Brexit Analysis

The consequence of this is that key pieces of upcoming EU financial services legislation will have to be implemented before the UK formally leaves the EU.

On 29 March 2017, the UK Government invoked Article 50, and therefore began the formal two-year negotiation period with the EU, at the end of which the UK’s membership of the EU will cease. As a result, the UK will cease to be a member of the EU on 29 March 2019. The UK Parliament has also passed the European Withdrawal Act, which repeals the European Communities Act 1972 with the purposes of ending the supremacy of EU law in the UK, and converts existing EU law into UK domestic law to preserve a working Statutory Framework (which the Government is then empowered to amend by Statutory Instrument to correct any deficiencies).

Presently, a two-year transition period has been agreed to as part of withdrawal negotiations between the EU and the UK, during which EU law would continue to apply and firms can continue to rely upon existing passporting rights while the details of the future relationship between the EU and the UK are agreed. While the EU has stated that the transition period will only take effect if a full withdrawal agreement is ratified by the relevant EU and UK bodies (which has yet to occur), the FCA and PRA have stated that financial services institutions can incorporate a two-year transition period into their Brexit planning.

The UK’s post-Brexit relationship with the EU

Since the invocation of Article 50, there has been considerable uncertainty concerning the future relationship between the EU and the UK, the extent to which the EU and UK regulatory regimes will be aligned following the UK’s withdrawal from the EU and the resultant level of access the UK will have to the EU single market. While a number of details are still to be negotiated and agreed with the EU and the ultimate outcome of negotiations remains subject to change, the UK Government has now agreed to a proposed model for its post-Brexit relationship with the EU, published in a white paper on 12 July 2018, with the following key features for financial institutions:

• that the UK will "maintain a common rulebook for all goods" with the EU, maintained by a treaty and overseen by Parliament. The common rulebook would (amongst other things) cover agricultural products and environmental, employment and consumer protections;
• a ‘facilitated customs arrangement’ between the UK and the EU to minimise border friction and allow for a ‘combined customers territory’ in which domestic policies may be applied to goods intended for the UK, but EU equivalents would be applied to goods to be exported into the EU. The intention is stated to be that the UK controls its tariffs with respect to trade with the rest of the world, but applies EU trade policy to trade with the EU;
• a "joint institutional framework" to interpret agreements between the UK and the EU, with disputes to be resolved by joint committees and by independent arbitration with a joint reference procedure to the European Court of Justice for the interpretation of EU rules;
• "regulatory flexibility" in the services sector, with arrangements on financial services, but which do not replicate the EU’s existing passporting regime. It is proposed that these arrangements will include the mutual recognition of professional qualifications, reciprocal recognition of equivalence under existing third-country regimes, a bilateral framework of treaty-based commitments facilitating market access and reciprocal supervisory cooperation; and
• the end to free movement, but "reciprocal mobility arrangements" with the EU in a number of defined areas in the interest of economic, cultural and scientific cooperation, including: visa-free travel for short-term business reasons, students and tourism; participation in cultural exchanges such as Erasmus+; and streamlined border arrangements.

This model for future relations is without precedent; it would entail less than the full single market access engendered by the "Norway Model" (by which the UK would join the European Economic Area (EEA) and the European Free Trade Association (EFTA) and be subject to EU standards and regulations in most areas). However, in some areas (in particular, the market for goods) it would entail greater access to the single market and regulatory alignment than a "no deal" Brexit and a reversion to World Trade Organisation (WTO) rules.

The proposal has yet to be agreed with the EU and as such, may be subject to change in the course of continuing negotiations. However, the proposal to maintain "regulatory flexibility" in the services sector would, if agreed to by the EU without amendment, mean that the UK will have reduced access to the EU single market and lose the benefit of the EU passporting regime. This analysis proceeds on the basis that the UK will, accordingly, be treated as a "third country" post-Brexit.

Regulatory flexibility would also mean that the UK regulatory regime is not required to be aligned with the EU regulatory regime after the UK withdraws from the EU and any transition period expires, and that their respective regulatory regimes may diverge over time. Nevertheless, three factors suggest that the UK is likely to retain a robust regulatory regime following Brexit:

• UK thought-leadership - the UK has been at the forefront of the development of modern financial services regulation;
• the international nature of regulatory developments - the UK has adhered to a number of international commitments beyond its membership of the EU, including (by way of example) the commitments on financial services regulation made at the G20 meeting in Pittsburgh in 2009; and
• equivalency decision - should the UK wish to be deemed “equivalent” under European financial services legislation (to allow some level of access to the EU financial services markets post-Brexit), it will be necessary to maintain robust regulatory standards.

