Brexit: Implications for Financial Services

We have prepared thoroughly to help our clients through Brexit.  You will find our briefings and commentary on our Brexit webpages.

We are aware that our asset management, investment fund and insurance clients are now thinking in a more practical way about opportunities and challenges that their businesses face.

This series of video blog talks look, as far as we are able in the context of the current uncertainty, at the possible options and practical implications for you.  Written notes supporting these video blogs can be found on our website

We will be adding to and updating these video blogs on a regular basis and we are very happy to come in to have a post-Brexit brainstorming session to work with you to identify potential issues and how these might be dealt with, as well as discussing opportunities which might arise.

How did UK regulators respond to the Referendum result?

On the morning of the Referendum result, the Financial Conduct Authority issued a statement. Included within that statement was the following:

“Much financial regulation currently applicable in the UK derives from EU legislation. This regulation will remain applicable until any changes are made, which will be a matter for Government and Parliament. Firms must continue to abide by their obligations under UK law, including those derived from EU law, and continue with implementation plans for legislation that is still to come into effect.”

How does the Article 50 process affect the application of EU law in the UK?

Article 50 is a mechanism for triggering the process for negotiating a withdrawal. Now what is clear is that EU law should remain in force in the United Kingdom until one of two things:

• either the withdrawal is negotiated; or
• two years expire.

The clear implication of this is that until one of those two events occur, the law will remain in force and that is very much what the Financial Conduct Authority statement seeks to implement or highlight.

What about the impact on the powers of the EU supervisory authorities?

The EU supervisory authority, such as the European Securities and Markets Authority and the European Banking Authority, will continue to have the powers that they currently have under EU law.  Amongst those is the power to censure the Financial Conduct Authority or the Prudential Regulation Authority where they do not abide by EU law. The more interesting question, however, is whether there will be an appetite on part of the European supervisory authorities to exercise that power, but EU regulatory power continues until Brexit.

What about passporting rights?

Passporting rights are central to the EU structure and the rights that are given to UK firms that are authorised by the Financial Conduct Authority, again in keeping with the statement made by the Financial Conduct Authority, will remain.  That is passporting rights both for UK firms looking to passport into a European Member State but also for European firms looking to passport into the United Kingdom.

What about forthcoming EU laws?

The Financial Conduct Authority was very clear to emphasise that when it comes to forthcoming EU laws, and here we think of MiFID II in particular but also other directly applicable regulations such as the Benchmark Regulation, and the UCITS VI Implementing Regulation, those will continue to come into force and effect and the practical implication is that firms which currently have projects in place for implementing those laws will have to continue with those and that is very much the clear message that the Financial Conduct Authority has given.

What is the overall message?

The overall message is that in many respects it is business as usual.  We say in many respects because of course the powers which the United Kingdom has to negotiate the content of current EU laws while still present may be truncated due to the political situation. I mentioned earlier that the powers of the European supervisory authorities, which again may also be not as applied as aggressively because of the political will, but overall technically speaking the expectation of the Financial Conduct Authority is that it is business as usual and if one can use a cliché perhaps it really is a case of keeping calm and carrying on.

What do market participants need to be doing now?

The immediate issue for counterparties is volatility in the markets.  We have seen particular volatility in sterling and the UK and global stock markets.  Counterparties will be reviewing their existing positions to ensure that they remain appropriate for evolving market conditions. 

Counterparties should also be ensuring that they have sufficient liquid assets to satisfy collateral demands.  If there are significant reductions in the value of sovereign and corporate debt, additional collateral may be required.  If there are credit downgrades, this might have the effect of reducing the types of eligible collateral that can be posted.  Counterparties should therefore ensure that their collateral processes are robust and functioning properly.

We have seen S&P and Fitch downgrade the UK’s credit ratings and, whilst we have not seen any indication that banks will be downgraded, it is prudent for counterparties to be prepared for that outcome over the coming weeks and months.  That could result in credit downgrade events of default being triggered, where counterparties would need to consider their options and potentially act to terminate contracts.

