How hard will Brexit be for you? What investment managers need to consider now

Speculation continues as to whether the UK will be able to use the third country regime embodied in MiFID I and II (for professional clients and eligible counterparties) and AIFMD, but absent from UCITS.  The other, hopeful, option is to gain acceptance that UK has regulatory equivalence. Of course, the challenge there is that equivalence is granted by the European Commission but can be revoked at any time.  While these options would have a minimal cost impact on UK firms, delivery risk of both is high.  A ‘soft’ Brexit is potentially now more likely, but it remains incredibly difficult to predict any outcomes with confidence.  Prudent firms will continue to plan for a ‘hard’ Brexit, and pull back if the opportunity presents itself.

Brexit plan

As with all significant business and regulatory changes, the Prudential Regulatory Authority (PRA) and the Financial Conduct Authority (FCA) are taking a close interest in how firms are planning and responding to Brexit.  The Bank of England wrote to banks and other large financial services firms in April 2017 giving them a deadline of 14 July 2017 to set out their plans. We understand that the FCA has followed up in a similar vein, writing to several of the largest asset management companies requesting detailed information about their contingency plans for a hard Brexit, including:

• Plans to relocate UK roles or operations to another EU27 country;
• Whether they have applied or will need to apply for new licences from EU27 regulators;
• The impact on their regulatory capital base; and
• The impact on IT systems and data.

We anticipate that the FCA will widen its information gathering to other firms, in order to manage the supervision risks.  They will expect all firms to have a Brexit contingency plan.

On the face of it, UK firms have a gigantic task: the UK has 47,269 MiFID outward services passports to the EU27 countries, while the EU27 countries have 990 MiFID outward services passports[1] to the UK. Currently UK portfolio management firms have assets under management of about $8.9 trillion, of which approximately 17.5% comes from the EU27.[2]

A hard Brexit is likely to reduce cross border services, which will affect the level of choice for consumers and also price competition.  There will be winners and losers, with the winners expected to be Frankfurt, Dublin, New York, Paris, Luxembourg and emerging territories like Malta all growing at London’s expense[3].

Hard Brexit

In a poll of investment managers earlier this month, two-thirds said that their biggest concern was continued access to EU27 customers or investments[4].  On a ‘hard’ Brexit, the distribution choices seem to be:

• Stay away from the EU27 countries;
• Continue to engage with EU27 investors using third country exemptions (in a similar way businesses based in the USA do today); or
• Establish or rent a presence in the EU27.

Many of the larger asset managers are working on establishing a subsidiary within one of the EU27 member states and restructuring their business appropriately (or bolstering the presence they already have) to carry out their own management company activities or to distribute funds and services from a EU27 location.  Others are looking to hire an independent EU27 management company for their existing EU27 funds or are planning to raise EU27 domiciled funds for the first time.  For distribution purposes, some firms are exploring hosting solution, becoming a tied agent of a EU27 MiFID firm.  Others may choose to hire third party distributors and focus their internal resources in the UK or other accessible markets.

No Favours Here

The European Securities and Markets Authority (ESMA) has published an opinion, setting out general principles on authorisation, supervision and enforcement related to the relocation of firms, activities and functions from the UK[5]. The principles set out how ESMA wants regulators to behave and can be summarised as follows:

• No automatic recognition of existing FCA authorisations
• Authorisations granted by EU27 regulators should be rigorous and efficient
• Regulators should be able to verify the objective reasons for relocation from UK
• Regulators should pay special attention to avoid UK firms setting up letter-box entities in the EU27
• Outsourcing and delegation to third party countries is only possible under strict conditions
• Regulators should ensure that substance requirements are met
• Regulators should ensure sound governance of EU entities
• Regulators must be in a position to effectively supervise and enforce Union law
• Coordination to ensure effective monitoring by ESMA.

In short, ESMA is very much alive to what it considers to be the risk of regulatory arbitrage and has put the industry on watch.

Capacity

Luxembourg and Dublin are the two leading fund locations in Europe and many firms are exploring these as locations of fund distribution, investment mandate sales and client services.  Historically, both centres have been focused on fund administration and on UCITS management company (“manco”) activities, and now they are offering AIFMD services through so called “supermanco” solutions.  Brexit seems likely to expand the burden on these centres.   Firms need to assess carefully what and how they could operate from these locations.  Regulators, lawyers and the local workforce may all need to evolve new skills so it seems inevitable that key staff will need to relocate to effectively establish a Luxembourg or Irish base. Regulators and lawyers may also need to hire from the established centres to support their own development.

Timing 

A ‘hard’ Brexit may come with a cliff edge and so failure to be ready on time could have major implications for business continuity. There is question as to whether EU27 regulators and lawyers will have enough capacity to deal with the required activity, particularly for firms who need to set up a regulated subsidiary: a new UCITS/AIFM/MiFID regulatory licence typically takes 6 to 12 months to achieve. We have seen ESMA seeking to rule out short cuts, suggesting that decisions need to be made no later than the end of this year to be ready, together with the substance to avoid being regarded as a letter box entity.

Use of third party manco or tied agent arrangements may allow the decision to be pushed out further and of course reduces the amount of substance needed, provided that the solution exists!

Brexit will now take shape rapidly. UK firms have a massive task collectively and it seems that there will be no short cuts. All firms need a hard Brexit contingency plan and the reality is that plans may need to be invoked before the outcome of Brexit is confirmed.

[1] FCA Freedom of Information response F014973 dated 17 March 2017

[2] Data published by FCA and the Investment Association. (2016) expressed in USD at 1.29 USD =1 GBP.

[3] Source; CFA Institute

[4] Source; Cordium UK annual conference audience poll June 2017

[5] Source: Principles on supervisory approach to relocations from the UK -31 May 2017