The prospect of the UK leaving the EU has raised a host of questions for the financial services industry. This client alert is principally concerned with how firms in the UK may access the EU single market post Brexit without the need to establish an EU member state regulated firm. This alert does not, however, consider the particular issues which concern EU single market access for fund management. For a detailed analysis of EU single market access for fund managers, please see our previous client alert.
Q: Should firms continue with their EU regulatory implementation projects? Even without the added complication of Brexit, the industry has been labouring under the challenge of implementing a huge raft of regulatory reforms emanating from the EU:
MiFID2/MiFIR, EMIR, CRDIV/CRR, Solvency II, AIFMD, BENCH, SFTR, MAR/CS MAD, BRRD...
These acronyms are so familiar as to warrant no explanation here; each represents a substantial – in some cases fundamental – reform affecting large swathes of the industry. So the very first question many have asked themselves is whether they really need to press ahead with those implementation projects, first among them perhaps MIFID2/MiFIR1?
The answer to that question is a firm Yes.
For three reasons:
- First, many regulatory reforms will apply before Brexit is fully achieved. For example, UK firms will need to be MiFID2 compliant by January 2018, before the likely earliest date of full Brexit.
- Secondly, the EU reform package is predominantly an implementation of a wider agenda agreed by the G20 at Pittsburgh in 2009 in response to the last financial crisis. The UK was at the forefront in developing that agenda and UK policymakers took a leading role in developing the EU's approach. To disavow those reforms now would be a remarkable volte-face.
- Thirdly, as we highlight below, come what may, firms will need to comply with EU regulation in order to access EU markets.
Q: How will UK firms gain access to the EU single market? By far the most important question, however, is the fundamental one of market access.
Over the last three decades, the EU has developed harmonised single market regimes covering banking, investment services and insurance. The key premise has been that firms licensed to conduct a financially-regulated activity in one EU member state (the home state), are able to conduct business in any other EU member state (the host state) without seeking a licence in that host state.
This is the so-called 'EU passport' and it can be exercised either by firms wishing to set up a branch in a host state (branch passport) or wishing to do business there on a cross-border basis (services passport).
Since the EU passport was introduced, non-EU financial services groups have generally (though not exclusively) sought to access the EU by establishing, licensing and capitalising an EU subsidiary, which uses its EU passport to operate as a single pan-EU hub. For a great many, the jurisdiction of choice in which to establish that pan-EU hub has been the UK.
With the UK out of the EU, how will they continue to do financial services business in the EU (with EU customers and on EU markets)? Are there other reliable methods for them to access the EU?
Can firms, for example, argue that when conducting financial services business into the EU on a cross-border basis, they are in fact outside the territorial jurisdiction of the relevant EU member state? Alternatively, when MiFID2/MiFIR applies from January 2018, will UK-based investment services firms be able to take advantage of the 'equivalence' regime under which third country firms may gain access to the EU single market?
Market access from the UK into the EU: Assessing the solutions
The solutions In the current debate on this question, there are four possible solutions under scrutiny:
- Territorial scope (Jurisdiction analysis)
- EEA Membership (the Single Market Passport)
- Equivalence (the Third Country Passport)
- Negotiating a New Package
Each of these solutions has attractions and limitations. In this client alert, we assess their utility by considering how they measure up against key criteria.
The criteria A good solution for the financial services industry would need to:
- deliver access for UK firms seeking to trade into the EU and vice versa;
- be available in good time (so that firms can avoid a damaging interruption to their business);
- be sufficiently simple so that it can be implemented swiftly by the EU, the UK and the market, and
- be reliable and not readily retracted or reduced as political tides change in future.
So, we have perhaps four key criteria: level of access, timing, simplicity and reliability.
Financial services firms will look for comfort that their businesses can be maintained during any transition from EU to non-EU status. The solution, whatever it is, must be available at or before that point, as a hiatus in market access would be damaging. In this light timing may prove to be the most critical factor.
'Negotiating a new package' could take an inordinate amount of time and would likely not provide sufficient assurance of business continuity, therefore this solution is not considered further in this alert.
But how do the other three solutions stack up?
1. Territorial Scope (Jurisdictional analysis) In many situations, a firm based outside the EU may conduct business on a cross-border basis with customers or counterparties in an EU member state on the basis that the firm is outside the territorial jurisdiction of that state. Under this argument, the firm is legally outside the jurisdiction of that state and cannot therefore be subject to licensing requirements and prohibitions under its law.
