Global | Publication | June 2016
The United Kingdom has voted to leave the European Union. Assuming this proceeds and depending on what arrangements might be negotiated, there are likely to be significant consequences for asset managers and for the financial services industry as a whole, and, we expect that whilst the departure process will take several years, asset managers will already be assessing the risks and opportunities that the UK’s exit may bring.
In this short briefing, we identify some of the key areas that we see that asset managers will be considering and monitoring closely over the coming weeks and months.
The general consensus is that there is an element of a journey into the unknown. This is in part a consequence of the economic and market uncertainties resulting from Thursday’s referendum (although the Chancellor, the Bank of England and other policy makers have sought to move quickly to reassure markets and to seek to provide a message of stability). In addition, though, the road map to eventual Brexit and the shape of the post Brexit relationship with the EU are both at a very early stage of evolution. Even the timing of the service of the Article 50 notice under the Treaty on the European Union by the UK (which triggers the two year negotiation period) remains the subject of considerable political speculation. Until the EU and the UK have agreed the nature of their post-Brexit relationship, it will not be possible to assess precisely the impact of that relationship on asset managers and the framework for regulation of the sector.
In the meantime, from a legal and compliance perspective, nothing has changed nor will it change until, at the earliest, the end of the two year period triggered by the Article 50 notification. To this end, the FCA made an announcement on 24 June to make it clear to the industry 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”.
A significant proportion of UK financial services legislation affecting asset managers (such as the AIFMD, the UCITS Directives and MiFIDII/MiFIR) is derived from EU financial services law. Some of those rules and requirements could fall away automatically following the UK’s exit from the EU, while the UK could potentially gain the ability to repeal or modify others. Much will depend on the eventual terms of the UK’s relationship with the EU following its departure.
The short term focus for asset managers, as in the case of many other industry sectors, is likely to be the effect of the uncertainties generated by the process we are about to embark upon and the resultant economic implications arising from market and currency volatility, the impact upon returns and margins, inflows and outflows of client assets and on asset class selection. It is also likely that there will be an impact on the ability to raise new funds, at least in the shorter term. New listed closed-ended fund IPOs, in particular, may struggle to get launched given equity market conditions until there is greater certainty on the roadmap ahead.
We do not expect that there will be any immediate review or change to the complex matrix of laws and regulations that govern the activities of asset managers based in the UK as a result of the referendum. As mentioned above, for the time being from a legal and compliance perspective, we consider that business will be as usual and asset managers will continue to need to prepare for forthcoming regulatory change. In other words, during the Brexit negotiations and for at least a two year period from the date the UK does decide to trigger its Article 50 notification, the UK will remain an EU member state and will continue to be subject to EU laws. During this period, the UK will still be able to participate in EU law and policy-making and in the activities of the EU institutions pending the entry into force of the exit agreement (other than in relation to its own withdrawal). However, practically speaking, the UK’s credibility as a participant in EU decision making is undermined (as witnessed by the recent resignation of Lord Hill as EU Commissioner responsible for financial services).
A number of asset managers have also asked whether in light of the referendum result they should continue their preparations for MiFID II and its related Regulation, MiFIR which apply on 3 January 2018. In our view the answer to this question should be “yes”. Firstly, on the basis that it is likely that when MiFID II / MiFIR apply the UK will still be negotiating its exit and therefore remain a member of the EU. Second, many of the provisions in MiFID II and MiFIR were part of the G20 reform agenda that politicians put in place following the financial crisis or reflect areas of priority for the UK’s domestic regulators quite apart from the European dimension. Third, should the UK have exited the EU by January 3, 2018, depending on what may be negotiated, access to the EU’s Single Market will still be desirable. At the very least such access, for those within the scope of MiFID II and MiFIR would be via the third country regime set out in MiFID II and MiFIR and the equivalence of the UK regulatory regime will be an important factor. It is also important to note that international standards will continue to be relevant as the UK will still be a member of the G20 and will still be part of international financial standard-setting bodies such as the Basel Committee on Banking Supervision, the Financial Stability Board and IOSCO. These have an impact in a number of areas relevant to asset managers.
