Brexit: What Matters
Rebecca Healey, Head of EMEA Market Structure and Strategy at Liquidnet, is author of the study:
Despite the fervour and noise, and irrespective of the final political outcome, firms with clients or brokers in Europe are being advised to take action now. The risk of not being able to trade and transact on March 30th, 2019 is too great, given that, at the current juncture, a no-deal outcome is looking increasingly likely. Three-quarters of respondents who contributed have outlined Brexit contingency plans, however just 49% have been able to put those plans into action given the state of flux negotiations are in. Implementation of Brexit will not only require considerable resources in terms of manpower and legal teams but is leading firms to reconsider the business they engage in; the opportunity cost of conducting that business; and what action they need to take now to future-proof themselves.
The outreach includes details on the following:
- Loss of Passporting rights
- Delegation & Equivalence
- Liquidity Fragmentation
- UK under EEA
- Regulatory Arbitrage
- The Outcome
Fifty-five investment management firms were contacted during the period April to August 2018 to understand the impact of Brexit on their organisation and their operational structures. Topics included both the distribution and marketing of their products, as well as the impact on execution and future liquidity formation. Only 29 firms felt able to participate at this stage representing $15.6 trillion assets under management globally. Participants included both asset managers and hedge funds, with 45% head-quartered in the UK, 34% in Europe and 21% in the US.
83% of firms have a theoretical plan to respond to Brexit; but only 49% of firms have put their plan into action. 31% have plans under review, with 17% still unsure what do to, waiting to pull the trigger once the political situation becomes clearer
59% are already working towards a hard Brexit rather than wait for potential political solutions which have no guarantee of emerging. Of these, 55% believe Brexit will be softer than currently anticipated but given the political uncertainties firms are left with no other choice but to implement hard Brexit plans
54% of UK respondents and half of US firms are aware of the challenges and pressing ahead with Brexit implementation plans; whereas just 40% of EEA firms have plans in place.
87% are planning to keep trading desks where they are. However, this may be temporary with only half anticipating that change may be required depending on the outcome of delegation. A third are keeping a watchful eye on the potential fragmentation of liquidity; but just 17% are ready to move today should the need arise.
70% believe the greatest impact will be on legal, with 52% expecting this to impact their clients significantly.
63% believe there will be no additional costs incurred in execution as a result of Brexit – despite a third anticipating a split in liquidity formation.
Half of the respondents are reviewing their settlements options. Only a third feel comfortable that no change is required.
Three quarters expect the UK to retain financial services post Brexit due to a mix of liquidity access, staffing talent and ease of access.
Frankfurt is anticipated to emerge as the European beneficiary of Brexit – but this is also dependent on the business type, with Dublin and Luxembourg emerging as winners for asset management services, and Amsterdam as the main location for trading venues.
Regardless of Brexit, firms expect MiFID II regulatory change to continue, with 42% believing that the outcome will negatively impact both sides of the channel.
Loss of Passporting Rights
While both the EU and the UK agree the need for robustly regulated markets, substantial differences remain in how this should be achieved. While the recent paper from the UK Treasury reaffirms the ability for non-UK firms to continue accessing UK markets via the overseas persons regime, and in the event of a hard Brexit, maintain access through the Temporary Permissions regime; this is not a view shared by all in the EEA.
The loss of the single market will matter, not just for European (EEA) and UK market participants – but the companies they invest in and the investors and pensioners they act on behalf of. With no agreement on equivalence and no guarantee of the proposed 21-month transition period, the City of London will become a “third country”, losing its passporting right to sell products direct to the EEA and vice versa. In 2016, the UK represented 41% of asset management in EEA; 5,000 UK firms used 336,000 passports to access the EEA, and 8,000 EEA firms used 23,500 passports to access services in the UK. Without passports, firms must alter not only how they market and provide services, but also how they execute and engage with their brokers, as well as settle their transactions.
Delegation & Equivalence
Many firms continue to base their Brexit strategy on the ability to continue delegation of services. There are as yet, no guarantees. Firstly, if an exit agreement is reached and enhanced equivalence is granted, ensuring new legal co-operation agreements between the FCA and individual EEA NCAs are in place in time will be challenging – particularly bearing in mind the likely fragility of the equivalence regime (see exhibit 1), the time it will take to implement as well as the need for individual member state agreement.
Secondly, in the event of a hard Brexit, there will be significant substance issues required. Recent ESMA opinion focuses on the need to demonstrate justifiable reasons for delegating EEA based activity to a non-EEA entity. Navigating the differences between fund vehicles, delegated managers, segregated accounts and differing regulatory substance requirements will be a minefield of complexity. The nuclear option is that firms will decide to split their fund and investor activity – UK to UK and EEA to EEA. This will then create execution as well as distribution issues to resolve such as EEA derivatives currently cleared on a UK-based CCP potentially moving to a EEA-based CCP or EEA firms accessing a UK based APA.