Where it applies, this line of reasoning is extremely useful.
It has been suggested that although UK-authorised firms have tended to rely on their EU passports, they may not have needed them in many instances. They could instead, perhaps, have determined that their activities were outside the territorial scope of the EU member states' licensing requirements.
It has also been said that territorial scope should or could be analysed on the basis of the so-called 'characteristic performance' test. The idea behind this test is that, put broadly, in determining where an activity is carried out when it is conducted cross-border, one must consider where the characteristic elements of that activity take place. On this basis, one might conclude (as is generally accepted) that cross-border deposit-taking activity occurs where the deposits are accepted (not where the depositor resides). Similar arguments might be made for insurance (where is the risk assumed?), execution of orders on behalf of clients (where is the relevant market on which execution takes place?) and so forth.
But the key issue with this approach is that whether or not your activities are territorially within the scope of an EU member state is a matter determined by the law of that state (as this has not generally been prescribed by the EU single market directives).
Unfortunately, EU member states do not always apply the characteristic performance test when determining whether or not a firm from outside the EU is within their territorial jurisdiction. There was a time when the EU Commission – seeking to encourage liberalisation at the outset of the single market – had wanted firms to adopt this approach so much that it issued an 'Interpretative Communication2', promoting it with little success. Then, as now, many EU member states adopted a more restrictive test based on initiation or solicitation, i.e. on whether the non-EU firm is perceived as actively marketing its services in the relevant jurisdiction.
Another issue with this approach is its vulnerability to the winds of political – or policy – change. In many EU member states, the territorial question is not settled in legislation but is a matter of interpretation (on which national regulators issue guidance). It is easier to change guidance than law. In Germany, for example, BaFIN's approach in the context of banking services hardened (reportedly in response to retail marketing activity by Swiss private banks into its jurisdiction) and although this approach was later confirmed by the German court3 it did not arise as a result of a legislative change.
So regulators in some EU member states could harden their approach on this question, whether as a result of Brexit (so as not to grant a passport by the back door) or for other reasons in the future.
Assessment: The 'territorial scope' approach is unlikely to grant a comprehensively wide level of access by itself – though it may be useful in tandem with other solutions – and is vulnerable to political and legal change: it is strong on reliability. In principle it would score well on timing (as it would require no particular negotiation to implement), but as firms would need to check the treatment under the law of each member state they wished to access, it would hardly score highly for simplicity.
2. EEA4 Membership (the Single Market Passport) EEA contracting states (in general) have the right to participate in the EU single market and have implemented the majority of the EU single market directives relevant to the financial services arena.
As a result, firms in EEA contracting states are entitled to exercise the same EU passport rights as those from within the EU. Clearly, if the UK were to remain an EEA member with full EU passport rights, this would offer access rights equivalent to those available today.
It is the closest thing to a 'business as usual' solution on the table and it is packaged up in a ready-made framework. It is nevertheless clearly the most attractive model for business in terms of timing and simplicity.
It also has real advantages in terms of level of access, although it is worth noting that not every single market measure emanating from the EU has been incorporated into the EEA Agreement. [View our table of EEA measures] This is due to the process under which EU legal measures are extended to the EEA. When EU legislation is made, for it to extend to the EEA it must be incorporated into the EEA Agreement. This is effected by means of a decision of the EEA Joint Committee (which includes representation from the non-EU EEA countries and the EU). The first step is for a draft Joint Committee decision to be considered on the non-EU side and then passed to the EU for consideration.5
It is increasingly the case that EU measures require adaptation before being extended to the EEA. This flows from the fact that EU measures increasingly confer on EU institutions (such as the Commission, ESMA, EBA and EIOPA) the ability to adopt binding decisions, grant authorisations, and give binding guidance. This has raised questions for EEA states about their level of involvement in these bodies and, perhaps as a result, it has begun to take longer for EU measures to be incorporated within the EEA Agreement. For example, EMIR and AIFMD have not yet been adopted and on it was only on 12 July 2016 that the EU determined its position regarding the inclusion of these and other measures in the EEA Agreement.
This may improve, however, if the UK were to join the non-EU EEA bloc. The EEA Agreement6 provides a mechanism under which the Commission and the council each have to afford a degree of information and consultation to the non-EU EEA countries during the development of relevant EU legislation. All are required "to co-operate in good faith during the information and consultation phase with a view to facilitating, at the end of the process, the decision-taking in the EEA Joint Committee". So even as a non-EU EEA country, the UK would be able to apply its expertise in financial services to the EU financial services legislative process, so as to facilitate swifter transition of EU single market legislation to the EEA.
