Brexit, certainty and strategy and what does it mean for customers?
After the Brexit vote the financial sector will now crave certainty to drive its strategic decision-making. It is unclear how quickly certainty can be provided or what firms will do in the meantime. The likely reaction of customers will be crucial to firms' behaviour.
The UK's referendum decision to exit from the European Union is the beginning rather than the end of a process, signalling to the government its future strategy but without giving any inbuilt certainty as to how that strategy should be fulfilled. It is now all a matter of execution. Yet it is not at all clear even who will be managing the execution, let alone how they will do it.
Current position for Pan-EU business conducted out of London
Historically, the standard model for institutions headquartered outside Europe that wish to offer financial services cross-border within the EU has been by way of an EU incorporated subsidiary-with-passport (normally based in London) conducting largely investment business cross-border within the EU and in some instances through a branch located in other European countries.
In addition, in the case of larger institutions, groups have often located a bank branch in one member state (normally the UK) so as to provide an entity with a strong credit rating to EU depositors. That entity does not benefit from a passport.
Banks (credit institutions) incorporated in the EU obtain their passport under the Capital Requirements Directive (CRDIV), including for investment business activities. Investment firms currently obtain their passport under the Markets in Financial Instruments Directive (MiFID). An institution incorporated within an EU jurisdiction obtains its licence in that member state and then notifies its regulators of an intention to passport.
The question of when activities (such as short flying visits, phone calls, emails and so on) are, as a matter of local member state law and regulation, conducted cross-border has been scarcely considered by many.
The point is legalistic and subtle. The market and many advisers have jumped over that question and have made passport notifications for all activities, on the basis the process is so easy that the issue need not be examined.
In fact, many key activities do not take place cross-border at all. For instance, deposit-taking has been generally regarded as taking place where the bank's books and records are located. Non-EU booking vehicles are often used for EU business without any cross-border issues arising.
Further, given the location of representatives of EU businesses in London many of the activities take place between people located entirely within the City. For those activities which could genuinely be cross-border a more rigorous legal analysis would be advisable going forward in instances where no passport is available. However, in many instances this will be unnecessary due to forthcoming changes in EU passporting law which echo G20 and FSB initiatives to ensure greater mutual reliance between regulators.
The MiFID II passport extension for UK banks and investment banks
Under the arrangements known as MiFID II (incorporating an updated MiFID and a newly produced Markets in Financial Instruments Regulation, MiFIR), which will come into effect from January 2018 before any Brexit termination notice takes effect, two new passports are introduced for cross-border investment business conducted with professional clients and eligible counterparties.
These passports will be available to banks in their investment business activities (MiFID2 amends CRDIV), and to investment firms.
The first passport requires the firm to register with the European Securities and Markets Authority (ESMA) in its list of permitted third country firms. The second permits a firm to establish a retail branch in those EU member states which require a branch presence for that business (paradoxically, due to the breadth of the current overseas persons' exclusion, the UK opted out of implementing this aspect of MiFID II) with the result that the firm is then granted a passport across Europe for wholesale investment business.
The term "wholesale" means investment business with, broadly speaking, corporates (except when below tiny capital thresholds), financial institutions, insurers, funds (including pension funds), fund managers and governments.
Many cross-border dealings, including multiple and extensive on-the-ground visits, can be conducted without a branch being established. This requires of course a thorough consideration of local law and regulation including tax laws, in the way that lawyers assessed the situation under the first incarnation of what is now MiFID, the Investment Services Directive.
To make use of the new passporting processes outlined above, the European Commission must make a determination that the laws of a third country — in this case, the UK — are "broadly equivalent" to those in the EU in prudential and conduct of business requirements. It is almost inconceivable that an equivalence determination will not be automatic given that the UK's laws will be identical to those of the EU in these respects.
There is also a requirement for those laws to be properly enforced. Again, it is hard to conceive of any non-automatic assessment on that front given that the UK regulators are currently EU regulators.
Information-sharing mechanisms will need to be established between the UK regulators and ESMA or the EU member state's regulators where the retail branch is established. In the case of the retail branch there will need to be tax cooperation arrangements.
There are already other equivalency regimes in place, such as for central counterparties and other market participants under EMIR. In this context there have been equivalence determinations for jurisdictional regimes which are considerably different from the EU's regime, on the basis that they give rise to similar outcomes.
Thus, under EMIR, equivalence has been declared for the regimes in the United States, Hong Kong, Singapore, Canada, Mexico and others.
There are some limited aspects that are not covered by the MiFID2 passport and other equivalence arrangements, such as lending by credit institutions under the passport in CRDIV. However, sophisticated arrangements have been developed for hedge funds that enable the provision of credit throughout Europe, which could cover much such activity.
This is, of course, a summary of the situation that presumes the UK does not negotiate a special deal with the EU, which is highly unlikely. In particular, banks and investment banks based in the continuing EU which wish to do business in the UK cross-border or through a branch will need a new relationship with the UK. The current approach of the Prudential Regulation Authority to non-EU institutions operating through a branch in London is to permit this so long as they are not conducting significant or systemically risky activities.