Banks

• The impact of Brexit on banks ultimately depends upon the nature of the Brexit model adopted. The following analysis assumes (in line with the UK Government’s proposal of "regulatory flexibility") that after leaving the EU, the UK will not be a member of the European single market for services and will be considered to be a "third country".
• Currently, banks can provide services and products to the EU from the UK under European regulatory passports. For example, a US bank can access the EU from a subsidiary established in the UK.
• Post-Brexit the UK will not, under the UK Government’s current proposals, retain the same passporting rights, forcing banks to move some or even a majority of their operations to the EU. Even if the UK eventually manages to negotiate a passporting right for its banks, initial uncertainty may mean international banks move business or rebalance infrastructure to the EU (ex-UK) or elsewhere before this outcome is achieved.
• In an opinion paper published on 12 October 2017, the European Banking Authority (EBA) commented that authorisation should not be granted, and outsourcing not permitted to UK-base entities, if it results in "empty shell" firms; this approach would serve to prevent firms setting up an EU subsidiary as a vehicle with the sole purpose of benefitting from an EU passport for business substantially conducted in the UK.
• Some domestic banks may view the loss of passporting rights as a corollary to reduced regulation. This is alluded to in the UK Government’s Statement on its position, which proposes "flexibility where it matters most for the UK’s services-based economy, and where the potential trading opportunities outside the EU are the largest". However, Brexit may not result in a reduced regulatory burden for banks. Even in areas where UK regulators have actively opposed European regulation (some aspects of remuneration being an example), the UK may need to maintain equivalent regulation post-Brexit to enable free access to the EU financial services markets.
• UK banks will need to consider a range of issues depending on the nature of their business.

Passporting

• In the context of EU financial services legislation, passporting is the exercise of the right by a firm, authorised within one EU member state (its home member state), to carry on activities in another EU member state (a host member state) on the basis of its authorisation in its home member state, without the need to obtain additional authorisation from the host member state.
• Post-Brexit, on the assumption that the UK does not maintain access to the single market for services, the UK would (potentially following a transition period) become a third country for passporting purposes and UK banks will be treated as third country firms.
• UK banks typically rely on two different passporting regimes to undertake business across the EU: (i) the MiFID II passport and (ii) the Capital Requirements Directive (CRD IV) passport.

(1) MiFID II passport

• MiFID II – comprising the Markets in Financial Instruments II Directive (MiFID II Directive) and the Markets in Financial Instruments Regulation (MiFIR) entered into force on 3 January 2018. MiFID II introduced two new passports for “third country firms” which could potentially mitigate the position for UK firms post-Brexit.
• Under Article 39 MiFID II Directive, the “branch passport” may permit firms to establish a branch in an EU member state to provide services to all clients (including retail and elective professional clients) in that member state, provided that certain conditions are met. Individual member states have to “opt-in” for this passport to be available to firms. Not all EU member states have opted into the branch passport, so UK-authorised firms could not use this option in all member states to provide services to EU clients.
• Alternatively, the Article 46 MiFIR “cross-border passport” does not require a branch to be established but does require an assessment of equivalency by the European Commission with respect to the third country. This would mean that the European Commission would need to assess the UK’s regulatory regime as equivalent to the EU prior to permitting UK firms to rely on this form of passport. UK firms would also need to register with ESMA and comply with certain conditions. Importantly, this passport can only be used by firms to provide cross-border services to per-se professional clients and eligible counterparties. Firms would not be able to use this passport to service retail clients.
• In addition to the two new passports, MiFID II provides for the possibility of EU clients accessing services from third country firms at the exclusive initiation of the client (the so-called “reverse-solicitation” exemption). However, this is not seen as a practical solution for providing services into the EU on a large-scale as there is likely to be significant regulatory focus on the substance of any reverse solicitation.

(2) CRD IV passport

• Banks incorporated in the EU, as well as certain subsidiaries of banks, can carry out banking activities in other EEA member states under the CRD IV passport. This currently permits UK-based banks to undertake deposit-taking, participation in securities issues and lending throughout the EU using home-state authorisation.
• Whilst the MiFID II framework seeks to provide third country access for wholesale business, the CRD IV passport does not.
• For purely UK focused firms (including UK entities and UK branches of foreign entities) the impact of the loss of passporting rights should be limited.
• For firms using the CRD IV passport, the impact of Brexit will depend on whether measures are sought to keep the CRD IV passport infrastructure in place. If the passport is not maintained, UK banks would require new licences in all of the EU jurisdictions in which they operate. This may only be possible in practice if the UK is granted equivalence under CRD IV. Alternatively, a UK bank could set up a fully authorised EU subsidiary from which to undertake CRD IV business in the EU.
• This could have a significant impact on UK based banks with clients or branches in the rest of the EU.
• The position post-Brexit for UK and EU banks will depend heavily on the provisions of the negotiations.

