The year 2016 was full of political surprises, including the Brexit vote. One year on from the referendum, the scope and nature of the deal the UK government will be able to strike with the EU remains unclear, but it seems likely that passporting rights, labour mobility and the management of assets from the UK for clients in the EU will be impacted in some way.
Formal Brexit negotiations commenced on 19 June – almost one year since the UK referendum on EU membership. As expected, the first phase of the negotiations will focus on settling Britain’s financial obligations to the EU and the rights of EU and British citizens residing in each other’s jurisdictions.
Only after this first phase is completed, which is expected by December 2017, will the negotiations move on to discuss the crucial and complex issues of trade and Britain’s future relationship with the EU, including in financial services. As a professional body for investment professionals, CFA Institute is focused on ensuring that any possible adverse repercussions for client interests are minimised throughout the negotiations.
Thus far, there has not been any short-term regulatory impact of the vote to leave the EU and the immediate outflow of capital from UK managed funds in the aftermath of the referendum proved to be short lived. Depreciation in the pound in the period since the referendum provided support to the UK equity market and coincided with a period of improving economic data and increases in asset prices more generally across developed markets. At the same time, growth in the euro area has been strong and employment and price pressures have continued to improve.
Despite these positive signs, uncertainty is still negatively affecting the investment industry. In a CFA Institute member poll on the likely consequences of Brexit, 50 per cent of respondents in the UK thought Brexit uncertainty would remain in the markets for more than two years, compared with only 2 per cent who thought the uncertainty would remain for less than six months.
Clarity needed
These results indicate the need for more clarity and predictability over the Brexit process in the coming months to reassure firms, markets and investors. There are several key areas that warrant attention.
Historically, the ‘passporting’ of financial services – the ability to provide services freely throughout the EU on the basis of a single regulatory authorisation in the firm’s home member state – to and from our closest neighbours helped create strong links between the UK and the continent. The UK runs a large trade surplus in financial services with the EU, amounting to some £22.8bn in 2015 according to TheCityUK. The UK is also the largest centre for asset management in Europe. According to the Investment Association, 55 per cent of the overseas client market, or £1.2trn, is managed on behalf of clients in Europe (ex-UK). It is therefore clear that the UK investment industry benefits significantly from the ability to provide services to European clients, underpinned by the passporting regime.
Historically, the ‘passporting’ of financial services – the ability to provide services freely throughout the EU on the basis of a single regulatory authorisation in the firm’s home member state – to and from our closest neighbours helped create strong links between the UK and the continentLoss of rights
Any loss of passporting rights would affect several aspects of the investment management business. These include, for example, cross-border marketing and distribution of investment funds, as well as some ancillary services, such as custody and administration. The provision of investment services to retail clients might also be impacted.
However, for firms to maintain their passporting rights, the UK would most likely have to accept membership of the European Economic Area, or be granted regulatory equivalence as a “third country” (that is, outside the EU, but with a similar regulatory and supervisory framework as the EU). Neither option is likely. Membership of the EEA involves accepting the free movement of people, contributions to the EU budget and the jurisdiction of the European Court of Justice (among other things) – all of which are incompatible with the UK’s stated negotiating objectives. On the other hand, third country status is likely too fragile an arrangement for a long-term trading relationship, as regulatory equivalence provisions are limited in scope and may be revoked at any time by the European Commission. Consequently, a bespoke trading relationship is likely to be sought, although its parameters remain unclear.
For investment professionals, any disruption in the ability to conduct portfolio management in the UK on behalf of overseas clients would be a key concern. Currently, several EU directives provide for the delegation and outsourcing of certain functions in the investment management value chain (including portfolio management) to “third” countries. But the nature and extent of these delegation and outsourcing provisions could change under Brexit, with regulators taking a closer look at the amount of assets that would be managed outside the EU post-Brexit. Political considerations are also likely to be a factor; the UK will undoubtedly want to retain as much of its asset management business as possible, while other countries may actively court the asset management industry through tax and regulatory incentives.
In this context, it will be critically important to avoid a regulatory race to the bottom and any dilution of standards or investor protections. The UK’s departure from the EU also poses challenges for the unification of capital markets, which remains a priority of the European Commission under its capital markets union (CMU) initiative.
EU capital markets are fragmented and still quite heterogeneous among EU member states. This fragmentation is reflected in the relatively low levels of capital raising and liquidity in smaller member states. Issuers favour consistent rules and legal certainty provided by more developed markets (for example, the UK); post-Brexit, it will become all the more important for the EU to strengthen its capital markets infrastructure to support capital raising and investment opportunities.
Regulatory consistency
Capital markets union post-Brexit cannot be realised without more consistency and predictability in the legal, regulatory and supervisory environment in the EU.
A specific area where more centralised supervision would be beneficial is cross-border investment funds. As the European Commission has identified, barriers exist to building a more harmonised and integrated market for the distribution of cross border funds in the EU. These barriers include divergent national requirements regarding marketing of investment funds and translations into local languages, the process for registration of funds with national authorities and taxation differences among member states. Addressing these obstacles while avoiding a regulatory race to the bottom will be crucial for investors.
Ultimately, whichever side of the debate one resides, upholding the interests of the end investor needs to be a core objective for the impending negotiations surrounding financial services. Along the way, despite general pessimism within the financial services industry, there will undoubtedly be opportunities for investment managers as uncertainty recedes and the future UK-EU trading relationship crystallises.
Rhodri Preece is head of capital markets policy (Emea) of CFA Institute
Key points
Only after the negotiations about EU residents finish will discussions move to trade.
Any loss of passporting rights would affect several aspects of the investment management business.
Upholding the interests of the end investor needs to be a core objective.
Key statistic
£22.8bn: The UK's trade surplus in financial services with the EU in 2015.
