This briefing note explores the implications of the decision to leave the EU for the financial services sector.
01 | Introduction
On June 23, 2016, the UK held its historic referendum concerning its future membership in the EU. The result of the referendum, announced in the early hours of June 24, took many by surprise with the UK voting by 51.9 per cent to 48.1 per cent to leave the EU after over 40 years of membership.
02 | The general consensus
The general consensus following the referendum vote 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 the referendum vote although the Chancellor, the Bank of England and other policy makers have sought to move quickly to reassure markets and provide a message of stability. In addition, the route to eventual Brexit and the shape of the UK’s 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 which triggers the two year negotiation period for the UK’s withdrawal remains the subject of considerable political speculation. Until the EU and UK have agreed the nature of their post-Brexit relationship, it will be very difficult to assess with any certainty the impact on the financial services sector.
03 | The legal and compliance perspective
In the meantime, from a legal and compliance perspective, life goes on as before the referendum vote. 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 June 24, 2016 to make it clear 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”.
So, for example, MiFID, the CRD IV, the CRR, EMIR etc are still in effect in the same way as before the referendum vote. The Market Abuse Regulation that became applicable in all EU Member States on July 3, 2016 also applies in the UK. UK firms can still passport under the EU Single Market Directives.
04 | The FCA announcement
The reference in the FCA’s announcement to future EU legislation is interesting but should not come as a surprise. One suspects that MiFID II and MiFIR, which now apply from January 3, 2018, were very much on the regulator’s mind. It would be a mistake for firms to simply down tools on their MiFID II / MiFIR implementation projects thinking that the legislation won’t apply. Firstly, there is every chance that MiFID II / MiFIR come into effect whilst the UK is still negotiating its exit arrangements. Second, many of the provisions in MiFID II and MiFIR were part of the international regulatory reform agenda that the G20 pursued following the 2008 financial crisis. Third, should the UK have exited the EU by January 3, 2018, depending on what may be negotiated, access to the Single Market will still be desirable. At the very least such access, for those within the scope of MiFID II and MiFIR could be via the third country regime set out in the EU legislation and the equivalence of the UK regulatory regime will be an important factor.
05 | So what should firms be doing now?
Before the referendum a number of firms would have carried out an impact analysis, looking at how a leave vote would impact their business model. These firms will no doubt be carefully reviewing events as they develop and assess their options. However, some firms will be playing catch up and will want to at least get a high level understanding of the possible exit options and the preliminary steps they should be taking.
06 | So what are the possible exit options?
The three options that appear to be touted the most are the so-called ‘Norwegian model’, the ‘Swiss model’ and the ‘total exit model’ (this has been referred to in some parts of the industry as the ‘New York model’). Each of these models has various pros and cons. In summary, under the Norwegian model the UK would join the European Economic Area and the European Free Trade Association. The UK would be bound by existing and future EU legislation as a condition of maintaining access to the Single Market. But this would come at a cost in the sense that the UK would not have a seat on the EU institutions. It would also have to make a contribution to the EU’s budget. In addition, at the moment the EEA Agreement has been slow to incorporate EU financial services legislation following the financial crisis and does not cover the work of the European Supervisory Authorities. Under the Swiss model, a series of bilateral agreements would have to be put in place although the precise details of these would be subject to negotiation. Some would argue that there is more flexibility with this model but one suspects that there would need to be agreement on future legislation if the UK wished to retain access to the Single Market. However, whilst Switzerland has negotiated a large number of bilateral agreements with the EU none of them currently provide for Swiss access to the EU internal market for financial services. Under a total exit model, unless the UK were able to negotiate a free trade agreement offering access to the Single Market it would be treated as a third country and be treated on no more favourable terms than any other non-EU country.
07 | Extraterritorial provisions
When conducting their analysis under the total exit model firms may wish to consider whether the EU legislation they are subject to has extraterritorial provisions. For example, EMIR has a number of provisions that have extraterritorial effect including the key requirements such as margin for uncleared trades and mandatory clearing. EMIR also provides for a recognition regime for central counterparties offering their services to EU-based clearing members from jurisdictions that are assessed by the EU as offering equivalent protection to the UK regime.
08 | UK asset management industry
For the UK asset management industry the impact of a total exit would be significant on the basis that several fund vehicles such as UCITS and European Long Term Investment Funds must be domiciled in the EU and managed by an EU-based management company. This would prevent UK domiciles and managers for such funds unless these were re-negotiated with the EU. Depending on the exit terms, UK alternative investment fund managers would be treated as non EU alternative investment fund managers and would only be able to market alternative investment funds to EU investors under private placement agreements if the Member States where the investors are based permit such marketing.
09 | Commercial agreements
Firms may also wish to consider their commercial agreements. For example distribution agreements may need to be reviewed where they currently provide for the distribution of financial services products in both the UK and other parts of the EU, in order to assess whether the potential separation of the regulatory regimes may impact on their terms. Outsourcing agreements may also need to be reviewed particularly where they impose obligations on parties to meet the costs of complying with applicable law and regulation.
10 | Regulation to be completely re-written?
Finally, another question on everyone’s mind is whether UK regulation will be completely re-written. Most in the market believe that it won’t be. Whatever system of regulation the UK seeks to negotiate it is worth remembering that it will continue to be a member of a number of international standard setting bodies such as the G20, the Basel Committee on Banking Supervision and the Financial Stability Board (FSB). For example, in terms of over-the-counter derivatives, the UK would seek to follow the G20/FSB standards on central clearing of derivatives and the margining of non-centrally cleared derivatives. On bank capital requirements the existing requirements would probably continue to apply but perhaps with three caveats: (i) where the Basel Accord is more liberal than EU rules (e.g. in the area of remuneration) the UK could follow the Basel approach; (ii) as the Basel Accord sets only minimum standards, the UK could still choose to impose higher standards on UK authorised firms; and (iii) the UK could restrict the application of the Basel rules to internationally active banks and apply a lighter regime to small banks.
This post is authored by: Jonathan Herbst, Partner, Norton Rose Fulbright, Peter Snowdon, Partner, Norton Rose Fulbright, Imogen Garner, Partner, Norton Rose Fulbright, Hannah Meakin, Partner, Norton Rose Fulbright, Conor Foley, Advisor - Government and Regulatory Affairs, Norton Rose Fulbright, Simon Lovegrove, Head of Financial Services Knowledge – Global, Norton Rose Fulbright.