Consumer issues

• Due to the UK regulator’s focus on the fair treatment of consumers, it seems unlikely that consumer rights regulation in the UK would be substantially diluted post-Brexit. For example, the FCA introduced onerous lending criteria in 2014 prior to the implementation of the EU Mortgage Credit Directive coming into force in 2016.
• A range of consumer focused financial services legislation comes into force before the UK leaves the EU, for example, the PRIIPS KID Regulation regarding key information documents for packaged retail and insurance-based investment products has applied since 1 January 2018. UK banks will, therefore, need to continue implementing such legislation if they offer packaged retail or insurance-based investment products. Post-Brexit, it is unclear whether the UK would retain such provisions as they are burdensome for banks. However, in practice, maintaining substantively similar requirements would allow retail investors to compare different products.

Regulatory capital

• Compliance with regulatory capital requirements is a significant cost for UK banks. Post-Brexit, the UK will become a third country for the purposes of the Capital Requirements Regulation (CRR). Subject to contrary agreement and an equivalency assessment, currently applicable preferential risk-weightings for exposures to CRR regulated financial institutions will cease to apply. However, the UK is a signatory to the Basel Capital Accord and, therefore, it is unlikely that the applicable regulatory capital regime will differ substantively post-Brexit.

Derivatives trading – European Markets Infrastructure Regulation (EMIR)

• Banks trading derivatives within the scope of EMIR are subject to extensive requirements regarding trade reporting, clearing and risk mitigation requirements. EMIR is an EU regulation and, therefore, is directly applicable in each member state without the need for national implementing legislation. Post-Brexit, EMIR will cease to apply. However, as EMIR stems from the UK’s commitments as a G20 member, it is likely that the UK will implement national regulations that are similar to EMIR.
• UK banks facing EU counterparties will still, to some extent, have to comply with the requirements of EMIR to enable their EU counterparties to themselves comply. UK banks, as third country firms, will no longer be EU credit institutions post-Brexit. They may, therefore, not satisfy the eligibility criteria as clearing members of EU central counterparties (CCPs). In order to continue providing services to EU counterparties, CCPs based in the UK will have to apply to ESMA for recognition. In theory, UK based CCPs should be equivalent as they are already EMIR compliant. However, in practice there have been delays in recognising non-EU CCPs, for example, those based in the US.

Benchmarks

• The new Benchmarks Regulation (BMR) has applied since 1 January 2018. Non-EU third countries will not be caught by the scope of the BMR directly.
• Regulated firms within the EU will need to ensure that they only use ESMA registered benchmarks. The BMR includes an equivalence provision to enable third country benchmarks to be registered with ESMA as well as third country recognition and endorsement provisions. Post-Brexit, it will be important to ensure that UK benchmarks benefit from the third country provision in the BMR.

Issuance of securities

• The Prospectus Directive permits banks to offer securities across the EU using one prospectus. Subject to contrary legislation, post-Brexit a prospectus for an offer in the UK / admission to trading on a UK market would have to be approved by the UK-competent authority. A prospectus for an offer in an EU member state or admission to trading on a market in another EU member state would have to be approved in the relevant jurisdiction. In practice, this means that a prospectus may require approval in multiple jurisdictions adding time and expense to securities issues.

Custody

• Post-Brexit, UK banks will no longer be EU credit institutions. Third country firms do not automatically qualify under the Alternative Investment Fund Managers Directive (AIFMD) as eligible to act as a depositary of EU alternative investment funds. UK banks that provide custody services will, therefore, be reliant on the UK receiving third country recognition under the AIFMD. Until the UK receives third country recognition, UK banks will not be able to provide this service.

Bank resolution

• The UK has implemented the EU Banking Recovery and Resolution Directive (BRRD). The BRRD requires banks to, for example, prepare recovery plans, resolution plans and “bail-in” provisions allowing the member state resolution authority to write down or convert eligible liabilities to equity if a bank is failing. The BRRD has represented a major cost for EU banks.
• Post-Brexit, in theory, the UK could repeal the BRRD. However, prior to implementing the BRRD, the UK had already introduced a special resolution regime for banks and certain investment firms. It is, therefore, likely that after leaving the EU the UK will wish to retain a regime providing for the orderly wind-down of banks.