MiFID II was designed with the inclusion of UK trading volume, and the implementation of Brexit will necessitate re-design of MiFID II calculations such as the Double Volume Cap (DVC) and Systematic Internaliser (SI) thresholds impacting execution methods and liquidity formation. More CAC40 instruments are now traded by SI than traded on the national French exchange, and of the 117 SI currently registered with ESMA, 48 are based in the UK. There is no third-country regime in place for EEA firms to access UK SIs as they do today under the share trading obligation. Obligations to trade equity instruments on a registered venue or MTF may also lead to changes in liquidity formation for UK instruments that are dual-listed within the EEA.
While there is no trading obligation for cash bonds, liquidity may also be impacted by the risk of Large-in-Scale thresholds diverging as liquidity pools in different geographical locations, with principal risk focusing in the UK and agency flow pooling in the EEA. Any liquidation of positions in less liquid markets have the potential to lead to poor execution outcomes, impacting end investors and companies, as well as European governments in terms of debt issuance. All of this will potentially have a knock-on impact on reporting requirements and subsequent levels of market transparency, resulting in participants having to readjust known liquidity formation patterns to decipher the future liquidity landscape.
UK under EEA
Location and fund management constructs will matter; they have the potential to limit the negative impacts of unravelling forty years of combined regulation. To ensure sufficient control and oversight asset management firms will not only need to know their own regulatory requirements but will also need to understand how their end clients operate and in which jurisdiction. ESMA’s recent guidance to competent authorities across the EEA is clear – any delegation of investment management services to non-EU27 member states must not circumvent a firm’s regulatory obligations – whether that is under MiFID II, UCITS or AIFMD. Regardless of delegated mandates or segregated accounts, if firms are operating a regulated fund entity within the EEA, they will fall under EEA regulation. There are other auxiliary issues which could also lead to surprising outcomes. EEA firms that invest in UK securities or use UK data relating to personal information could currently lead to their firms being in breach of GDPR regulation in the event of a hard Brexit.
To ensure continued full compliance and control, this is likely to lead to two outcomes. Firstly, greater oversight to ensure regulatory convergence across the NCAs with the EEA; and secondly, UK convergence with current EEA legislation to limit the negative impact from Brexit, as cited in the recent paper from HMT.
Offering the UK special status in the absence of being able to reach a negotiated deal will be challenging given the need to reach consensus within the EEA. There are European concerns that the UK will gain an unfair advantage if granted access under the current equivalence regime; and some are looking to require “branches” in individual member states to be established. While this is dismissed as impossible by some due to the need to ensure equivalence for the US, this is unlikely to mean business as usual. NCAs still need to grant jurisdictions equivalence under Article 47 of MiFIR, and the lack of certainty will all most certainly lead to a rush of applications to be processed and approved at the 11th hour.
Recent ESMA guidance indicates a growing level of concern regarding the risk of regulatory arbitrage. To ensure all EEA regulators are adopting the same approach, ESMA are specifying standardised criteria such as appropriate staffing levels and independent and robust systems for risk management, compliance and internal audit. ESMA have also mandated that NCAs must review any existing as well as planned outsourcing arrangements. Any delegation to non-EEA entities must be reviewed fully to ensure that proper oversight and supervision can be maintained once the UK is outside of the EEA.
The reality is Brexit may lead to surprising outcomes. Some in Europe appear to view Brexit as an opportunity to draw back the European asset management industry to within its borders. This may yet lead to challenging outcomes for capital formation both in the UK and the EEA, but also within individual EEA member states themselves. A large portion of risk capital remains in the UK, and the historic and cultural aspects as to why this is the case cannot be wiped out overnight.
In the immediate aftermath of Brexit, the key for both EU and UK regulators will be to maintain the orderly functioning of financial markets and contain systemic risks. It is in the interest of both the UK and EEA member states to avoid any further fragmentation of liquidity which reduces efficiency and increases costs for all market participants, and ultimately end investors. All firms will need to ensure they select sell-side partners and venues which will enable their business to continue whatever the political outcome.
Smaller EEA brokers will want to retain access to UK clients and UK small & mid cap brokers will look for reciprocal arrangements. One fact is for certain the process of reorganisation and relocation is already underway which will lead to greater complexity for all participants. This represents a clear opportunity to differentiate for those who are able to identify the opportunity. The potential for technology to manage processes cross border and redefine access to liquidity and ensure execution will enable firms to demonstrate real value to their clients, provided they have the technical know-how and staffing resources to meet this new demand.
The asset management industry needs to keep its eye on the prize. Aging demographics, declining returns, fund outflows and the increasing cost pressures of passive investments continue to weigh on performance. Capital markets no longer deliver double-digit returns and as profit margins shrink, asset managers in the UK as well as those in the EEA will have to decide where to locate and what business they want to engage in. Those who service them will need to follow suit. Buy side or sell side, venue or service provider, Brexit is set to usher in further innovation and competition in financial services.
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