Since inception, the EU sought to not only harmonise financial services among member states, but also create a legal architecture to promote cross-border selling, investing, and oversight through rules for delegation and financial transactions. In addition to developing the passport system, recent EU initiatives focused on resolution, prudential requirements, central clearing for derivatives, transaction reporting, and implementing the work of the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS). The FSB and BCBS have steered global thinking on prudential requirements and resolution regimes encapsulated within EU directives and regulations.
Since the UK joined the EU in 1973, its investment industry has operated within an EU single market utilising cross-border passporting of funds to access a wide investor base. Now, Brexit could change all that. Given the UK’s commitment to global reform in the financial services industry, it is difficult to see how the UK could substantially deviate from the initiatives that are already finalised or underway in the immediate aftermath of Brexit. However, divergence is likely over time as the UK reframes national laws to meet international commitments and carve out their own regulatory structure rather than continuing to conform within the EU requirements. Such divergence in the first instance will likely exacerbate the regulatory compliance burden facing financial services institutions and will likely be a key consideration for firms when deciding whether to conduct business in the UK in the near term. However, firms have begun to look beyond the UK financial services post-Brexit state and towards the longer term uniquely positioned British market.
The UK’s Financial Conduct Authority (FCA) has clearly indicated it will seek to evolve regulation to reaffirm the country’s position as a global financial center. Given the political pressure to foster opportunity for UK financial institutions in a post-Brexit economy, there is a push to create a market model competitive to the EU.
Key Considerations for Asset Managers
Much has been written about whether it will ultimately be a soft, hard, or no-deal-Brexit. Whether two-way passporting for funds is permitted, what rules apply to trading counterparties and transaction contracts, and who falls under jurisdiction of the European Court of Justice, there will be a transition period where both sides will continue to work out the details. The next question will be what rules apply when that transition is over?
The Transition Period
During the transitional period, the UK will need to consider which EU measures it would like to retain and address any gaps accordingly. Until the UK drafts new laws, which could take years, it’s possible that the UK would remain a member state, and at least technically subject to EU laws and requirements, including any new EU laws that take effect during that time.
The FCA has made it clear they will allow passporting into the UK during the transition period, meaning an EU fund can sell into the UK under pre-Brexit requirements. But for now, there is no clear agreement for UK-based funds to passport into the EU. Without such an agreement or member state protocol, there remains no certain mechanic for such an activity to continue during the transition period and even post-Brexit.
The transition period is just the beginning of an evolving post-Brexit UK marketplace. What rules may apply immediately post-transition versus the opportunity arising longer term, demonstrates the need for financial services firms to be forward planning in their pan-European strategy. If the UK were to seek to join the European Economic Area (EEA), and adopt a model similar to Norway, they could continue to take advantage of passporting and would be required to maintain the EU’s regulatory framework. Alternatively, under a customs union, the UK and EU would bolster a free trade and services agreement in which the UK would have the freedom to regulate its own financial services sector. A third option is the Switzerland model –take a closer look at all three.
The Norway model Norway contributes to the EU budget and adheres to the EU rules and regulations. However, there is misalignment because the financial services sector is required to follow rules and regulations even without influence and engagement on shaping those rules because they lack EU membership.
The Switzerland model Switzerland contributes to the EU budget, but it’s a smaller amount than within the Norway model. Switzerland must adhere to some of the EU rules and regulations. This model is considered attractive given its lower EU budget contribution however, the challenge remains where the industry is bound by rules and regulations over which it has no influence.
Customs Union or Turkey model The Turkey model, also known as the customs union, includes an agreement for no tariffs or quotas on exported industrial products, but that only applies to goods, not services. This may seem attractive to the wider UK economy but would leave the financial services industry without EU market access.
Asset managers should also consider what their distribution strategies will look like post-Brexit. For UK-based firms relying on the passporting system, it’s unlikely they can continue business as usual. If the passport lapses or once any temporary passporting solution expires, it would be necessary for asset managers to consider how their business models and group structures would need to change. Managers may need to setup a management company or EU Manco.
Managers would then need an EU subsidiary that could provide banking services into the remainder of Europe. For EU firms that wish to provide banking services into the UK, it would be necessary to consider establishing a UK subsidiary. Transferring distribution activity also brings into question where does the value of the EU distribution activity reside?
Delegation & Substance
The ability of UCITS asset managers and AIFMs to delegate – whereby funds are domiciled and regulated in another EU country, but managed in the UK – has been a key area of focus ever since the UK triggered Article 50 stating intention to leave the EU. The European Securities and Markets Authority (ESMA) published two opinions in 2017 explaining its views on what regulatory requirements local supervisors should have in place. In addition, the European Commission intends to grant supervisors new powers to monitor delegation and outsourcing outside the EU.
