BREXIT, MiFID II and the Single Market – where to now?

September 29, 2016

In this article, Nigel Brahams, financial services partner and Madeleine Croydon, associate at Fox Williams LLP, provide a brief guide to the current position for UK based firms under EU law, and the various scenarios applicable to the UK financial services industry post- Brexit.

  1. The Single Market and Treaty of Lisbon
  2. Article 50
  3. Passporting rights under MiFID and MiFID II
  4. "Brexit means Brexit"
  5. Third country status under MiFID II / MiFIR
  6. Third country equivalence
  7. Access for third country firms
  8. Possible forms of Brexit
  9. Trade reporting and clearing
  10. The future


 

The Single Market and Treaty of Lisbon

The Lisbon Treaty was signed by the heads of state and government of the 27 EU Member States on 13 December 2007. The Treaty on the Functioning of the European Union (TFEU) contains the specific objectives of the Treaty of Lisbon, restating and developing earlier EU laws, principles and treaties. The Treaty sets out the four key freedoms of movement which underpin the single market:

  1. Free movement of Goods – Since January 1993, controls on the movement of goods within the internal market have been abolished and the European Union is now a single territory customs union without internal frontiers.
  2. Free movement of Workers - Article 45 of TFEU guarantees every EU citizen the right to move freely, to stay and to work in another member state.  This freedom applies to all member states' citizens regardless of nationality as well as to the European Economic Area (Iceland, Liechtenstein and Norway). Controversially for some, certain rights are also extended to family members of the worker.
  3. Right of Establishment and Free Movement of Services - Articles 49 and 56 of the TFEU provide that Member States are required to ensure unhampered right of establishment of EU nationals and legal persons in any Member State and the freedom to provide cross-border services. This is to be done by the removal of barriers (both legal and administrative) to the development of service activities between Member States. This is intended to be an on-going process with a view to promoting ever-closer union and has led to the promulgation of the single financial market under MiFID, MiFID II, and MiFIR. 
  4. Free Movement of Capital – Articles 63-66 of TFEU also aims to remove restrictions on movement of capital both within the EU and between Member States and third countries. 

 

Article 50

51.9% of voters in the recent UK referendum voted in favour of the UK leaving the European Union.  Though the referendum is not legally binding and the exact form of Brexit was not spelled out, it is likely to be politically difficult for the UK government to ignore the result, irrespective of the consequences. 

The triggering of Article 50 is itself subject to a legal dispute, concerning  whether Parliament is required to enact Article 50 or if, as the government maintains, it can be activated using the Prime Minister’s Royal Prerogative Powers. A group of businesses have already launched a preemptive and ongoing legal challenge to the government’s view, in an attempt to ensure that Article 50 will not be activated without an Act of Parliament. 

Under Article 50 of the Treaty of Lisbon, any country wishing to leave the EU is required to notify the European Council of its intention to leave. Following notification of its intent to withdraw, the UK will have up to two years to agree the exit terms with the European Council. Any extension of this period must be unanimously agreed upon by all members of the European Council.  

It is certainly possible that the UK may require an extension of this two year negotiation period. There is no precedent for a member of the EU departing according to the Article 50 process. The closest example is that of Greenland, who left the (then) European Economic Community in 1985. Their exit required a three-year negotiation period, primarily involving a wrangle over fishing rights for European fisherman. In light of this, it is not hard to imagine the UK requiring a much lengthier exit period. Whether the European Council will agree to an extension is unclear. The Council’s response to this is hard to predict, considering the EU’s eagerness for the UK to activate Article 50 as soon as possible. It may be that the larger member states will foster a more collaborative attitude, in order to curtail negative economic impact. However, this is likely to be balanced with a desire to ensure that the exit process does not appear too painless, in an attempt to quash any other potential Leave campaigns in other Member States.

EU treaties will cease to apply once a withdrawal agreement has been entered into or, if one has not been agreed, at the expiry of the two year (or extended by agreement) negotiation period. The withdrawal agreement will be negotiated by the UK with the European Council. The Council must act by qualified majority (at least 55% of the members of the Council representing the participating Member States, comprising at least 65% of the population of these States) after obtaining the consent of the European Parliament. 

 

Passporting rights under MiFID and MiFID II 

From a financial services perspective, the Markets in Financial Instruments Directive (MiFID) is one of the most important pieces of EU legislation, providing banks with the ability to “passport” services in other EU Member States. The principal post-Brexit risk for institutions that use the UK as a base to access EU markets is the loss of the passporting rights which provide them with access. Should the UK leave the EU and not retain membership of the EEA, the UK would become a “third country” under MiFID. 

 

“Brexit means Brexit” 

Theresa May announced “Brexit means Brexit”, though the precise meaning of this well-used phrase is unknown. May’s objectives have yet to be fully elucidated but reportedly her goal is to maintain free trade with the EU, whilst restricting freedom of movement. 

The extent of the impact on the UK’s leading global financial services industry and related financial services regulation will depend on the final agreement that the UK reaches with the EU. The financial services industry is understandably in favour of an agreement which would preserve the concept of “passporting”, allowing regulated UK financial services firms in each Member State the ability to conduct certain types of financial  services business authorised by their home state, throughout the European Union, without needing to obtain further regulatory licences from each individual host state regulator. 

 

Third country status under MiFID II / MiFIR

Currently, any third country (i.e. ex EEA) financial services firm wishing to provide services into or in an EU Member State must be established as an authorised entity in a Member State. Alternatively, they can establish a subsidiary in a Member State and rely on passporting rights to operate from that country across the EU. Currently, many US and Asian banks access EU markets via a UK subsidiary. In the event of a Hard Brexit, these firms may relocate parts of their business to other EU locations to continue to retain access. However, MiFID II and MiFIR are due to replace MiFID in 2018 and potentially permit much e access to third country firms. 

