As the Millennium approached, concerns about computer systems
malfunctions, and the possible impact of what became known as Y2K,
grew to the point that nearly all large organisations had Y2K task
forces and contingency plans. The history is well known. 1 January
2000 came and went, and the Y2K fears failed to materialise.
The spectre of a possible exodus of London-based financial services
firms and other regulated entities in the aftermath of the United
Kingdom's Brexit referendum has received much coverage. In the
face of uncertainty as to the timing (in all likelihood two years
away at least) and terms of a UK exit from the European Union, many
of these firms are understandably accelerating their own
contingency planning in anticipation of a potential loss of
"passporting" rights—the now well-documented rights
of an entity authorised in one EU member state to provide regulated
services either on a cross-border basis or through locally
established branches in every other member state of the EU without
needing to be separately authorised outside of the home member
state.
The prospect of financial services firms relocating significant
parts of their businesses to other cities in Europe has
wide-ranging implications, from the effect on potentially thousands
of employees and their families to the potential value of City of
London real estate.
In this Commentary, we explore whether the loss of
passporting rights would, in terms of regulatory and operational
significance, be equivalent to the City of London's "Big
Bang" of the 1980s, or would it be more a Y2K whimper.
The Current Framework and Best- and Worst-Case Scenarios
London dominates the EU's capital markets and is
overwhelmingly the largest market for authorised financial services
and regulated real estate businesses in the EU. Many authorised
firms operating cross border from the UK to the EU currently do so
on the basis of an EU "passport" under EU financial
services-related directives.
In the short term, and until Brexit is implemented, the current EU
framework on financial services regulation will continue to apply.
Accordingly, there is no immediate reason to assume that London
will cease to be the European hub for financial services
businesses. However, the uncertainty around the UK's future
relationship with the EU causes concern. The best-case scenario is
that the UK retains access to the EU Single Market (through
admission to the EEA or otherwise). If that happens, it would very
much be business as usual for authorised firms that operate from
the UK. Not many commentators are predicting this form of soft
landing, and certainly many businesses are planning for the
scenario where the UK becomes a so-called "third country"
(i.e. non-EU country) for the purposes of EU financial services
regulation. It is this scenario that we explore in more detail
below.
Central to the analysis below is the concept of
"equivalence". Under the relevant EU directives (notably
AIFMD and MiFID II—discussed in further detail below) non-EU
businesses may have access to institutional clients in the EU, via
a "third-country passport". This is available if the
non-EU country's regulatory regime is regarded as
equivalent.
We consider it to be highly likely that the European Commission
would determine the UK's regulatory regime to be equivalent to
EU standards, and therefore access to institutional investors would
remain possible. This is because at the point of exit, the UK's
financial services legislative framework would reflect, and in many
cases be derived from, EU law. It would therefore be difficult for
the European Commission to determine that the UK was not an
equivalent jurisdiction.
Non-EU Entities with a UK Presence
Understandably, given London's dominant position, much of
the current focus has been on how significant the fallout will be
for non-UK entities with a UK presence if the UK exits the EU
without access to the EU Single Market. This depends on whether
such non-EU entities operate in the UK either as subsidiaries or
branches and whether their businesses require access to
institutional or retail clients.
Branches v Subsidiaries; Institutional v Retail
Clients. Those non-EU companies currently operating in the
UK through branches will not be affected by Brexit for regulatory
reasons, as they do not currently enjoy passport rights under the
Single Market directives anyway. These businesses tend to establish
in the UK to serve the domestic market and/or to access the UK
market infrastructure—i.e. LSE, LIFFE, Lloyds market, LME
etc.—rather than to benefit from the EU passporting rights
under the Single Market. There is therefore no regulatory reason
for such banks and financial institutions to leave the UK as a
result of Brexit. Of course, as third-country firms, they could
still enjoy access to the institutional market, assuming the EU
regards the relevant home country regulatory regime as
equivalent.
For those authorised firms that operate in the UK through
subsidiaries, which are licensed or regulated in the UK, the
consequences of a UK exit are potentially more significant.
If the UK exit involves it becoming a third country, those
subsidiaries would not be able to rely on EU passports (as the
relevant directives would fall away). Whether this affects the
ability of a financial services business to carry out its business
will depend on the nature of its clients. If a business needs
access to institutional clients (i.e. professional clients, such as
pension funds, government development funds and significant
corporates), such access may not be affected by Brexit. This is
because of the principle of equivalence described above.
