There are 80 days remaining until the UK leaves the EU. Since the last Brexit talks, Theresa May resigned as UK Prime Minister and on July 24, Boris Johnson was appointed as the new PM. Over the same period of time, a whole new European Parliament and European Commission was elected. Given that newly chosen Commissioners formally assume their role November 1, any upcoming Brexit deliberations will be between the EU’s existing team (led by Michel Barnier) and UK PM Johnson’s new team. Although Stephen Barclay provides continuity as Brexit Secretary, the UK’s policy direction has shifted significantly with Johnson’s elevation. His stated determination to see the UK leave the EU on October 31 — “do or die, come what may” — leaves little to interpretation.
With these changes, there has been considerable speculation as to what, if anything, these developments signal in terms of Brexit negotiations. However, for asset managers caught in the midst of continued confusion, the old adage of “plan for the worst and hope for the best” remains the logical course of action. With time running out once more and seemingly intractable divergence in the UK parliament, asset managers grappling with the ongoing Brexit uncertainty should now look to implement their no-deal contingency plans.
Prior Contingencies Remain Valid
In anticipation of the original Brexit deadline of March 31, we flagged several impacts of a no-deal Brexit and these each remain equally valid as we head towards the new exit date. It is also worth noting that the contingencies originally agreed between the UK and EU regulators also remain valid and become effective should the UK, as expected, depart on October 31. These include:
- Memoranda of Understanding entered by the European Securities Markets Association (ESMA) and the UK’s Financial Conduct Authority (FCA) permitting EU UCITS and AIFMD management companies to continue to delegate to UK-domiciled entities.
- Recognition by ESMA of certain UK Central Clearing Counterparties, allowing continued central clearing of derivatives at these counterparties for a period of 12 months from the start of Brexit.
- The Central Securities Depositary Euroclear UK & Ireland (which operates CREST, the settlement system used for Irish equities listed on Euronext Dublin and the London Stock Exchange) will be recognized as “equivalent” for a period of 24 months from the start of Brexit.
Ongoing Regulatory Policy Debates and Indicators
EU Comments on Equivalence
We have often suggested that these “equivalence” contingencies are a less than optimal foundation to base access to the EU financial markets. This is because equivalence is temporary, subjective, and can unilaterally be withdrawal at any time and without warning by the EU. This point has come into sharp focus within Brexit planning. Recently, the EU flexed its muscles in this regard through a policy paper which stated categorically that regulatory equivalence can be withdrawn at any time at the EU’s sole discretion. Just last month, the EU Commission allowed equivalence status granted to Switzerland to expire, removing the ability of EU and Swiss investors to trade freely across borders. This move has been a signal to the UK, where many in the market expected seamless and continued trading of EU securities on the UK stock exchanges, even in the event of a no-deal Brexit. This is evidently not a done deal however.
In another example, the EU repealed certain equivalency decisions under the Credit Rating Agency (CRA) Regulation from several countries. This had a negligible practical impact to those countries but is illustrative of the fact that the EU retains the power to accept or reject third country access to the bloc as it sees fit. It seems clear that the EU seems set on toughening their requirements for recognizing non-EU countries rules as equivalent – a stance that will impact the UK financial sector post-Brexit.
UK Post-Brexit Regulatory Divergence
The investment fund liquidity debate has seen divergent interpretations expressed very publicly from stakeholders in the UK and the EU. This sheds light on a discussion that has been very prevalent through Brexit – whether the UK would look to stay closely aligned to EU rules on regulatory standards or would it look to diverge and forge its own path on regulations in a post-Brexit regulatory ecosystem.
Important No-Deal Brexit Considerations for Asset Managers
The so-called Brexit “flextension” has allowed time to make more granular assessments of the practical impact of a hard or no-deal Brexit on asset management. These considerations include:
Data transfers between EU & UK
In the event of a hard Brexit, another crucial area of difficulty to consider is any transfer of personal data by EU funds and service providers to and from the UK in accordance with General Data Protection Regulation (GDPR) requirements. When personal data leaves the EU, including post-Brexit UK, the information is considered to have been sent to a "third country." The EU has very strict legal controls to ensure the safety of the data when sent to a third country. As such, any EU funds or firms must take steps to put in place EU-approved “Standard Contractual Clauses” with all UK entities in order to remain compliant with EU data privacy standards.
