Brexit and its Implications
The votes have been counted and ‘Brexit’ has won the day. The UK electorate has voted 52% to 48% to leave the European Union (EU).
The Prime Minister David Cameron has announced he will resign in the Autumn as soon as a new Leader of the Conservative Party has been elected. Meanwhile the UK currency, the Pound Sterling has suffered massive falls in value overnight against the US Dollar and the Euro and the London Stock Exchange has also seen massive falls in value in early trading.
The UK regulator, the Financial Conduct Authority (FCA) issued a news release this morning saying:
“On 23 June, the UK voted to leave the European Union (EU). This has significant implications for the UK.
The FCA is in very close contact with the firms we supervise as well as the Treasury, the Bank of England and other UK authorities, and we are monitoring developments in the financial markets.
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.
Consumers’ rights and protections, including any derived from EU legislation, are unaffected by the result of the referendum and will remain unchanged unless and until the Government changes the applicable legislation.
The longer term impacts of the decision to leave the EU on the overall regulatory framework for the UK will depend, in part, on the relationship that the UK seeks with the EU in the future. We will work closely with the Government as it confirms the arrangements for the UK’s future relationship with the EU.”
The now “lame duck” Prime Minister, David Cameron has announced that he will not initiate the immediate EU withdrawal process. This task will fall to the new Prime Minister in the Autumn or later. Our thoughts turn now to what the implications might be for the financial services sector.
The Withdrawal Process
In terms of breaking away from the EU the high-level process can be found in the Treaty on European Union (TEU), which together with the Treaty on the Functioning of the European Union (TFEU), is the legislation upon which the EU is founded.
The right of any Member State (including the UK), to cease to be a Member State of the EU is enshrined in Article 50 of the TEU – see link (the link provided is a consolidated version, the relevant article can be found on page 59).
The UK is required to notify the European Council of its intention to withdraw from the EU under Article 50. Unless agreed otherwise by the EU, the UK then has 2 years within which negotiations must be conducted with the EU to conclude an agreement setting out arrangements for the withdrawal. These arrangements will include a framework for the UK’s future relationship with the Union following withdrawal.
When a withdrawal agreement is concluded and has entered into force then the ‘Treaties’ (being the TEU and the TFEU) cease to apply. If a withdrawal agreement cannot be agreed, the Treaties will cease to apply two years after the notification, unless the European Council, in agreement with the UK, unanimously decides to extend this period.
It is not therefore a foregone conclusion that the details of future trading relationships will have been concluded and finalised as part of the withdrawal arrangements. What is clear is that at that time the UK will cease to be a Member State and will lose all automatic rights of access to the EU markets and institutions.
Unlike firms grappling with the detail of MiFID, EMIR etc. the UK will not have the comfort of ESMA Q&As or Technical Standards to fall back upon to help it ‘conclude an agreement’ – it will be down to hard negotiation on both sides.
Although perhaps not of immediate relevance to the UK case, should a departed Member State change its mind it is entitled to ask to re-join (Article 50(5)). It does raise the intriguing possibility of a change of course by a future Government if the UK finds life outside of the EU too tough! As former Prime Minister Harold Wilson famously said: “A week is a long time in politics!”
As far as we can ascertain today (24 June 2016), the UK is likely to remain part of the EU until at least the Autumn of 2018. This is based on the observations that the EU has never agreed new trading relationships in a period of less than 2 years (with between 3 and 7 years being much more the norm). There is also no evidence to suggest that such a complex and unprecedented withdrawal agreement can be concluded in less than 2 years.
Much of the UK’s financial services law is now derived directly or indirectly from EU Directives and Regulations designed to harmonise trade. Unless repealed and replaced by the UK Parliament, even after the official withdrawal date has been agreed, it is highly likely that the majority of such law will remain in force within the UK. The volume of law to be repealed and replaced is simply overwhelming. It is likely to take years for the UK Parliament to complete such a task. In other similar situations internationally, where a Territory has seceded from a State or similar structure, what tends to happen is that much existing law remains in force going forward and is only gradually changed.