If a business operating from a third country needs access to retail
clients (i.e. individuals, small companies and other clients which
do not fit the institutional mould), then it can only do so on a
reverse solicitation basis (i.e. the client would need to engage
with the business on its own initiative and not have been solicited
by the business). If the UK becomes a third country, then this
limitation will present significant challenges to private wealth
firms and similar businesses engaging with EU retails clients.
However, the position as regards retail clients may be softened
depending on the negotiations between the UK and the EU in relation
to Brexit. We will therefore monitor these negotiations once they
commence.
EU27 Entities with a UK Presence
If the UK becomes a third country, it is unlikely that branches
of EU firms located in the remaining EU member states (the EU27)
will have to close or convert to UK authorised subsidiaries. The
more likely scenario is that they will be "grandfathered"
by the UK regulators as directly authorised UK branches of the EU
firms. Those entities currently operate in the UK under an EU
directive passport. Accordingly, they do not need to be authorised
by the UK regulators. However, we need to wait for the unfolding of
the post-Brexit model before we can be sure what will happen.
In the medium term, whether a business needs to consider relocating
any of its operations will depend on the types of clients it wishes
to access in the EU and the manner in which its business is
currently structured. As demonstrated above, if such businesses
have institutional clients, the landscape may not fundamentally
change. Similarly, those non-EU entities which use branches to
operate in the UK will be unaffected by Brexit. On the basis of the
foregoing, we take the view that most businesses will continue to
enjoy access to their EU client base, even if there is a complete
"divorce" from Europe.
The Impact on Regulated Real Estate Businesses
There are a number of real estate sector businesses that are
themselves regulated. Typically, they are regulated for insurance
mediation services, investment advice or alternative fund
management activities. To the extent that they engage with EU
clients, the points above apply, and the real estate
businesses' approach will depend on whether they market to
institutional or retail clients.
Third-Country Passporting—MiFID II. As real
estate firms tend to engage with institutional clients, their
access to the Single Market from the UK should not be materially
affected. This is because the Markets in Financial Instruments
Directive, known as MiFID II, comes into effect in January 2018 and
introduces a passporting mechanism to third-country investment
firms, allowing them access to institutional investors.It is
therefore likely that a UK-authorised real estate firm providing
advisory/arrangement services for these types of clients would be
able to do so via the MiFID II third-country passport, even after
Brexit.
Third-Country Passporting—AIFMD. Perhaps of
more interest to the larger real estate firms, will be their
ability to market real estate funds in Europe. Although the
Alternative Investment Fund Managers Directive, or AIFMD, envisaged
the extension of the EU passporting regime to include all
full-scope managers ("AIFMs") of alternative investment
funds ("AIFs"), passporting is not yet available to
non-EU firms because it has not yet been decided whether they are
equivalent.
In its advice to the European Parliament, the Council and the
Commission on the application of the AIFMD passport to non-EU AIFMs
and AIFs published on 19 July 2016, the European Securities and
Markets Authority ("ESMA") concluded that there were no
significant obstacles impeding the extension of the AIFMD passport
to managers in Canada, Guernsey, Japan, Jersey and Switzerland.
ESMA was more equivocal about the extension of the passport to
managers in other jurisdictions, including the United States. The
Parliament, the Council and the Commission are now considering
ESMA's advice.
Should the UK become a third country, as noted above, we consider
it is likely that ESMA would conclude that it is an equivalent
jurisdiction for the purposes of the AIFMD, and therefore
UK-authorised AIFMs, like those in the Channel Islands for example,
would be able to access institutional investors in the EU via a
third-country passport.
Conclusion
Ultimately, this is not a Y2K situation, and it is appropriate
that authorised firms give significant consideration to their
contingency planning. But neither is it a reverse "Big
Bang". While it is undeniable that authorised businesses, and
therefore real estate businesses which rely on such businesses as
tenants, face a period of uncertainty, it is very likely that
access to institutional clients in the EU will continue post-exit
and regardless of the terms of that exit.
The UK will either maintain Single Market access and continue with
business as usual, or it will be in a strong position to obtain the
equivalence decisions required to allow its authorised firms access
to EU institutional investors. As such, from a regulatory
perspective, it is hard to see a compelling argument for an
exodus.
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.