment in Transferable Securities (UCITS)

The impact of Brexit on UK domiciled UCITS is likely to be severe, requiring possible radical restructuring, as they can only be established within the EU and there is no equivalence regime. For those managers who currently use the UK as a base from which to passport their financial services, a settlement that permits the UK to remain a domicile for UCITS would need to be negotiated. In the absence of such, those managers would have to be re-domiciled to an EU country and seek re-authorisation under the UCITS Directive, or cease to continue as UCITS altogether.

There is the possibility that the UK would build a home grown UCITS style vehicle to compete with the EU, but this is likely to take time and will not have the benefit of being pass-portable across the EU.

Alternative Investment Managers Directive (“AIFMD”)

The UK is unlikely to gain much regulatory autonomy by leaving the EU when it comes to marketing and passporting of funds. The AIFM Directive would still require non EU alternative fund managers to comply with EU requirements, including capital requirements and pay guidelines. Those managers wanting to continue to market their funds in the EU would not be exempt from regulatory burden. Indeed, under AIFMD, non-EU regulations must be deemed equivalent for the cross-border provision of products and services. Furthermore, in lacking a seat at the EU legislative table, the UK have less leverage in making recommendations for policy improvement.

Markets in Financial Instruments Directive (“MIFID”)

The Markets in Financial Instruments Directive (MiFID) is one of the cornerstones of EU financial services law setting out which investment services and activities should be licensed across the EU and the organisational and conduct standards that those providing such services should comply with. In 2011 legislative proposals were published to amend MiFID by recasting it as a new Directive, MiFID II, set to enter into force on 3rd January 2017.

One of the most obvious risks posed by Brexit is the exclusion, or restriction, of access of the UK to the European single market. Under MiFID II due to come into force shortly, the EU will tighten rules on third country access. Third country firms who want to sell their products and services to retail investors in the EU are required to open a branch within EU borders. In order to do so, the Commission (based on ESMA advice), must recognize the regulations of the third country as being ‘equivalent’. Assuming that the UK correctly implement MiFID II, then UK legislation would fall within the requirement of equivalence, however, once the UK is free to make its own determinations there does exist the likelihood that there will be a divergence from MiFID II, resulting in the possibility of non-equivalence.

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