The shape of regulation that will apply to UK asset managers after Brexit will depend on the nature of the UK’s relationship with the EU including the key issues of access to EU markets and the continued ability to distribute products to European investors. Whilst it is thought that the clearest way in which this could be achieved would be to adopt the “Norwegian model” through the UK acceding to the European Economic Area (EEA) Agreement (which would retain single market access), whether this would be acceptable from a political perspective is not yet fully clear, since this model is generally understood to require free movement of people and significant financial contributions to the EU’s budget, opposition to which were features of the pro-Brexit campaign.
Short of EEA membership, the model could be some sort of bespoke arrangement for the UK accessing the single market, whether through a series of sector-specific treaties (the so-called “Swiss model”), a more extensive free trade agreement (the so-called “Canadian model”) or some sort of special affiliate status negotiated for the UK adapted from the current EEA arrangements. If, however, the UK is treated as a third country under EU financial services legislation and if UK investment firms wanted to continue to provide investment services or products to clients in the EU, UK rules will need to be deemed equivalent by the European Commission. The paragraphs that follow consider the position if the UK does not conclude any such arrangement and is considered a “third country” under EU financial services legislation.
Assuming the UK does not accede to the EEA Agreement or negotiate an arrangement with equivalent access, the UK will become a “third country” for the purposes of the AIFMD. As such, UK based AIFMs will lose their right to manage funds based in other EEA domiciles and their right to market UK domiciled AIFs to investors in other EEA signatory states using the AIFMD marketing passport. UK managers and funds would be able to take advantage of private placement regimes in electing EEA signatory states on the same basis as US or Channel Island based funds and/or managers, for example, although such private placement regimes may be abolished after 2018. Should the European Commission decide to introduce a passport regime for third country AIFMs or AIFs, then it is likely that the UK should be in a position to demonstrate that it has a suitably equivalent regulatory regime and be able to access this arrangement. However, the introduction of such a regime is uncertain and possibly less likely following Brexit (not least as the UK was one of, it not, its main proponent in negotiations under AIFMD).
A more likely post Brexit scenario for UK managers is that those managers who wish to distribute more widely to EU investors than can be readily accessed through private placement regimes will need to set up a fund domicile and distribution platform in a suitable EU member state, for example in Ireland or Luxembourg, with an AIFM established in such jurisdiction, in some cases, delegating portfolio management back to operations in the UK.
Unlike the AIFMD, the UCITS Directive, which governs the cross-border management and distribution of retail mutual funds, has no provisions relating to third country passporting or private placement. Following Brexit (once again assuming that the UK does not join the EEA or negotiate an arrangement with equivalent access), UK based managers will lose their right to manage UCITS funds based in other EEA domiciles and their right to passport UK domiciled UCITS funds. Indeed, UK UCITS funds may lose their UCITS brand and status and default instead to categorisation as non-UCITS retail funds which would instead be subject to the AIFMD. Therefore, UK based managers seeking to market their funds with ease across the EU would be required to restructure their location, operations or business models.
For those managers who currently use the UK as a base from which to passport their funds, a settlement that permits the UK to remain a domicile for UCITS would need to be negotiated. Without such a settlement being negotiated, those managers (and any UCITS established in the UK) would have to be re-domiciled to an EU country and seek re-authorisation under the UCITS Directive. Under a potential agreement between the EU and the UK, full compliance with the UCITS directive would likely still be required. Individual EEA member states may still decide to give their retail investors access to UK funds under bilateral arrangements where they consider the UK regime remains equivalent or, alternatively, may allow them access to professional investors only under a private placement regime under AIFMD. However, most UK based UCITS managers already typically have an Irish or Luxembourg distribution platform, which delegates portfolio management back to the UK, and this is likely to be the model others need to follow if looking to access pan-EU retail distribution.