With the increased possibility of the Bank of England’s base rate of interest being set to negative, counterparties should also ensure that their trading documentation adequately caters for this eventuality.  This would typically be achieved through adhering to the ISDA negative interest rate Protocol for qualifying contracts, or by making bilateral changes to contracts for non-qualifying derivatives and other trades.

Should market participants continue to comply with, and implement, EMIR and SFTR?

While the United Kingdom remains a member of the European Union, the duties under EMIR and SFTR which apply to counterparties - and any duties under the MiFIR regulation in relation to trading when it comes into force - continue to apply.  In a statement issued last Friday, the FCA, which is the competent authority in the UK charged with enforcing EMIR, stated that: “firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect.”

What happens to EMIR following the UK’s withdrawal from the EU?

The precise effects of withdrawal and whether EU Regulations such as EMIR and SFTR will continue to have a direct effect in the UK remains uncertain.

To the extent that the UK was to remain in the European Economic Area, then EMIR and SFTR should continue to have effect (as it does in Norway, Iceland and Liechtenstein which are members of the EEA but not members of the EU).

To the extent that the UK does not remain in the EEA or no other full mutual EU recognition regime is put in place, then EMIR would not apply to trades entered into between overseas banks and UK banks. However, given that EMIR gives effect to an international G20 obligation which falls, in any event, on the UK, it is likely that the same or similar requirements that apply under EMIR in the UK will apply after withdrawal. The UK Parliament will have to make, or empower another authority to make, a law to this effect.  

Whatever the outcome - but particularly in a post Brexit UK which does not remain in the EEA and which does not benefit from full mutual recognition - there will be many competing demands for rule-makers’ time and attention.  One would therefore expect that, at least initially, any new UK rules would be based on - or borrow heavily from – the current EU rules.  This is what market participants will be familiar with and they should already be compliant with these rules.  Over time, the UK’s rules could track new EU regulation in order to obtain and maintain some recognition of equivalence or it could diverge – for example, the UK might choose to follow the way that some jurisdictions have implemented legislation to deal with G20 objectives in a more user-friendly way.  For example, EMIR requires both EU parties to any trade to report their transactions but Dodd Frank in the US only imposes this obligation on major swap participants who report for both themselves and their counterparties.

Further, EMIR does provide a mechanism for the recognition of third country central counterparties (CCPs) subject to the UK satisfying an “equivalence” requirement. The effect of “third country recognition” is that it would be possible for EU counterparties to clear trades with UK counterparties through a UK CCP with CCPs being treated as qualifying CCPs for the purpose of the EU banks’ regulatory capital requirements under the EU Credit Requirements Regulation.

Irrespective of the final arrangements between the UK and the EU, to the extent that a UK counterparty trades with an EU counterparty, that trade will be subject to EMIR.  The effect of this is that many of the provisions relating to risk mitigation techniques will apply because of the EU counterparty’s requirement to comply with these.  If there were no equivalence status for a non-EEA UK, EMIR would not require an EU counterparty to clear trades except in limited circumstances but one would expect the UK to introduce its own clearing requirement or UK counterparties may still wish to clear for pricing or exposure purposes.

Conclusion

In conclusion, there is likely to be no significant change for some years, and possibly no real change in practice if we remain in the EEA or there is some form of equivalence recognition.  Even if a post Brexit UK completely breaks away from the EU, an ongoing requirement on the UK to implement international objectives which the EU implements through EU regulations, and market familiarity and infrastructure, means that in practice the likelihood is that market participants are still going to have to comply with EU regulations for a number of years to come.  However, we have seen how quickly things change and counterparties should be monitoring the position on an ongoing basis and considering whether and how to influence policy makers and regulators to ensure that workable solutions are found for whatever Brexit model the UK ends up following.

What are some of the immediate considerations for institutional investors?

An immediate action for investors will be to review their investment strategies; this may include re-allocating some existing investments to other asset classes.

Volatility in the markets will be a concern for investors.  One of the immediate actions for overseas investors, and UK investors with foreign currency exposure, will be to monitor and mitigate their currency risks. 

As well as risks, there may be real opportunities, for example, in the real estate sector and also in the infrastructure sector where the Government’s focus may be intensified.

