Investment managers may need to assume that the UK's departure from the European Union involves an exit from the single market, and plan accordingly.

The debate about whether the UK departure from the European Unions that “Brexit” is a “soft” process – retention of single market access with free movement and judicial oversight – or “hard” – with adoption of World Trade Organisation trade terms and ability to set specific immigration rules – sometimes involves a use of language that can be misleading. “Hard Brexit” sounds unpleasant; a “softer” departure might, depending on one’s point of view, not be an exit from the EU at all. Given that the majority of votes cast for Brexit in June last year was large, but not crushingly so (not, say, a two-thirds majority for change) it is arguable that the UK’s departure from the EU should reflect continued wiggle-room for debate about how far the UK electorate wanted to go. (Some commentators, such as Dr Eamonn Butler of the Adam Smith Institute say the terms “hard” and “soft” aren’t helpful – what he wants is a “clean Brexit”. Language is a truly wonderful thing.) In any event, a group of businesses with a great deal to think about is the asset management industry. The UK sector now faces the possibility that if the UK leaves the single market, this creates a challenge for obtaining continued access to the EU (such as the need to create local subsidiaries, etc).

This article, by Stephen Burke, group corporate development director at Cordium, a firm specialising in consulting over regulatory matters. If readers want to respond to this article they can email the editor at tom.burroughes@wealthbriefing.com. The editors of this news service are pleased to receive guest contributions; they don’t necessarily endorse all views of such articles.

Theresa May has been re-elected but she has lost her parliamentary majority. Even with a “confidence and supply” agreement with the pro-Remain Democratic Unionist Party, political risk in UK is raised and it is unclear whether Mrs May, or the DUP agreement, will survive the Brexit process.  It is a far cry from the strengthened negotiation position that Mrs May was seeking in the Brexit negotiations, which started on19  June.  There will be an estimated 100 days of face-to-face negotiation that will determine the terms of Brexit.

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 Alternative Investment Fund Managers Directive, but absent from UCITS [the European cross-border funds regime].  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 and the Financial Conduct Authority 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 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 (source: FCA, Investment Association). 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. 

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 (source: Cordium annual summer conference, poll of audience).  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. br />

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 (source: Principles on Supervisory Approach from relocations from the UK, 31 May 2017). 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.