During this next 2 year period, it is clear that at day to day level, EU Regulations and Directives will still apply on a ‘business as usual’ basis.
The ‘withdrawal agreement’ is, of course, the most important part of the process, during which the possibility of the UK either going it alone or, perhaps, applying to become a member of the European Economic Area – or even some hybrid arrangement – will no doubt be thrashed out. Having said that, like the Government and the EU, no one actually knows what is going to happen so the following is food for thought.
Impact on Financial Services
The EU Single Market in Financial Services has to a greater or lesser degree, been one of the most integrated and successful aspects of the EU Single Market. It covers banking, investment services, investment funds, pension funds, mortgage broking and lending, consumer credit broking and lending, life assurance, general insurance and motor insurance. It touches the daily lives of citizens and is a major component of the UK economy.
As observed above, for the next 2 years there is likely to be no change as the UK will still be an EU Member State and the UK will still have access to the Single Market. However beyond that timeframe the picture is decidedly uncertain.
Going forward beyond the next 2 years, the impact on UK financial services will depend significantly on the nature of the future trading agreements that are negotiated between the UK and the EU. What is fairly clear from the referendum campaign is that membership of the Single Market via membership the European Economic Area (EEA) is unlikely to be acceptable to a UK Government, as it involves free movement of people. Therefore, unless there is a dramatic change of stance, the UK will need to negotiate access to markets on a market by market and case by case basis. The recent precedent for this was the 7 years it took to negotiate a very much more limited set of agreements with Switzerland.
The scenario is thus beginning to look like no change for the next 2 years followed by a period of likely restrictions on access to the Single Market in Financial Services.
In practical terms, this means that firms that currently conduct cross-border business or have Branches in other EU States under Service or Branch Passports, may no longer be able to conduct such business without authorisation from the Host State regulator(s).
Similarly, unless the UK Government passes legislation in Parliament to permit it, the automatic right of firms based in other EU States, that operate in the UK under Passports, will lapse and they will need to seek authorisation from the FCA and/or PRA in the UK.
The foundation stones of the Single Market are the Insurance Mediation Directive, Solvency 2, the Capital Requirements Directive, MiFID, the Banking Consolidation Directive, UCITS directives, AIFMD, the Payment Services Directive and similar directives applying to mortgage lending and consumer credit.
The Directives are transposed into national (i.e. UK) law by way of statute or UK regulations. However, with each of its Directives, the EU issues implementing regulations and technical standards that are automatically binding and become law in Member States. There are 2 significant Directives that are in the process of implementation and where Brexit is likely to pose problematic questions.
The AIFMD came into force in 2013. Significant aspects of the Directive have not as yet been implemented fully, namely the ability to passport into the EU from outside of the EU and decisions regarding replacing the national private placement regimes.
Passporting is a valuable benefit under the AIFMD, both in terms of the right to manage AIFs established in other Member States, whether directly or via a branch, and the right to market AIFs. As a UK AIFM would be transformed into a ‘non-EU AIFM’ the passporting rights would no longer be available. Whilst the AIFMD allows for the extension of the passport regime to non-EU AIFMs in due course, and assuming that the UK would be assessed in a favourable light for such an extension, the great unknown would be in the period between the UK no longer being able to benefit under the AIFMD as a ‘EU AIFM’ and the, eventual, extension of the passport to the UK as a ‘non-EU AIFM’. This uncertainty would apply to both UK firms that were hoping to obtain a passport for the first time and to UK firms that are already operating under a passport. Although we are looking at the AIFMD for the purposes of this article, it is not unknown for AIFMs to delegate portfolio management to MiFID firms who of course would also face similar problems on the availability of passports under the MiFID regime.
On a positive note, some of these issues, if not all of them, could well be addressed during the ‘withdrawal agreement’ process, although this would presumably depend upon the tenacity of the UK representatives involved.