How can investors manage their holdings in investment funds?

As part of their overall review, some investors might consider re-allocating some of their investment fund holdings.  It is important that investors understand the terms on which they invested, as these will determine their ability to withdraw. 

UK authorised investment funds are required to have regular dealing points at which investors in them can withdraw.  For many funds, UCITS included, these dealing points will occur daily, whilst for others that are invested in less liquid asset classes, these dealing points will be less frequent.  All these funds will be able to implement liquidity tools in times of market stress.  These tools include applying a fair value adjustment to the net asset value, deferring withdrawals for a limited time, or even suspending withdrawals.  Funds investing in direct real estate (and other less liquid assets) are generally more likely to implement these tools. 

Other investment funds may be established for a fixed life with no ability for investors to withdraw.  For those funds, the main option is to sell in the secondary market.

What should investors who have derivatives and trading contracts be doing?

Investors with derivatives contracts should ensure that they have sufficient liquid assets to satisfy collateral demands.  If there are significant reductions in the value of sovereign and corporate debt, additional collateral may be required.  If there are credit downgrades, this might reduce the types of eligible collateral that can be posted.  Investors should therefore ensure that their collateral processes are robust and functioning properly.

Whilst we have not seen any indication that banks’ credit ratings will be downgraded, it is prudent for investors to be prepared.  That could result in credit downgrade events of default being triggered, where investors would need to consider their options and potentially act to terminate contracts.

With the increased possibility of the Bank of England’s base rate of interest being set to negative, investors should also ensure that their trading documentation adequately caters for this.  This would typically be achieved through adhering to the ISDA negative interest rate protocol for qualifying derivatives, or by making bilateral changes to contracts for other trades.

Should investors continue to comply with EU laws?

Finally, the legal position has not changed.  While the UK remains a member of the European Union, the duties imposed on investors under EU regulations continue to apply.  These include the regulations on the central clearing of derivatives.

What effect will Brexit have on UK based alternative investment fund managers?

In order to understand what effect Brexit might have on UK managers of alternative investment funds it is necessary to start with the current position.  Where UK AIFMs market their EU AIFs (for example non-UCITS retail schemes, UK investment trusts, English limited partnerships and Irish QIAIFs) they have the benefit of an EU passport which enables them to market those funds to professional investors in the EU and to manage EU funds with minimum formality in other EU states subject to complying with all the requirements of the AIFMD in managing and marketing those funds.  Where UK AIFMs market non-EU AIFs (such as Cayman hedge funds and Guernsey investment companies) to professional investors in the EU they are, under Article 36 of the AIFMD, subject to the national private placement regime (NPPR) of each of the Member States where the AIFs are marketed or managed.  In relation to those funds, they must comply with all of the requirements of the AIFMD except that the full AIFMD depositary regime is replaced by the so-called depo lite requirements.  That will continue to be the position until the UK leaves the EU at the end of the 2 year period prescribed by Article 50 of the Treaty on the European Union.

What happens after that depends on what the new relationship between the UK and the EU will be. 

If the UK were to become a member of the European Economic Area (EEA) exactly the same rules would continue to apply, as the AIFMD applies throughout the EEA, although the UK would have lost its ability to input into how the AIFMD regime evolves. 

If the UK leaves the EU without becoming a member of the EEA, and becomes what is described in the AIFMD as a third country, then subject to what I am going to say later about passports for non-EU AIFMs, UK AIFMs in respect of all their AIFs will be non-EU AIFMs and will be subject to the national private placement regime of each of the Member States where their AIFs are marketed to professional investors. This would be governed by Article 42 of AIFMD and would involve more limited compliance with the requirements of AIFMD relating to disclosures to investors and to EU regulators and, for private equity firms, the asset stripping provisions together with any additional requirements imposed by the Member State in question. 

Would this lead to the UK regulatory system being liberalised by removing the provisions inserted into it under AIFMD?

This would not necessarily lead to the UK regulatory system being liberalised by removing the provisions inserted into it under the AIFMD.  It may be that these would be retained to facilitate access to the passporting regime which the AIFMD contemplates for third country AIFMs.