The political issue The key issues with EEA membership, of course, are political.
From the EU perspective, if the UK were able to fall back on single market access rights as an EEA member, this may not provide sufficient discouragement for other EU member states considering EU exit.
From the UK perspective, on the other hand, membership of the EEA "entails" acceptance of the right of "free movement of persons" enshrined in article 1 of the EEA Agreement. If the UK decided it was not prepared to continue that commitment, that might involve a decision to leave the EEA as well as the EU. (But neither 'free movement of persons' nor 'EEA membership' was the subject of a referendum, of course.)
Assessment: EEA membership is clearly the best solution available from the point of view of timing, level of access, simplicity and reliability. But the key issue is whether the UK government and the EU can be convinced that this solution should be pursued, despite the apparent political issues.
3. Equivalence (the Third Country Passport) Since the financial crisis, EU financial regulations have increasingly contained provisions providing better treatment for non-EU (third country) entities where they are from a jurisdiction deemed to have 'equivalent' regulatory provision.
In some cases, 'equivalence' can provide single market access rights; in others it reduces the impact of EU regulations (e.g. Solvency II group supervision; EMIR intra-group transaction exemptions and so forth). So to what extent can 'equivalence' rights of this nature be harnessed to enable UK firms to access the EU single market?
Under EU law as it currently stands, there are no single market access rights for firms from 'equivalent' third countries in the context of deposit-taking or insurance business. (Nor are there similar third country marketing rights for retail funds or securities offerings.)
There is a mechanism, however, for wholesale7 investment business under MiFIR, under which8 third country firms wishing to conduct investment business across the EU may do so as of right, if they are registered with ESMA to do so (the third country passport).
To be eligible for registration with ESMA, a third country firm must:
- be authorised in its home jurisdiction to conduct the same range of investment business activity which it intends to conduct in the EU;
- come from a third country whose regulators have the relevant information-sharing and co-operation agreements in place with ESMA; and
- come from a third country for which the Commission has adopted an 'equivalence decision' under article 47 of MiFIR.
The Commission is not obliged to adopt an equivalence decision in respect of the UK. It may do so where the UK fulfils a range of criteria. There is no serious doubt as to the UK's ability to meet those criteria, since they relate to the implementation of EU regulations which the UK helped to devise and upholds.
Some have questioned, though, whether the Commission would make an equivalence decision in the UK's favour – granting a back-door passport may not be a sufficient deterrent to other would-be exiting EU member states. There is also the potential for some political pressure to be brought to bear by other third countries seeking equivalence for the UK to be required to follow the same process as them and to take its place in the queue.
Nevertheless 'third country equivalence' is receiving considerable attention from EU officials considering Brexit, and a recent statement9 from EU Parliament's MiFID2 rapporteur appears to promote the equivalence route.
There are, however, some real issues with the third country passport:
- It is dependent on the EU Commission adopting a
decision in favour of the UK.
- Anyone who has been through an equivalence process with the EU – there have been several in the context of EMIR recently – will be aware these can be long and complex processes.
- In the UK's case, getting equivalence may mean accepting the EU party line on key contentious issues, such as remuneration restrictions under CRDIV/CRR and the treatment of FX forwards under MiFID2/MiFIR.
- An 'equivalence decision' can be
- The UK would need to ensure that it continued to remain equivalent as EU laws developed. There would need to be measures to prevent divergence over time.
- Without EEA membership, the UK would be unable to participate in the legislative process and would have no role in consulting on laws which it would then need to reflect at home.
- There is a 'hiatus' risk.
- Firms wishing to register with ESMA must apply for registration. This can take six months.
- To be certain of business continuity, UK firms would therefore need to see an 'equivalence decision' in place at least six months ahead of full Brexit.
- The earliest conceivable date for an equivalence decision is January 2018, when MiFID2/MiFIR begins to apply, and then only if the Commission does not insist on beginning the equivalence assessment process only after the MiFIR start date. This may need to be an objective in the UK's negotiating agenda with the EU.
- It is far from a comprehensive solution.
- It does not grant market access rights for banking, insurance or other aspects of the financial services arena.
