Тhe decision of the British electorate to leave the European Union (“EU”) will have a profound impact on the financial sector in the UK. In this post, we will look at some of the available means to avoid or mitigate the disruption in the wholesale and investment-banking sector as a result of the exit from the EU, namely the third party ‘equivalence’ regime under the Markets in Financial Instruments Regulation (“MiFIR”), which provides similar rights to the EU passport, as well as a bespoke agreement (“Continental Partnership“) that could carve out broader access to the EU single market. This post concludes a series of posts on this issue on Regulation-Y.
I. Default option: The third party „equivalence“ regime
The Markets in Financial Instruments Regulation (“MiFIR”) enters into force on January 3, 2018 and is expected to significantly expand the existing third party access rights in the EU financial sector to certain investment banking activities. The third country access rights, currently available under EU law, are limited to certain payments services, central counterparts and to some extent to insurance.
In essence, the third party access under MiFIR will allow UK banks to provide certain broker-dealer and corporate finance services without having to obtain a separate license or to set-up a branch or a subsidiary in the EU. The third country passport will be available only for services to “per se professional clients” or “eligible counterparts” (MiFIR, Article 46, para.1) e.g. credit institutions, investment firms, insurance companies, institutional investors or large enterprises that meet a certain threshold.
The services, covered by the third party access under MiFIR, include essentially all investment banking activities including broker-dealer or corporate finance services, underwriting of financial instruments, reception, execution and transmission of orders and the provision of investment advice, etc. The MiFIR passport, however, will not extend to services that are critical for a full-scope investment or a wholesale bank such as deposit-taking and commercial lending. Disentangling MiFID activities from the related banking and payment services activities in a particular institution could be time-consuming and costly (Davis Polk & Wardwell London LLP, Lex et Brexit, Issue 1, Jul. 2016). At the same time, the UK-based investment banks will bear significant additional compliance costs to ensure that the third party access rules are used to provide only eligible investment services (thus running a risk of potential penalties and enforcement actions).
In addition, the third party access of the UK-based financial institutions under MiFIR is not a given and will be subject to a number of requirements and limitations, and in particular:
1. Equivalence determination by the European Commission
The UK Financial Conduct Authority (“FCA”) should reach an equivalence determination by the European Commission meaning that it meets “legally binding prudential and business conduct requirements which have equivalent effect” (MiFIR, Article 47, para.1) to the requirements under EU law. FCA should also enter into an agreement for the exchange of information, coordination of supervisory activities and prompt notification to European Securities and Markets Authority (“ESMA”) in case a registered investment bank infringes any of the conditions of its authorization (MiFIR, Article 47, para.2). At first sight, the FCA should be able to easily obtain an equivalence determination from the European Commission on the substance given that by the time it leaves the EU UK should have already implemented MiFID II and would apply the same rules as the rest of the EU. However, the “equivalence” determination process is forward looking and the FCA may have to overcome significant difficulties to convince the European Commission that the UK financial regulation will remain in line with EU law following Brexit. The experience with Alternative Investment Fund Managers Directive (“AIFMD”), which sets out a similar third country access regime with respect to fund management activities, also demonstrates that equivalence assessments are by definition long and complex (Davis Polk & Wardwell London LLP, Lex et Brexit, Issue 1, Jul. 2016). Following 18 months of negotiations equivalence decision under AIFMD have been reached by only few jurisdictions (i.e. Guernsey, Jersey and Switzerland), whereas a number of other jurisdiction, including the US, could not finalize their assessments. In the case of the UK the equivalence determination may also prove a politically charged process, which would additionally delay and complicate it. For example, the European Commission may not be willing to run the equivalence determination along with the Brexit negotiations, which may lead to significant blackout period from Brexit`s effective date to the equivalence determination.
2. Registration with European Securities and Markets Authority (“ESMA”)
Based on its license from the FCA and the equivalence decision, each investment bank in the UK should register with ESMA (MiFIR, Article 46, para.2). Under MiFIR, the registration with ESMA should take approximately 10 months i.e. 30 working day for ESMA to confirm that application is received and is complete and further 180 working days grant a registration (MiFIR, Article 46, para.4). Similarly to the equivalence determination, ESMA may not be willing to accept applications from UK investment banks while the Brexit negotiations are in course or to fast-track the registrations of a large number of complex UK financial institutions so that they could continue their business as usual after the Brexit effective date. This would add an additional risk of blackout periods, particularly for the larger and more complex applicants.