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Market Abuse Regulations (MAR)

• MAR came into effect on 3 July 2016 and repeals and replaces the previous civil market abuse regime in the UK. The FCA is unlikely to relax regulation in this area when the UK leaves the EU, and it is likely that the UK will be required to maintain compliance with MAR for equivalence purposes under other regimes.
• Regardless of whether the UK maintains compliance with MAR, the regulations themselves have extra-territorial effect as they apply to all actions and omissions relating to financial instruments admitted to trading on an EU trading venue (and other financial instruments whose price or value depends on or impacts a financial instrument traded on an EU trading venue). However, financial instruments admitted to trading on a UK trading venue will no longer fall within the scope of MAR once the UK leaves the EU.

Fourth Money Laundering Directive (MLD4)

• MLD4 replaced MLD3 and was implemented on 26 June 2017. Even when the UK leaves the EU it is unlikely to make major changes to the MLD4 legislation as it is committed to compliance with the Financial Action Task Force Recommendations.
• On leaving the EU, the UK will become a third country under MLD4 and will no longer be in scope. However, it may still impact UK firms to the extent that they deal with entities based in the EU, particularly in relation to due diligence requirements. In addition, given the UK’s commitments as a member of the Financial Action Task Force, it would be required to implement a broadly equivalent domestic anti-money laundering regime in any event.

Tax

• Post-Brexit, the UK may be in a position to simplify its current VAT regime and reduce the VAT applicable to certain products. However, whether it would do this given the revenue VAT generates is a different matter. The UK’s double tax treaty will be largely unaffected by Brexit, however, provisions which assume the UK’s membership of the EU may require amendment.
• Without the benefits of EU directives, tax leakages in cross-border transactions and payments may occur. Consideration should be given to implementing any cross-border mergers before the UK leaves the EU. Additionally, without a requirement to comply with EU case law, the UK Government could reverse legislative changes made to accommodate EU treaty principles. 

Implications for staff who are (non-UK) EU nationals

• Until the UK leaves the EU, European Economic Area (EEA) nationals working and living in the UK retain their rights in respect of free movement and can continue to live, work and study in the UK.
• At present, it is considered unlikely that any negotiated exit from the EU would result in EEA nationals who are already in the UK being required to leave suddenly as this would likely result in any British citizen living in an EEA country being required to return to the UK. The EU and the UK have agreed an implementation period, running from the UK’s withdrawal from the EU to 31 December 2020, during which the rights of EU citizens and their families living in the UK will not change.
• The UK Government has also announced that EU citizens entering the UK post 29 March 2019, as well as EU citizens already resident within the UK, will automatically be eligible to apply for settled status once they have remained in the UK for five years.
• People who are living in the UK by 31 December 2020 will have until 30 June 2021 to make an application for status under the scheme. From 1 July 2021, EU citizens and their family members in the UK must hold or have applied for UK immigration status to reside and / or work in the UK legally.
• Individuals can take the following steps to consolidate their UK position if they are concerned about their status:
  • apply for a registration certificate;
  • apply for a document certifying permanent residence (applicable if you have been exercising an EU Treaty right in the UK for at least five years); or
  • apply for British nationality (again applicable if you have been living in the UK for at least five years).
• EEA nationals born in the UK may already possess British nationality, depending on their date of birth and the residency status of their parents at the time of their birth.
• There is significant potential for policy and operational changes to the UK immigration system as it is currently only designed to cope with processing applications from those coming from outside the EEA. The Government’s statement on the position of the UK’s future relationship with the EU dated 6 July 2018 stated that withdrawal from the EU will mean the end of free movement "giving the UK back control over how many people enter the country". Major reform may be necessary to deal with the possibility of all EEA nationals becoming subject to immigration controls. However, the UK Government’s statement and white paper goes on to propose an agreement between the EU and the UK on a "mobility framework" permitting intra-corporate transfers, streamlined border arrangements, and visa-free travel in a number of defined areas including for short-term business reasons, which may suggest an intention that movement of labour between the UK and EU remains relatively frictionless.

Consequences for high-net-worth individuals

• In 2015, it was announced that any individual who had lived in the UK for more than 15 out of the last 20 years would, from April 2017 be treated as domiciled in the UK for all tax purposes. Any individual born in the UK with a UK domicile of origin would also be treated as UK-domiciled at any time that person is resident in the UK.
• Certain anti-avoidance provisions have exemptions designed to make them compliant with EU law, these may no longer be necessary when the UK leaves the EU.
• There is potential for the economic slow-down caused by Brexit to require UK tax rates to be increased.
• Whilst VAT is harmonised across the EU, we are unlikely to see significant changes given that VAT is the second highest revenue raiser for the UK government after income tax.