What is happening? The Big Picture
On June 23, 2016, the UK voted to end its historic political and economic union with the EU. At present, different governments across what the EU are formulating or attempting to formulate a credible exit plan for the UK. A fine line will likely be maintained among EU leaders between those who actively want to punish the UK and deter other members from following suit, and those who recognise that having a strong UK is in the EU’s and global interests. Compromises will have to be made on both sides.
Invoking Article 50 of the Treaty of Lisbon will set off the starting gun for negotiations, which in theory cannot exceed two years. The two-year negotiation time-frame is unrealistic. In fact, one could argue that the time-frame is not only unrealistic but impossible given the degree of interconnectedness between the UK and EU political and economic systems. As such, there is likely to prolonged uncertainty in regards to the UK’s status within the EU for around a decade, and that is assuming talks make decent progress. In extremis, the negotiations could last up to 20 years.
Uncertainty in capital markets will last for a long time, and it is highly probable the UK will lose considerable standing in the world economy during this process. A handful of banks have already confirmed they are moving euro-denominated trading activities to the continent and others will follow suit as they seek a home within the EU rather than a third country which will have no direct influence on EU developments and institutions.
The relationship the UK will have with the EU is unknown now. Some feel the UK should join the European Economic Area (EEA), which would give the country access to the single market but would subject it to full compliance with EU law and regulations, including potentially the freedom of movement of people, as well as a contribution to the EU budget.
Optimists speak of the UK retaining an associate membership of the EU with full access to the single market albeit with enhanced flexibility to implement EU rules and requirements such as free movement of people. However, free movement underpins the single market, and it is mission critical, especially for the countries in Eastern Europe, and any meaningful climb-down by the EU on this fundamental lynchpin is highly unlikely. Free movement of people is a huge benefit to the EU, the City and its financial institutions, as it broadens the talent pool available. Lord Jonathan Hill, the former EC Commissioner, expressed doubt that the single market alongside its requirement for free movement could be sold to the British people.
A failure to enable British banks and funds to have passporting rights across the EU would reduce the UK’s standing immeasurably with Frankfurt, Paris, Luxembourg and Dublin becoming the main beneficiaries of financial institutions’ exodus. The UK’s influence within the EU would be non-existent. In theory, the UK could go at it alone and work with third countries beyond the EU. However, one of the UK’s strengths is due to its ability to provide a gateway into the EU for the rest of the world.
So what does this mean for Fund Managers
Fund outflows preceding the vote were already considerable and withdrawals will likely continue over the next few months until greater clarity on the UK’s status emerges. Part of this is because the status of UCITS and AIFMs is unknown. If a German pension fund is required to invest in onshore fund vehicles, would they really invest in a UK manager who might in a few years be designated as non-EU and possibly non-eligible for investment pending the outcome of protracted negotiations?
However, firms can reorganise their businesses to arrest this issue. Some fund managers are exploring whether to move parts of their businesses to Dublin or Luxembourg, two jurisdictions with excellent service providers and experience in the fund management industry. Firms could simply delegate portfolio activities back to a London manager. Others may relocate key persons into the EU or partner with an EU AIFM or UCITS to maintain the cross-border distribution benefits. All of this will come at a cost, but it may be the only option available for managers if they wish to retain favourable access to EU institutions and retail allocators. However, exit is still several years away so firms should not rush this decision. Restructuring out of Dublin or Luxembourg only to have fund passporting benefits retained in the UK would be an expensive mistake for managers to make. Nonetheless, firms should be reviewing all of their options.
Equally, exit does not mean non-compliance with EU Directives or regulations. Rules including the Markets in Financial Instruments Directive II (MIFID II) will be enacted before any Brexit materialises. The Financial Conduct Authority (FCA) has confirmed all EU regulations and Directives must be complied with during the period in which the UK is a member of the EU. Many fund managers will probably be reticent about backtracking on their compliance processes anyway given the time and money spent on complying with these rules in the first place.
Whether the UK scraps or amends EU laws is an unknown. If the UK goes at it alone following a withdrawal, it must ensure the rules governing financial services are aligned with the EU. For example, UK deviation around centralised clearing of over-the-counter (OTC) derivatives with the European Market Infrastructure Regulation (EMIR) will only frustrate market participants who will inevitably complain of arbitrage. Dual regulations will add costs. Financial institutions have spent years trying to achieve harmonisation globally as well as within the EU, and this must continue to be a priority for any UK government irrespective of any negotiation outcomes with the EU.
The UK must fight tooth and nail to attain equivalence status with the rest of the EU to preserve its single market access. A failure to implement EU rules will not be viewed kindly by EU policymakers in such a sensitive time. An inability to attain equivalence will mean that funds that choose to remain domiciled in the UK will not be able to passport across the EU, but would need to rely on private placement regimes. As private placement is likely to expire in the next few years, equivalence is a must for the UK. Simultaneously, EU AIFMs and UCITS may struggle to access the UK market through the passport scheme.
In theory, the UK could create a dual funds regime. Guernsey, Jersey and the Cayman Islands allow managers to establish AIFMD compliant fund vehicles but permits others to retain the status quo. Again, this would be contingent on the EU granting equivalence to the UK’s fund regulatory regime.
The Capital Markets Union (CMU) initiative is up in question. There have been soundings from MEP Markus Ferber that market regulations will continue to be implemented as planned. However, the status of CMU is uncertain. CMU’s cheerleader – Lord Hill- has stepped down, and most resources within the Brussels machine will now be devoted to Brexit. CMU projects, which have been initiated – such as eased capital requirements for investors (insurers etc.) into European Long Term Investment Funds (ELTIFs) and amendments to the Prospectus Directive – will probably march on albeit at reduced pace. Rules including the Simple, Transparent, Standardised (STS) Securitisations Directive could be held up as renewed political resistance may emerge. Efforts to harmonise fund distribution rules across the EU will also be hampered by the uncertainty, and it is probable that the UK will be marginalised in any future discussions. As such, the CMU may not go down the path that many UK managers and financial institutions had hoped for.
There are going to be tough and uncertain times ahead for the UK financial services industry and it needs to ensure that it minimises any negative fall-out from the referendum by close involvement in the negotiations, both in respect to the single market but also in other negotiations for trade deals with third party countries.