More substance in the EU implies more local roles and infrastructure for asset managers. For many, this will mean greater disruption to existing business structures and processes, including moving some assets out of the UK. This could include management agreements with EU clients or assets used in the EU distribution activity, for example, where customer relationships are currently managed in the UK.
The UK’s Financial Conduct Authority (FCA) has clearly indicated it will seek to evolve regulation to reaffirm the country’s position as a global financial center.
Whilst focus has remained on retention and continuation of seamless EU access to the best extent possible, if the time horizon of Brexit is extended, it is irrefutable to suggest that the UK as a financial center will look to leverage its existing global role. The fact that the UK will be free from the EU regulatory Trilogue approval process means that it may be able to frame a more nimble and flexible regulatory environment in several key areas.
OEICS Recast as “UCITS Lite”
Many open-ended investment companies (OEICs) operate based on UCITS regulations. It’s possible for UK OEICs to retain many of the factors that investors covet in UCITS, such as high corporate governance standards, independent depository oversight, whilst allowing more flexibility in parameters elsewhere. For example, a “UCITS Lite” product might have less stringent investment concentration rules, allow higher proportions in specifics holdings, allow greater leverage or borrowings upon discretion of the board, and also lighten the stringent remuneration provisions on the asset managers of such funds. These discretions may reduce fund costs and increase returns in a market where these components are increasingly important.
Commonwealth Funds Passport
The British Commonwealth is made up of 53 independent and voluntary member states dispersed across the globe and are mainly countries which previously formed what was known as the British Empire. With the UK leaving the EU, it needs to forge new alliances and perhaps leverage historic ties.
Among Commonwealth members are some financial heavyweights (Australia, Canada, India, New Zealand, and South Africa) as well as certain rapidly developing nations showing high growth and savings rates spread across Asia, Africa, and the Americas. The crown dependencies of Jersey, Guernsey, and Isle of Man as well as larger autonomous territories such as Cayman Islands and Bermuda are financial centres of note that the UK can leverage to a much greater degree outside of the EU than within.
It’s also worth noting that many of the Commonwealth states are similar in terms of legal basis and systems of business to the UK, so it’s not inconceivable that the UK could coordinate a passport fairly quickly.
Alignment of UK with US Clearing standards
There has been significant debate about the appropriateness of retaining Euro clearing in the UK post-Brexit. But there is a wider debate between the US and the EU regarding clearing standards. The CFTC, the US OTC, and clearing regulator has grown increasingly agitated with the EU as it tries to harmonize the rules to the benefit of global trade. The EU does not consider many US central clearing counterparties to be “equivalent,” causing issues for US OTC brokers wishing to trade with EU counterparties. The EU has proposed significantly enhanced requirements on the supervision of third-country CCPs. The CFTC said they believe this “unilateral change by EU authorities to the CFTC-EC Equivalence Agreement to be a violation of trust and cooperation between the US and Europe.”
In a post-Brexit world, the UK would be free to move its rules to match that of the largest OTC trading bloc (the US) to foster increased activity between both countries on trading derivatives contracts rather than to appease the EU who have been slightly intransigent on harmonisation of OTC regulation in recent years.
When the UK ceases to be part of the EU on midnight 29 March 2019, many fear that billions of euros worth of financial contracts will go up in flames. However, the European Central Bank created a technical working group to study risk management around the day Britain leaves the EU, aiming to avoid just that.
To say that it is a challenge to have a clear view on the consequences of Brexit for the asset management industry is putting it mildly. For decades, asset management in the EU has been based on fund passporting rights, indirectly and directly effective EU legislation, centralised regulatory oversight, and member state implementation. The consequences of Brexit will depend on both the disentanglement of a single member state from this construct and the future state of the UK as a competing differentiated market. And by losing its seat at the table, the UK financial services industry will be limited in its ability to influence and engage with the EU regulatory bodies and yet still be subject to EU rules and requirements.
Both the UK and EU are seeking to create a treaty for exit allowing businesses to continue relying on EU law until the end of 2020. But failure to reach an agreement on the Irish border and deadlock over future terms of trade have panicked UK firms and heightened the risk of the UK’s no-deal departure.
For asset managers both in the UK and global managers who see the potential opportunity, now is their chance to make a change. Those managers should see Brexit as a unique opportunity to shape their ideal financial product which will compete on a global stage. Managers can engage with politicians to enhance the best parts of existing funds, such as the EU’s UCITS or the US’ 40 Act funds, add new elements where they see fit, and create an expedited, attractive, frictionless investment vehicle. It’s open season for such managers to work with the FCA and others to embed qualities into a new, future state fund alternative.
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