- Firms wishing to conduct investment business with retail
clients or certain professional clients11
under MiFID2 are exposed to branch establishment requirements in EU
member states.12 These are subject to stringent
- authorisation of the branch in the relevant EU member state;
- minimum initial capital requirements at branch level and a generally stricter level of equivalence determination; and
- compliance by the third country with the OECD Model Tax Convention on Income and Capital.13
Assessment: 'Equivalence' has shortcomings in terms of level of access and reliability. It also poses potential risks from a timing perspective. It may, however, prove useful – even critical – if the UK does not retain EEA membership. UK firms may find they are able to combine equivalence with a territorial scope analysis to provide a combined solution.
Market access into the UK? Will Brexit affect the ability of firms to conduct financially regulated business into the UK from outside the UK?
Non-EU firms For non-EU firms, the position is likely to stay the same. The UK has historically taken a liberal approach to cross-border activity into the UK. This has enabled many firms from the US, Asia and elsewhere to conduct financial business with UK clients and on UK markets without triggering UK authorisation requirements. This is based primarily on the application of the so-called 'overseas persons exclusion'14 and on the territorial limitation embedded in the UK authorisation requirement, which applies to firms conducting regulated activities "in the UK".
This approach has been central to the UK's ability to operate as world-class financial centre and, as such, is generally regarded as sacrosanct. Change is very unlikely.
EU firms For EU firms, however, there will be a change (unless the UK retains its EEA membership) in that they will no longer benefit from the EU passport when conducting business in the UK. UK branches of EU firms which previously relied on the EU passport would need UK authorisation.
Some EU firms conduct EU-wide activity from their UK branches (relying on their branch passport for activity in the UK and their services passport for the EU wide activity). After Brexit, that model may need to be revisited. While a firm in an EU member state may rely on its services passport from any of its branches in principle, its home state regulator will need to be satisfied that it is in a position adequately to supervise it in respect of that activity.
EU firms carrying on cross-border business into the UK would need to do so in reliance on the "overseas persons exclusion" (or on the basis that it is not conducted "in the UK"). This would require EU firms to conduct detailed analysis on a business line by business line basis to ensure they remained outside the UK authorisation requirements.
Final remarks Brexit will change the regulatory landscape for financial services businesses.
While UK firms will continue to have to comply with the EU/G20 regulatory agenda, market access between the UK and EU will become more complex and potentially more restricted.
For the industry, EEA membership easily scores best against our criteria, but it raises political issues for both the EU and the UK. An alternative solution may be for firms to rely on 'territorial scope' and 'equivalence' but these are less reliable and do not offer a complete solution, and both are subject to significant timing risks. If the UK does not pursue EEA membership, it would need to negotiate measures to ensure that MiFID2/MiFIR equivalence is in place in time.
A final observation. Andrew Tyrie MP, Chairman of the House of Commons Treasury Select Committee said15 of the MiFIR third country equivalence regime:
"We pretty much wrote it as it suited us. But once we left, we would become a 'rule taker', and that 2018 protection may be eroded, or removed, or anything could happen to it over time... So it's really only a temporary form of protection, and it's not something on which the City can rely long-term. MiFID II's equivalence benefits have been overstated, I think."
1. The Markets in Financial Instruments Directive (2014/65/EU) and the Markets in Financial Instruments Regulation (600/2014/EU).
2. Commission Interpretative Communication on The Freedom to Provide Services and the interest of the General Good in Second Banking Directive, 20 June 1997 (SEC(97) 1193 final).
3. BaFIN's approach was later upheld in the Fidium Finanz AG case in the Frankfurt am Main Regional Court (Verwaltungsgericht - VG) Fidium Finanz AG (File no 1 E 4355/06).
4. The Agreement on the European Economic Area
5. Annexes VIII and IX to the EEA Agreement house the measures which relate to the freedom of establishment and the freedom to provide services in the financial services arena.
6. Article 99.
7. Business with "eligible counterparties" and professional clients within the meaning of Section 1 of Annex II to MiFID2, sometimes referred to as "per se professional clients".
8. Articles 46 and 47 of MiFIR.
9. For example, this by Markus Ferber (the ECON Rapporteur on MiFID2): http://www.markus-ferber.de/verschiedenes/presse-aktuell-single-view/article/brexit-implications-for-financial-markets-regulation-tax-policy-and-competition-policy.html.
10. Article 47(4) of MiFIR.
11. Professional clients with the meaning of Section II of Annex II to MiFID2, sometime referred to as "elective professional clients".
12. Article 39 of MiFID2.
13. Specifically, with article 26 on effective information exchange in tax matters, including multilateral tax agreements.
14. Article 72 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001.
15. Cited in Thomson Reuters, Regulatory Intelligence 14 July 2016.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.