The future of financial services regulation

The future of financial services regulation

Following the UK’s vote to leave the European Union, an area of particular interest for Ireland is the potential impact on financial services.

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Partner & Head of Regulation

KPMG in Ireland

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Seán O'Casey Bridge, IFSC, Dublin

The legal process for leaving the EU comes via Article 50 of the Treaty on European Union (TEU). The intention to withdraw from the EU is notified to the European Council by the government of the withdrawing State pursuant to this provision. Once triggered Article 50 acts as the catalyst for the negotiation process for the transitional and also any future arrangements between the EU and the leaving State.

These negotiations are conducted under the provisions set out in Article 218(3) Treaty on the Functioning of the European Union ("TFEU") over the course of a two year timeframe. In the absence of an agreement to extend the negotiations, if no agreement is reached within those two years then EU law will cease to apply to the UK and it would become a so-called third country. The UK trading relationship with the EU will then most likely be governed by World Trade Organization rules, which will cause considerable challenges for the UK financial services sector.

An Issue of Timing

The UK government has indicated that they will trigger Article 50 no later than the end of March 2017. Presently, it appears that the political challenge will be to strike a compromise between the competing forces of control over immigration and cessation of contributions to the EU Budget and participation in the internal market. However as the EU has consistently stated that there will be no informal negotiations prior to Article 50 being triggered, so therefore the ability to assess both the nature and the ultimate outcome of the negotiations may not begin to materialize with any certainty until the spring of 2017.

The EU are also likely to use this time to formulate their approach to the negotiations. As a Member State has never left the EU, the complexities of departure is both without precedent and has the potential for detrimental ramifications for the EU.

European Financial Regulation

The EU Financial Services arena, is one where many of the challenges associated with withdrawal from the EU will be exemplified. Since the creation of the "single market in financial services", was first envisaged in the 1999 Financial Services Action Plan, there has been a sustained period of legal harmonisation, resulting in many Member State financial services laws being developed or replaced by an increasingly detailed single rule book for European financial regulation.

A key benefit of this integration is the resultant ability of Member State credit and financial institutions being able to carry on business and sell services throughout Europe without necessarily establishing an authorised presence or similar in each individual Member State, so called "passporting". It has also enabled non-EU credit and financial institutions to avail of the passporting regime, contingent on their establishment of an authorised subsidiary in a Member State.

If the outcome of the withdrawal negotiations does not result in the UK maintaining access to the internal market (under the current model this would be best achieved via membership of the European Economic Area ("EEA") then this could pose particular challenges for the City of London and result in UK financial institutions not being able to continue to offer a full range of financial products and services to their existing and prospective customers.

Examples to consider

The Alternative Investment Fund Managers Directive ("AIFMD") introduced a new passport system for the marketing of alternative investment funds ("AIFs") in the EU. The marketing passport is automatically available to authorised EU alternative investment fund managers ("AIFMs") managing EU AIFs. However, if post-Brexit the UK becomes a third country then UK AIFM will lose their EU marketing passport.

Further, an EU AIF, with a UK AIFM may need to consider appointing an EU AIFM, becoming self-managed or appointing a third party AIFM in another EU jurisdiction.

Finally, EU credit institutions and investment firms automatically qualify as providers of depository services under AIFMD, third country entities do not. Given the restriction on the entities that can act as a depository for EU AIFs, a UK-based bank currently providing custody services to such an EU AIF may not be able to continue to do so if it ceases to be an EU credit institution or investment firm.

The Markets in Financial Instruments Directive

("MiFID"), also provides for a passporting regime which enables EU credit and financial institutions/investment firms to conduct investment business across the EU by regulating the conduct of investment services, such as the trading of securities and derivatives, the execution of client orders and portfolio management on a Union wide basis. Depending on the outcome of the negotiations there is potential that UK-based firms will lose their MiFID passports and therefore will not be able to deal with EU-based clients and would need to consider establishing a subsidiary in another EU Member State.

The Capital Requirements Directive ("CRD") contains a passport regime that allows deposit-taking institutions to conduct services, such as lending and deposit taking throughout the EU using their home Member State authorisation. Without at least EEA membership, UK banks would lose the automatic EU passport for banking services.

Prospectus and Transparency Directives ("PD") The issuance of securities in Europe is facilitated by a pan-EU regulatory regime, provided by the Prospectus and Transparency Directives ("PD") and ("TD"). For example, the PD allows the use of one prospectus to offer securities in multiple jurisdictions across the EU. In the absence of EEA access the UK would have to draft domestic prospectus and transparency legislation and accordingly each request for admission to trading on a UK market would need to be approved by the relevant national authority in the UK and similarly by each Member State authority where a request for admission was being made by a UK entity.

UK-based Central Counter Parties ("CCPs") and Trade Repositories (TRs) as well as the counterparties wishing to use their services are currently subject to the European Market Infrastructure Regulation ("EMIR"). If the UK becomes a third country, then these UK based CCPs and TRs would have to apply for third country recognition from the European Securities and Markets Authority ("ESMA") in order to continue to provide services to EU counterparties, this could be a protracted process and could cause considerable business disruption. UK based clearing houses who are currently engaged in euro-denominated clearing may also have to consider establishing a presence in the Eurozone in order to continue to provide for the clearing of certain products.

If necessary, the resolution of a number of these issues may be achieved by UK credit and financial institutions being able to avail of third country equivalence recognition. This is possible to varying degrees under the respective "third country regimes" contained in the relevant EU legislation such as AIFMD and EMIR. The forthcoming MiFID II regime also provides for third countries doing business with EU entities, introducing different provisions for retail clients and professional clients. Such that the conduct of regulated investment business with a retail client in a Member State if the third country investment firm has established a branch in that Member State.

For the provision of investment services to a professional client, the establishment of a branch may not be necessary, as long as the third country investment firm is registered with ESMA and an equivalence decision has been adopted by the European Commission for the country where that investment firm is established. If the UK enact "preserving legislation" to retain the existing EU financial services framework, this should assist any third country equivalence decision. However, experience to date, has shown that such equivalence decisions can be protracted as well as political in nature and any divergences from the relevant EU law could impede a positive outcome.

The UK will also have to assess the impact on legal certainty of the Brexit negotiations on other aspects of EU law relevant to financial services, such as the application under the EU Rome I and Rome II Regulations that determine the governing laws of contractual and non-contractual obligations. The establishment of court jurisdiction and reciprocal recognition of judgments is also governed by EU law in the form of the Brussels Regulation.

As a final note, it is worth remembering that as EU law will continue to apply in the UK until the negotiations are concluded or the two year time period has elapsed. This will mean that Packaged Retail Investment and Insurance Products Regulation, Securities Financing Transactions Regulation 16, MIFID II/MIFIR, 4th EU Anti Money Laundering Directive and the Insurance Distribution Directive will all enter into application in the UK before the withdrawal negotiations have been completed.

While this is likely to assist with any future equivalence assessment, credit and financial institution will need to consider, both their domestic UK and EU operations, the services they provide and the location and type of customers they provide those services to. Such an assessment will inform decisions on establishment of new or restructuring of existing regulated entities in each relevant jurisdiction from both a commercial as well as a regulatory compliance perspective.

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