The AIFMD makes provision for the passport, which is currently reserved to EU AIFMs and AIFs, to be potentially extended in future. There is a procedure in AIFMD which has to be followed for this to happen.  That procedure is set out in Article 67.   It requires the European Securities and Markets Authority (ESMA) to issue to the European Parliament, the Council of Ministers and the EU Commission opinions on the functioning of the existing passport for EU AIFMs, on the functioning of the existing national private placement regimes and on the management or marketing of AIFs by non-EU AIFMs.

ESMA has produced some initial advice and has agreed with the European Commission that a country-by-country approach is required because the tests set out in Article 67 may result in different outcomes depending on the regulatory and supervisory framework of the third countries in which non-EU AIFMs and funds are established.

Because of resource constraints, ESMA has decided to deliver its advice in waves of selected countries. The Commission will take a decision when a sufficient number of countries have been appropriately assessed.

The Commission says that ESMA’s opinion on the functioning of the passport will be particularly helpful for the planned review of AIFMD that should start in 2017.  The upshot of all of this is that it is not clear whether and when the passport regime for non-EU AIFMs will come into force.  It is also not possible to predict whether the UK would pass ESMA’s assessment, bearing in mind that ESMA advised the EU authorities to delay their decision on the application of the passport to the USA, until such time as conditions which might lead to a distortion of competition are addressed.  The terms of the future trade relationship between the EU and the UK could be crucial to this assessment.

An additional uncertainty hanging over this is the provision in Article 68 of the AIFMD under which, if the passport for non-EU AIFMs is brought into force, consideration is to be given after three years to terminating the national private placement regimes so that passporting becomes the only and mandatory way of marketing AIFs to professional investors in the EU.  Any such decision would be about five years away on current timetables.

In relation to marketing to retail investors the position will remain unchanged - each EU member state can make its own rules.

In summary, the rules remain as they are until the UK actually leaves the EU and the rules that apply after that will depend:

• Firstly on how the future relationship between the UK and the EU is shaped;
• Secondly on whether and how the passport for third country AIFMs is introduced; and
• Thirdly on any changes arising from the proposed review of AIFMD in 2017.

The only point that can be made with certainty is that by leaving the EU the UK loses its ability to influence how those second and third factors will play out.

What funds are we looking at here?

Well, first of all we should distinguish between funds set up and authorised in the UK, and those set up elsewhere in the EU. 

Within those jurisdictions you then have UCITS and non-UCITS funds, but currently only UCITS funds can realistically be sold cross-border to retail investors under their UCITS passport.  For non-UK funds we are therefore looking only at UCITS funds – non-UCITS funds set up in other jurisdictions will continue as before (and we discuss their sale to professional and institutional investors in our video on alternative investment funds that accompanies this recording).

So what does Brexit mean for EU UCITS?

The first point to make is that if there is an agreement for the UK to join the EEA, there would be no real change and non-UK UCITS could still passport into the UK.   This seems at the moment unlikely after the meeting of the Council of Ministers on 27 June made it clear that the internal market for the EEA as well as for the EU includes freedom of movement but there is speculation as to a deal.

This means that these EU UCITS would no longer have automatic access to the UK retail market under their passport and will have to obtain approval from the FCA as individually recognised schemes under the FSMA. 

What plans should these funds be making?

First of all, there is the obvious point that until Brexit is effective two years after Article 50 notice is given, there will of course be no change. 

The two years gives time to plan but action will be needed before then to decide on and implement a project.  The FSMA recognised scheme regime I mentioned may change but this is not certain and in any case the process for individual recognition of funds has always been relatively costly and cumbersome.

It looks as if duplicate ranges may have to be launched for the UK if that is worthwhile for a manager, and for managers currently offering EU UCITS into the UK this will be costly and less efficient to run on an ongoing basis.  For EU managers with no capability to set up funds in the UK, they will need to set up a UK manager or find a UK host manager. 

This reorganisation might also involve merging the existing non-UK UCITS into the new UK UCITS if the main market is the UK and the two ranges of duplicate funds are not viable on their own.