On the matter of MiFID, the application of MiFID II (and MiFIR), as we know, has been delayed until 3 January 2018. Now this time frame throws up an interesting, but hopefully hypothetical, scenario especially if the UK provides the European Council with its notification to leave the EU sooner rather than later. As mentioned above, based upon Article 50 of the TEU the UK could cease to be a Member of the EU two years from now, if not earlier. UK firms subject to MiFID II may therefore be in the unfortunate position of having to comply with MiFID II on 3 January 2018, only to find that it ceases to be relevant to them later in 2018 when the ‘two year’ period has expired. Of course, what that would mean in terms of UK legislation that transposed and adopted MiFID II is another question.
The UK financial services sector was almost universally opposed to Brexit. The City will be a major loser if access to the single market is lost. Given this scenario, The City and the wider financial services sector will lobby politicians very hard to try to preserve access.
The reality is likely to be that the UK would continue to operate under the requirements of AIFMD, MiFID etc. by way of bringing in UK legislation that mirrors those requirements. Whilst the UK would not be a Member State, the effect of mirror legislation would arguably minimise the disruption that would be encountered if, instead, the UK decided to start its financial regime from scratch. Also, the UK might be looked upon in a more favourable light by the EU when negotiating the terms of a withdrawal agreement if the UK were to continue to be seen to ‘comply’ with EU Directives and Regulations by way of UK legislation.
Although this article is naturally concerned with the ‘financial world’, to gain perspective it must not be forgotten that EU Directives and Regulations extend beyond this to cover many different areas, some of which may also be of relevance to a wider range of firms e.g. ranging from data protection obligations (currently Directive 95/46) to anti-Money Laundering and Counter-Terrorist Financing.
Inward Investment & UK Headquarters
Significant numbers of non-UK financial services companies have located their European HQ in the UK in order to have a wider presence in Europe via the UK membership of the Single Market in Financial Services. Whilst the UK will remain an important financial centre, it remains to be seen what impact Brexit will have on the future attractiveness of the UK compared to other European financial centres for the location of a European HQ.
It is probable that many companies will evaluate whether Dublin/Ireland (same time zone, same language, similar legal and taxation system, preferential Corporation Tax rate) becomes as attractive or even more attractive as a location compared to London/UK.
It is also highly likely that companies from the USA and other non-EU companies looking to locate/invest in Europe will now have to consider what impact Brexit and loss of automatic access to the Single Financial Services Market will have on their appetite to invest in and locate in the UK.
One of the key benefits of the Single Market and its passporting system has been the ability to be authorised in one Home State, but to trade in several other Host States without the need for authorisation by the regulator in each state. Those of us old enough to remember European cross-border financial services before the Single Market, will recall the horrendous regulatory burden of multiple regulatory applications, multiple trading entities and multiple capital adequacy requirements required for each State in which business was to be conducted. It was expensive and inefficient compared to the Single Market passporting system.
What Is To Be Done?
In the shorter-term, there is little positive action that can be taken by firms. More importantly, that is precisely the time to consider and reflect upon business objectives, identify risks (or opportunities) potentially posed by Brexit and to seek advice (where needed). Firms should then be in a position to identify actions required or desired in the shorter to medium term to achieve those business objectives.
This is also likely to be an iterative process. It is possible (indeed highly likely) that the regulatory environment and regulatory requirements may evolve in response to trade negotiations and market conditions. It is highly unlikely that governments, regulators or firms will get this right at the first attempt. It is much more likely that firms will need to keep Brexit and its implications under rolling review, for as long as it takes.
How Can Complyport Assist?
The Complyport Governance, Risk Management and Compliance (GRC) team are not only skilled and experienced in management of regulatory issues, but have significant cross-border experience. Complyport is very well placed to assist firms and their other professional advisers to assess the impact of Brexit upon the firm and its business objectives, to identify risk (and possibly opportunities) and to plan action required.
With a strong knowledge of and depth of experience in Irish regulatory requirements and a strong international network of professionals other European jurisdictions, we are ideally placed to assist.