Having formally left the European Union (EU) in January 2020, the UK's transition period–during which time EU rules continue to apply–will expire on December 31, 2020. At present, a Brexit deal has not yet been concluded owing to political differences between the UK and EU negotiating teams as well as the disruptive impact of COVID-19.
Key insights
- Regulatory divergences could occur between the UK and EU, yet experts are divided on whether this could result in the UK losing its prized equivalency status with the EU
- Events in Switzerland have shown that equivalence can be taken away at short notice, which is a serious risk for UK asset managers reliant on EU markets for investment
- Asset managers should consider the various scenarios and potential impacts on operations before the end of the transition period
- In an extreme scenario, the UK may want to consider developing its own unique fund brand to compete with UCITS, although this would be a complex and extensive undertaking
If a long-term agreement cannot be reached, UK-regulated managers of UCITS and alternative investment funds (AIFs) will be designated as non-European Economic Area (EEA) managers, and their UK-based UCITS and AIFs will be designated as non-EEA AIFs, potentially excluding them from freely marketing these products into the EU through the current passporting arrangements. Such an outcome could impede the ability of UK asset managers to raise capital from EU investors. The impact would be mutual as EU-based funds could face corresponding impediments on their ability to be marketed into the UK.
Preventing short-term disruption to cross-border fund distribution
Regulators in the UK and EU have been preparing for a no-deal Brexit. In February 2019, the European Securities and Markets Authority (ESMA) and EU member state regulators announced they had agreed memoranda of understanding (MOU) with the UK's Financial Conduct Authority (FCA) covering supervisory cooperation, enforcement and information exchange on market surveillance activities, investment services and asset management activities in the event of a no-deal Brexit.1
In a statement, ESMA said the MOUs “will allow certain activities, such as fund manager outsourcing and delegation to continue to be carried out by UK-based entities on behalf of counterparties based in the European Economic Area (EEA).”2 In July 2020, ESMA reaffirmed the MOUs were still valid and would take effect once the transition period ends.3 This means delegation, whereby investment management activities are outsourced from an EU-domiciled management company to UK entities, will still be permitted post-transition, generally enabling UK-based investment management firms to continue to provide their services into the EU.
Although ESMA's stance on delegation has been welcomed, there are concerns market access could be restricted over time. Previous attempts–led by France–to curtail delegation were successfully stopped by onshore fund domiciles including Luxembourg and Ireland4, yet experts warn the practice could yet face additional scrutiny in future reviews of the Alternative Investment Fund Managers Directive (AIFMD) and UCITS.5 If the rules on delegation are subsequently tightened, it could force UK-based UCITS and AIF managers to move more of their operations into the EU.
Divergence over the long-term
While the UK Treasury has confirmed it will prioritize equivalence with existing EU rules as they apply to financial services following the transition period, it added the UK and EU would both have autonomy in how they develop their regulations; something the department conceded could result in divergences.6
Although ESMA's stance on delegation has been welcomed, there are concerns market access could be restricted over time
Nonetheless, regulatory bodies, including the Bank of England and the FCA, have said that it is possible for the UK to diverge from EU regulations but simultaneously maintain equivalence, citing the US and Japan as primary examples.7 In some instances, the UK may take a tougher regulatory line than the EU, which is happening with the Markets in Financial Instruments Directive II (MiFID II). Whereas the EU's review of MiFID II is likely to dilute some of the research unbundling provisions, the UK's FCA has pledged to keep the rules as they are.8
Equivalence, however, does have its critics in the asset management industry particularly given that equivalence can be revoked by the EU unilaterally with only 30 days’ notice. For many, this is a significant risk. Moreover, the EU has withdrawn financial equivalence from countries in the past, most notably Switzerland, which was deemed to be non-equivalent in 2019, resulting in a trading ban on Swiss equity securities at EU stock exchanges.9 Should the UK face a similar fate to that of Switzerland, then a number of asset managers–who are heavily reliant on EU investors–could be forced to relocate some of their core operations into the EU incurring high costs to do so. The 'flight from London' may be back on the table.
The 'flight from London' may be back on the table
Building a UK UCITS–or UKCITS–from scratch
If UK asset managers are restricted from selling their funds into the EU, there could be a strong case for the government to develop its own mutual fund wrapper to compete with UCITS on a global scale. This would undoubtedly be a complex process. First, the UK is not a tax neutral jurisdiction–unlike Luxembourg and Ireland–meaning foreign investors are potentially subject to multiple layers of tax on their investments. Additionally, other cross-border fund passporting schemes in Asia have struggled to attract credible volumes, mainly because investors prefer UCITS and AIFs.
While regulators have sought to minimize disruption through MOUs, tensions between the UK and EU could potentially jeopardize relations. Over time, however, differences could emerge between UK and EU regulations, an outcome that might have a negative impact on the UK's equivalence status.