How will UK authorised funds be affected?

Without an EEA special deal, UK UCITS will lose their ability to passport outside the UK, with a similar impact to that we have just looked at for their non UK counterparts passporting into the UK.  UK managers may need to set up new ranges in other EU jurisdictions.

Can portfolio management be delegated back to UK firms under these arrangements?

The new Luxembourg or Dublin ranges all this envisages are based on an assumption that it will be permissible for the portfolio management to be delegated back to the UK as it currently is now.  This should be the case – just as US delegated portfolio managers can be used now, although the CSSF and Central Bank of Ireland would need to put in place co-operation agreements with the FCA.  Their funds industries would certainly expect them to do that. 

Will the UK’s own fund rules in COLL change?

We would not expect the FCA’s rules for the UK authorised fund regime to change, at least not in the first few years even if this involves consulting on and adopting EU Level 2 regulations into UK rules.  We already have the NURS regime for retail funds that are not UCITS, which relaxes some UCITS requirements - for example to allow other types of assets to be held beyond those eligible for UCITS, in particular property.  The current UCITS category could be amalgamated with the NURS category but this would bring changes where we do not see there being any appetite from the FCA for a cosmetic change.  Remember generally its priority is consumer protection and it approves of the protections of the UCITS regime so we would not expect less stringent rules.

A UK “ex-UCITS” regime might therefore be left broadly untouched. It might also, going forward, shadow the UCITS regime on an ongoing basis to enable UK UCITS funds more easily to continue to be sold in other countries outside the EU, in the Far East or Switzerland, for example. 

What about UCITS with management companies in another jurisdiction?

EU management companies managing UK funds under the UCITS management company passport and UK managers managing non-UK UCITS under the passport, so-called “super-mancos”, will lose their passports and have to be replaced by domestic management companies.

Other points?

There will be lots of other issues that emerge, both of detail and for particular funds – for example feeder funds where the master is in the UK but the feeder will not be permitted under the UCITS regime as the master must be a UCITS fund.  Going the other way, the FCA might conceivably allow non-UK masters for UK feeders.  We will have to see.

Will funds still need a depositary following Brexit?

Well, for now of course we still remain in the EU until the Article 50 process has played out and so all the requirements to have a depositary under UCITS and AIFMD will remain in place.  Even when we do leave, the requirement for a depositary is still enshrined in the Financial Services and Markets Act, the OEIC Regulations, COLL and FUND.  The government would need to repeal these pieces of legislation and FCA would need to consult on amending the FCA Handbook.  In reality, given the important investor protection role which the depositary plays, we think that it is extremely unlikely that the concept of a depositary, certainly for authorised funds, will be removed any time soon.  The concepts of a depo-lite and a depositary for “unauthorised AIFs” which are very much EU driven and not a concept the UK had prior to AIFMD are something the government and the FCA would need to consider and whether indeed the UK should return to a pre-AIFMD world where unauthorised funds did not need a depositary.  This would obviously give the UK a competitive advantage and position the UK as an attractive centre for fund establishment.

What rules would apply to depositaries post an exit?

Again, until we leave, the full rigour of the current rules which apply to depositaries will continue to apply.  On exit, any EU Regulation of direct application will cease to apply with immediate effect – so, for example, Level 2 of AIFMD and UCITS V would no longer be applicable.  Level 1 of AIFMD and UCITS are implemented into UK law by way of Statutory Instrument and the FCA Handbook.  On exit, this would remain in place unless the government and the FCA choose to repeal them which we will not know about for some time.  Given the nature of the rules currently in place and the no doubt strong desire for financial institutions to continue to operate in Europe in some way, we think it unlikely that the government would seek to change the regime fundamentally.  They may, of course, take the opportunity to consider some of the more uncertain areas of the depositary regime and to clarify or amend these but we would not envisage a wholesale restructuring of the regime.  The FCA and government could, of course, also seek to adopt Level 2 into UK law, otherwise this could be somewhat of a vacuum but, again, this adoption could be on an as is basis or modified to address some of the key issues which depositaries have found in implementation – for example the need under Level 2 of UCITS to obtain opinions on segregation.