There are two regimes for third country firms, depending on whether they are selling to retail investors and opted up professionals or to per se professionals / eligible counterparties. Most business in the international financial markets is conducted with professionals and eligible counterparties, so we have focussed mainly on this area for the purposes of this article.

 

Third country equivalence

Under Article 47(1) MiFIR, the European Commission can adopt a decision that a third country’s prudential and business conduct requirements are equivalent to MiFIR and CRD and that such third country allows equivalent open access to EU firms. This was intended to cater for other signatories to the G20 Accords, such as the USA, which enacted Dodd Frank. 

So long as the UK enacts MiFID II / MiFIR and other EU financial services regulation in full, it would be hard to argue that the UK had failed to meet these requirements.  Indeed, Andrew Bailey, Chief Executive of the FCA, has confirmed that firms should continue to move forward with their implementation plans for MiFID II, despite the referendum decision, stating that: “…firms must continue to abide by their obligations under UK law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect.”

 

Access for third country firms

Provided third country firms only do business with per se professional clients and eligible counterparties, they will be able to do so without establishing a branch in an EU Member State, provided their country is  granted equivalence status and they are listed on a register maintained by the European Securities and Markets Authority. By contrast, third country firms wanting to conduct regulated investment business with a retail client / opted up professional will likely need to establish a branch in that Member State. 

There are downsides to this plan. The equivalence process is not well worn, was not created with Brexit in mind and could take years to implement. Additionally, hardened Brexiteers would likely oppose such a scheme.

 

Possible forms of Brexit

Although it now seems that some form of Brexit is likely, it is still too early to predict with any certainty what form Brexit will take. Nonetheless, we have below reviewed various potential hard and soft Brexit options for the United Kingdom and their likely impact on the UK financial services industry: 

The “Norway” option

  • Member of European Economic Area (EEA), - full access to the single market. 
  • This would maintain the passporting regime for banks and investment firms. 
  • Loss of influence over regulation directly in Brussels
  • Significant contribution to the EU’s budget. 
  • Free movement of people - likely to be politically difficult. 
  • Least disruptive for the UK financial services industry
  • Enables non EU based firms to continue to base their regional headquarters in London.
  • Some potential to enter into other trade arrangements. 

The “Switzerland” option 

  • European Free Trade Association (EFTA). 
  • Bilateral accords governing access to the EU in particular sectors.
  • Swiss have access to single market of goods and some services in exchange for accepting some EU legislation. 
  • Freedom of Movement – Under discussion following Swiss Referendum
  • Smaller financial contribution.
  • No passporting of financial services.
  • Potential to enter into trade arrangements with other countries. 

The “Turkey” option

  • Turkey has negotiated a “customs union” with the EU, allowing goods to travel between the two, without any customs restrictions. 
  • Comply with EU product standards regulations, but no influence over content. 
  • No EU fees
  • No freedom of movement.  
  • No access to the single market and financial services passport.

Total isolation

  • The UK breaks with EU and EEA altogether and negotiates bilateral agreements under a “third country” status, i.e. Canada (seven years and counting).
  • World Trade Organisation rules could apply. 
  • UK exports required to comply with applicable regulations, although the UK would have no input in the development of the regulations. 
  • Supported by UKIP and extreme Brexiteers.
  • No passport or single market access. 

“Sadiq” London option

  • Special status for London
  • Financial Passport just for London
  • Free movement within financial services industry

The “Boris cake and eat it” option

  • EU allows UK full access to the single market
  • Emergency “handbrake” on freedom of movement for up to seven years.
  • Unlikely to be politically acceptable to EU or Brexiteers.

Enhanced third country option

  • UK adopts all EU financial services legislation as if it remained a member state.
  • EU accepts UK as a third country and UK accepts EU firms access to UK markets. 
  • Acceptance hardwired into any negotiation.
  • Free movement of persons working for EU / UK authorised financial services firms.
  • UK firms passported into the single market under MiFIR but only for transactions with professional customers and eligible counterparties.
  • UK firms would need to open an EU branch for dealings with retail customers. 
  • Brexiteers will fight scheme as will want to make own laws.
  • Not a well-trodden path and not planned with Brexit in mind.

Trade reporting and clearing 

The European Markets Infrastructure Regulation (EMIR) prescribes the rules under which banks are able to trade derivatives, in line with the pledges given by the G20 nations after the collapse of Lehman Brothers. The regulations encompass rules regarding clearing, trade reporting and risk mitigation. Post-Brexit, EMIR would no longer apply to the UK, though as a G20 nation it is highly probable that the UK would implement the contents of EMIR into domestic legislation. In the unlikely event that it was not transposed, EMIR would still apply to any EU-based entity in a transaction with a UK entity necessitating continued UK compliance with certain EMIR requirements. For example, UK entities would need to uphold arrangements with central counterparties (CCPs) in order that EU counterparties can clear eligible trades through a suitable CCP. 

The future

At this stage in the Brexit process, very little is known as to what sort of relationship the UK will continue to have with the EU. The widespread UK discontent with the EU’s policy of unfettered freedom of movement makes the possibility of the UK remaining within the EEA increasingly uncertain. Consequently, the likelihood of the UK retaining its passporting rights looks in doubt.

In time, the UK may attain an equivalence decision from the European Commission. However, there is a material risk to the financial services industry in the UK in the short to medium term, due to continued uncertainty created by the anticipation of a prolonged withdrawal process. With a more benign form of Brexit, in the longer term there could also be opportunities for the UK financial services industry to act as a bridge between the EU and the wider world, although this would require much thought and some political courage.


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Madeleine Croydon
Associate
Direct dial: +44 (0)20 7614 2572
mcroydon@foxwilliams.com

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