In the short term we expect there to be little impact as, until the UK concludes its exit negotiations with the EU, the UK remains a member of the EU and current EU legislation (including that which applies in the next two years) applies. However, asset managers will need to keep track of the UK’s exit negotiations and assess the impact of any arrangements on their distribution network. Assuming the UK does not accede to the EEA Agreement or negotiate an arrangement with equivalent access, the UK will become a “third country” for the purposes of MIFID. As with AIFMD, it is possible that third country passporting rights might be introduced and that the UK would have an equivalent regime for these purposes. However, if it did not, then once again it might be necessary for some managers to set up or expand their EU domiciled hub to market products and services cross border, delegating back to the UK as appropriate. Online distribution platform arrangements will also need to be carefully considered.
Given the likely need for UK asset management firms to rely on delegated arrangements from EU distribution hubs and platforms as discussed above, a further concern will be potential changes to the delegation rules that currently enable MIFID investment firms, AIFMs and UCITS management firms to delegate to a UK based investment manager. This will depend on whether the post-Brexit UK regime would be deemed to be sufficiently equivalent to enable delegation by EU firms to UK investment managers, which we consider on balance to be the more likely scenario, although changes to those rules could be made that are less favourable than at present. For example, the EU might pass more stringent rules in relation to the remuneration regime that must apply to the delegated third country manager, including bonus caps, which is something the UK has resisted strongly to date but which it may be unable to influence so strongly in future. However, the delegation model could also be adversely affected by changes in the tax regimes of different EU member states. There may be changes to delegation rules enabling MIFID investment firms, AIFMs and UCITS management firms to delegate to a UK based investment manager.
When considering the restructuring of EU management companies, to the extent there is delegation of portfolio management by an EU entity to, say, a UK management company, the substance of the EU management company will be an important focus of the EU and national Member State regulators. There is already a supervisory focus on whether some EU management companies are simply “letter box entities” and this is likely to intensify in a post-Brexit world. The activities of sub-managers and/or sub-advisors also needs to be considered including the requirement for them to be operating in accordance with national regimes such as the overseas person exclusion in the UK or EU regimes under MiFID II/MiFIR.
The overall impact of Brexit is likely to depend upon on the nature of the asset manager and the scope and scale of its activities. It is quite possible that smaller managers not requiring significant access to EU distribution (for example, those for whom access to the EU market through third country private placement regimes is sufficient) will be able to flourish in a less burdensome UK regulatory regime and that it may become significantly more economic for start up managers to launch than at present. However, the burden is likely to increase significantly for those managers that do need to take the step up to establishing a hub in Dublin or Luxembourg, for example, even if using a third party provider or platform.
Some commentators consider that larger asset managers with existing European operations (in jurisdictions such as Luxembourg and Ireland) will see little impact upon their ability to distribute products throughout the EU, since they are for the most part probably distributing UCITS and AIFs from non-UK domiciles already. However, the position for asset managers which are subsidiaries or divisions of banks (or other financial institutions such as insurance companies) may become more complicated by reason of developments in those types of sector, and in particular if banks are considering a reactive restructuring of their operations, including potential relocation of parts of their business.
The extra-territoriality and scope of EU financial services legislation applying to UK firms should also be considered. Even where investment services are not provided to EU clients, some regimes apply in respect of financial instruments traded on an EU trading venue. So for example, Brexit is not likely to result in changes for investment firms when it comes to the application of the Short-Selling Regulation or the Market Abuse Regulation as the rules under these regimes relate to where the shares or instruments are listed, rather than where the investment firm is based. In respect of trading in the derivatives market, the obligation under Article 57 of MiFID II in relation to position limits for commodity derivatives is also likely to apply to UK asset managers. Article 57 does not refer to the domicile of the person who holds those positions, and so applies on an extraterritorial basis to any person that trades commodity derivatives on any EU trading venue.
The requirements in relation to mandatory clearing, minimum margin requirements and reporting to trade repositories under EMIR are likely to continue in the UK, regardless of the post-Brexit UK model. This is because EMIR was the result of an internationally agreed framework and it is unlikely that the UK will deregulate its own derivatives market, particularly given the UK’s G20 policy commitments.
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