Thus U.S. institutions have been required to subsidiarise many of their UK operations. Banks and investment banks based in EU member states have not had to subsidiarise to date, due to their entitlements to passport into the UK without restriction under CRDIV and MiFID. There are therefore systemically important branches located in London, established from bases in other EU member states, primarily operating under the oversight of regulators based abroad.
In the post credit-crisis world this brings with it considerable risk that UK and other regulators have been clamping down on in order to ensure adequate prudential oversight and satisfactory recovery and resolution plans.
There will need to be new arrangements put in place to the satisfaction of UK regulators to deal with these points which ensure mutually beneficial recognition is in operation between the UK and continuing EU member states.
The G20 and Financial Stability Board (FSB) have been leading the way on a global level in working through the detailed aspects of equivalence regimes and deference to home state regimes and authorities.
This work at a global level paves the way for any post-Brexit arrangement.
The most difficult problem with understanding the implications of Brexit lies in the fact that the UK's future trading relationship with the EU, and indeed with the rest of the world, is unknown territory. Without knowing what the deal is, firms find themselves in limbo.
It is worth considering the worst-case scenario as a starting point: under that scenario, Brexit will be followed by no individual deal, leaving the UK as a third-country participant in the EU single market, on "World Trade Organisation terms". This severe outcome for the UK may be appealing to some of the remaining member states.
Establishment and services
For EU member states, the treaties and EU law draw a distinction between rights to establish and to provide services in other member states. That distinction has always been important but may now become stark for UK firms. Establishment means having a legal presence in another member state; service provision is done using cross-border communications such as the internet.
Firms that provide services from the UK without an establishment in the EU face, under the worst-case scenario, a severing of their right to provide those services. Not having a presence in any EU state would make it difficult to take legal action against the service provider.
Nevertheless, for the sake of legal certainty, service providers may need to consider the costs and benefits of establishing a branch in at least one member state from which they could then provide services across the rest of the EU.
Firms that already have an establishment (branch) in one other member state are in a more secure position. Once the UK leaves the EU, the home state of that branch will change to the country in which it is located. Firms with more than one branch may be able to select which branch will become its EU parent.
Letter box entities
In the future, it is unlikely that a UK firm establishing in the EU will be able to do so without transferring genuine economic activity into the EU. Directives frequently have provisions designed to prevent "letter box entities", for which the more recognisable term in English is "brass plate company".
The idea of establishing a legal entity in, say, France or Germany and then delegating economic activity back to the UK is questionable under a number of existing directives.
Losing the market
The governments and financial sectors in other member states will now be considering how best to profit from the UK's departure. France, for example, has long coveted the UK's asset management industry and may see its chance to become the Boston of Europe. The EU customers of UK firms may be attracted, also for reasons of certainty, to providers outside the UK.
Other member states may well stress the need to avoid letter box entities as a means of ensuring the transfer of significant economic activity into the EU.
During the referendum various potential deals with the EU have been considered, ranging from the "Norway model", where the UK becomes a member of the European Economic Area (EEA) and the "Canadian model", where the UK would have a much lighter bilateral deal with the EU.
The options all fall along a spectrum involving a trade-off between commercial advantage on the one hand (terms of access to the single market) and adherence to EU law on the other.
In short, the options that provide better access to the single market also entail a greater requirement to follow EU law, including the "four freedoms" which provide for free movement of goods, people, services and capital.
Whichever deal is reached, the terms of access to the single market will not be on as beneficial terms as the UK enjoys as a member state. A non-member of the club cannot be given the same rights as the members without destroying the purpose of the club. Other member states will know this.
In particular, free movement of people is regarded as an integral feature of the single market and this may provide a substantial barrier to the deal the UK is able to extract.
The terms of the deal with the UK will be affected by the need of the remaining members to keep the EU together. Although fundamentally based on its single market, the formation of the EU was driven by the need, in the wake of the Second World War, to prevent further conflict in Europe. Other member states will give due weight to that rationale and may well be prepared to sacrifice some economic benefit as the price of keeping the EU together.
It is possible that the unleashing of exit fever in Europe may result in calls for referenda elsewhere. There is no guarantee that those calls will be answered, however, and indeed the results may be very different; the UK is perceived as the most euro-sceptic nation in the EU and yet even there the vote was marginal at 52 percent in favour and 48 percent against.
Whatever deal is reached with the EU, the hope must be that the terms of trade with the rest of the world will be sufficient to lead to the UK's net advantage. This is of course by no means certain.
Firms now have difficult decisions to make. They can sit tight and wait for further information about the deal the UK might hatch with the EU. Or they can make decisions to engage with the EU through one or more of the remaining member states.
Decisions will presumably be based on how firms feel customers are going to react to uncertainty. It may be difficult to attract new customers outside the UK and existing customers may need to review their relationships with UK firms.
Leigh Thomas is a correspondent at Reuters in Paris