Review of investment policies
Many funds currently have exposure to UK companies through references contained in their stated investment policy to invest in EU companies. Post Brexit, by design, the UK will no longer be part of the EU, and such funds should review their investment policy to ensure UK investment remain permissible or they require a change to their documentation to account for the change in the UK’s status.
UCITS fund of fund holdings
Many existing UCITS schemes in Ireland, Luxembourg, and elsewhere currently hold UK UCITS within their investment portfolios. It is important to note that once the UK exits the EU, that all UK UCITS immediately become UK Alternative Investment Funds (AIFs). As such, managers should consider UCITS on what impact those funds becoming AIFs has on their portfolios in light of the UCITS investment restrictions that already exists and that they hold only acceptable investments.
“Dual hatting” is a practice where an asset manager employee performs a function for multiple entities within a single parent organization. It is quite common for UK firms setting up entities in Ireland or Luxembourg to leverage existing employees to cover a specific area of oversight with their specialist knowledge. Regulators have suggested that they would permit “dual hatting,” but remain acutely sensitive to any possibility of potential use of “letterbox entities.” That refers to setting up companies without adequate local human capital and expertise and instead only leveraging resource and expertise from outside the domicile. The focus on adequate regulatory substance within the EU for regulated firms will remain intense for the foreseeable future.
Impact of Brexit on benchmarks and indices
The impact of a no-deal Brexit on the various equity and bond indices would be the exclusion of UK securities from most EU based indexes. This could have a significant reallocation impact to funds which track or closely mirror EU indexes. It would have a notable impact to passive index tracking funds and also a large tranche of exchange traded funds (ETFs) with EU focus. There are other pan-European indexes where the UK may remain a part, but it is important that both asset managers and investors consider the specifics of benchmark composition well in advance of October 31.
Luxembourg Brexit laws
In July, the CSSF in Luxembourg notified all UK-regulated entities wishing to rely on their current passporting rights for a transitional period of 12 months following the date of a hard Brexit that they would need to advise the regulator before September 15. An online portal has been set up and any in-scope UK firms not providing the required notifications will not be able to take advantage of the transitional period and will be in breach of their regulatory obligations.
EU money market funds
Under the EU Money Market Fund regulations, EU money market funds may only invest in deposits with EU credit institutions or institution in third countries that are deemed equivalent under the Capital Requirements Regulation. No equivalence decision has been made nor is expected to be made by the European Commission in advance of the Brexit deadline, so EU money market funds must consider permittable investments in the case of UK bank issuers which will not be EU nor deemed equivalent.
Funds registered for sale in the UK
All funds currently registered for distribution in the UK wishing to continue to market their funds in the UK in the event of a hard Brexit must notify of its intention under the FCA’s Temporary Permissions Regime (TPR) before the end of 30 October 2019 via the FCA’s Connect system.
Operational challenges of a mid-week split
In what is already a scary staging post, Brexit is planned to occur at midnight on Halloween night (a Thursday). However, what has really spooked the markets is that regardless, global markets remain open the next day, Friday November 1. This means that on the Thursday, all UK entities will trade, settle, and report as an EU Member State and the next day will trade, settle, and report as a non-EU third country. This has a raft of systems, compliance, reporting, and regulatory implications that need to be addressed and it is highly unusual for a market event such as this to occur overnight with a trading day the very next day. This must be a big consideration for anyone in asset management operations.
In the end, we may be 80 days from Brexit, or we may see further delays. With the Johnson-led UK emboldened to leave without a deal, the likelihood of a no-deal Brexit is more likely. However, a range of other scenarios (deal, delay [again], revoke Article 50 meaning no Brexit, a people’s vote, another general election) all remain live options for the UK until the Halloween deadline has expired.