Will new depositary agreements be needed?

This depends on how the current regime changes and whether the depositary services need to be provided from a different legal entity.  If the current regime stays in place, then it is possible that only minor changes would be required to reflect references to the new rules etc.  If there are more fundamental changes then it is possible that existing agreements will need to be more heavily amended – so, for example, if Level 2 falls away and is not replaced this would have a reasonably large impact on agreements.  Obviously we would need to have more certainty around the regime before these changes could be made.

What will happen to relationships with global custodians?

Again, this will very much depend on what regime we are left with post exit.  Depositaries will need to look at the delegation regime post exit and determine whether the current delegates meet the requirements.  It is likely that global custody arrangements will need to be amended unless the regime stays very much as it currently is.

Will depositaries need to relocate or be re-authorised?

Under current UK rules the depositary must be established in the UK or in an EEA state and have a place of business in the UK. UK funds must, therefore, be serviced by UK depositaries currently and so there will be no need for depositaries to relocate.  Issues may arise however where UK depositary services are provided by a UK branch of a European entity.

There is currently no depositary passport and so UK depositaries have to obtain a UK permission to act as depositary.  Unless the FCA change the eligibility and authorisation requirements, depositaries should be able to rely on their current authorisations. It will of course mean that UK depositaries will be unable to avail themselves of any future EU depositary passport, which has been mooted under UCITS VI unless there are third country equivalence provisions that would allow UK depositaries to passport their services into Europe.

What do insurance participants need to be doing right now?

Most insurers should have had in place contingency plans to deal with the short-term impacts of the vote – dealing with market volatility and ensuring they had a clear communications strategy. However, these will need to be updated and refreshed. The current rules and regulation have not changed and it should be business as usual. It is important that contingency plans are worked up into more detailed plans and insurers, reinsurers and brokers consider the various possible scenarios following an exit.

A critical question in the long-term is whether the UK will be able to access the single market and whether UK insurance companies and brokers will be able to continue to passport into the rest of the EU without being locally authorised. Equally for EU insurers and brokers they will want to be able to passport into the UK to provide insurance to UK clients.

What will be the impact on UK focussed businesses?

For UK based firms that have little European business the key question will be the extent to which the UK ends up applying its own rules rather than following the European directives. It is unlikely that there will be a departure from Solvency II. It is also likely that if the UK does not benefit from passporting that the UK will seek to be an equivalent regime for the purposes of Solvency II in any event.

Whilst there may not necessarily be wholesale changes therefore, there may be some flexibilities or departures from EU regulations in the long-term. Depending on the approach of the regulators, this may have its benefits (i.e. being able to have a conversation with the regulator about an issue which originally derived from European regulation) but may also have its challenges (i.e. a risk of gold-plating).

What should European insurers be considering?

For insurers with material European businesses that rely on passporting, the key will be to consider what options they might have should the UK not get passporting rights. Insurers should prepare long-term contingency plans by considering their current operating model and business strategy and the extent to which these aspects might be impacted by the loss of passporting rights. Contingency plans may be complicated if other EU countries follow suit and look to withdraw from the EU and the plans of other insurance groups may also need to be considered (for example, what Lloyd’s might do).

Any change is unlikely to take effect overnight and, if in the ‘worst case’ scenario the UK does not get passporting rights it is likely to involve a very long transition period and possibly dispensations for existing business.

Are there any interim steps that insurers can be taking in this market?

In the meantime, however, insurers should consider structures or corporate actions that may mitigate any adverse impacts of losing passporting rights as part of their contingency plans. For example, using some kind of reinsurance structure for cross-border business going forward or looking to either set-up or buy insurance platforms in key markets where passporting rights may be lost. We may see European groups looking to make acquisitions in the UK to hedge the risk of Brexit and similarly, going the other way, UK based groups looking to make acquisitions in other key European markets. However, based on the uncertainties involved those transactions will need to make sense in any event. On a practical level, insurance groups should seek to ensure contingency plans are factored into the governance process and ORSA (if applicable).