II. Model for a bespoke agreement: The Continental partnership
Clearly, the third party access rights discussed above could offer at best a partial solution for the UK financial sector. None of the existing models for closer cooperation with the EU examined above seems to offer a solution to the concerns of the British financial institutions. Therefore, the British prime minister Ms Theresa May has declared herself in favour of a “unique to the United Kingdom and not an off-the-shelf solution“. Although the exact term of such unique bespoke agreement with the EU remain unclear, it will ideally carve out additional rights for the UK in immigration matters while retaining the access of the UK financial sector to the single market.
In a recent publication, a group of leading EU experts proposed a model that could bring the UK close to such a bespoke agreement by placing the future UK-EU relations in the broader context of the relations of the EU to its wider periphery (Pisany Ferry et al for Bruegel, Aug. 2016).
The authors suggest a new Continental Partnership (“CP”) that would sustain the existing deep economic integration, but will exclude labor mobility and political integration. In addition to the UK, the CP will also be open to other EU neighbors such as the EEA member states, Switzerland and possibly also Turkey and Ukraine. The CP will thus create in the long-term an outer circle of countries around the EU that adhere to the rules of the single market but will not take part in the supranational political union. A key feature of the CP is the separate institutional structure and a decision-making and enforcement system. The CP members will meet in a CP council and will establish a separate supranational court that would follow the case-law of the European Court of Justice. Although the CP council will not be able to pass EU legislation, it will consulted before new pieces of legislation are adopted, which would give the CP Members a say in the final decision-making process at the EU level.
The proposal does not address explicitly the question of the architecture of the financial regulation under the CP. Its focus is rather the creation of a model for economic cooperation that does not require a common migration policy. Nonetheless, the CP opens significant opportunities for the UK financial institutions. The proposal suggest a close cooperation between the Bank of England and the European Central Bank and does not exclude creation of common institutions in the future. Moreover, under the CP model the UK will remain subject to all rules of the single European market, which, similarly to the Norwegian model, will allow the UK financial institutions to keep their passporting rights. At the same time, the new decision-making mechanism would give the UK a say on new regulations in the financial sector, which, albeit non-binding, should be taken into account by the EU legislator. Given the relative political and economic weight of the UK in the EU, this could give the UK significantly higher degree of decision-making authority compared to Norway or Switzerland for example.
As the proposal rightfully points out, the CP will require significant concession by the EU to the UK with respect to the free movement of workers, which may require equivalent concessions by the UK such as limits on its access to the single market of financial services. Number of major European cities are already lobbying and introducing incentives to attract more financial companies from London (see Schoenmaker for Bruegel, Nov. 2016). Therefore, brokering of a deal that would retain the existing unlimited access of the UK banks seems rather unlikely.
The third party “equivalence” regime would at best partially mitigate the impact of Brexit on the financial sector. The scope of the third party “passport” under MiFIR would be limited to certain investment-banking services only and will be subject to costly and time-consuming registration and compliance requirements. In view of the arguable benefits and the significant disentanglement and compliance costs, large part of the large investment banks may nevertheless decide to move out of the UK.
Overall, in the absence of common or at least closely coordinated supervision, the UK financial institutions are unlikely to retain their existing broad access rights to the single market. This would be possible based on a bespoke agreement between the EU and the UK that would carve out special access rights for the UK-based financial institutions to the single market. In a recent publication, a group of leading EU experts propose a new Continental partnership under which the UK will remain part of the single market and will take part of a new decision-making mechanism open to other non-EU members. The CP could allow the UK-based financial institutions to retain fully or partially their existing passport rights while giving the UK a right to a non-binding consultative opinion on new financial regulations. However, in view of the political dynamic created by the Brexit referendum, the EU seem rather unlikely to concede to retain the unrestricted access of the UK banks to the single market.
Atanas Sabev is an LL.M. candidate at Harvard Law School (class of 2017) and a Senior Consultant at PwC. This is part one of three posts about the consequences of Brexit on the European financial single market.