Brexit has worked some City of London fund managers into a frenzy about the prospect of becoming free from the reams of EU financial regulations that have been imposed on them since the financial crisis.
But the £9tn UK asset management sector’s large EU investor base means that fund rules emanating from Brussels will continue to plague most British investment groups.
As the UK and EU prepare to embark on negotiations to decide their future relationship, the big question for many British asset managers that operate in Europe is how far the EU27 will reshape regulations — and how damaging it will be for the UK.
The UK’s stature as a financial services powerhouse gave it considerable sway over crafting regulations when it was part of the bloc. Britain is credited with curbing the protectionist inklings of some EU member states and driving through provisions that opened the market up to non-EU players.
Assets of European investors managed on a delegated basis
However, some fund managers fear that the EU will reverse this approach now that it is free from the UK’s influence. Brussels is due to review several of its flagship asset management directives in the coming years, giving it the opportunity to enact crucial changes.
Any move to toughen up existing rules or roll back third-country access would have big implications for UK managers with EU customers, as it would make it harder for them to keep pace with regulations and potentially compromise their access to European investors.
Although the European Commission has vowed to limit itself to making targeted changes to its fund rules, individual member states eager to capitalise on Brexit to expand their asset management sectors, such as France, may have other ideas.
“The UK’s departure changes the balance of the debate on openness within the EU and gives countries like France greater weight,” says Denzil Davidson, financial services lead at advisory group Global Counsel. “It would be surprising if these countries didn’t try to turn this to their advantage.”
FTfm examines the possible regulatory skirmishes affecting UK asset managers.
The ability to set up a fund in one country but manage it from another — known as delegation — is at the heart of international fund groups’ business model. The practice essentially allows top portfolio managers operating from financial centres such as Hong Kong, Boston or London to run money for investors on the other side of the globe.
But the liberal approach to delegation under the EU’s main regulations governing fund management — the Ucits and Alternative Investment Fund Managers (AIFM) directives — has become a lightning rod for critics who believe this could allow UK managers to access the EU via the back door.
We do not want to end up in a situation in which UK asset managers are essentially running letterbox companies with EU licences
Three years ago, France led an attempt to overhaul the rules on these grounds. This failed after resistance from other EU countries. However, regulatory experts believe delegation will come under attack again when the EU reviews the Ucits and AIFM directives in the coming years.
“Delegation is a constant political football: it will come up in every single piece of regulation that gets reviewed,” says former UK MEP Kay Swinburne, now vice-chair of financial services at KPMG.
The fact that about £1.7tn of European investors’ assets are managed on a delegated basis from the UK — now a third country that is not subject to EU oversight — is prompting some policymakers to echo France’s calls for a more robust system.
Markus Ferber, a centre-right MEP and an influential voice on the European Parliament’s monetary and economic affairs committee, says he would support moves to review fund managers’ delegation arrangements.
“This would help to establish what an EU asset manager is and under what circumstances and to what degree outsourcing of essential services to third countries is allowed,” he says. “After all, we do not want to end up in a situation in which UK asset managers are essentially running letterbox companies with EU licences.”
Any overhaul could result in asset managers having to deploy more senior staff in the EU and comply with more onerous procedures to be able to delegate.
But Mr Davidson believes the EU will stop short of outlawing non-EU delegation altogether as this would compromise Brussels’ efforts to develop Europe’s capital markets. “Ultimately, if you don’t allow delegation to managers outside the EU, international asset managers won’t run funds with EU assets and it will discourage people from investing in the EU.”
UK fund managers received an early preview of how politics can interfere with regulation when the European Commission shelved plans to grant market access to 12 non-EU countries in 2017.
Under the AIFM directive, non-EU alternative managers can sell their funds in Europe provided that the country where they are regulated has been deemed equivalent by EU supervisors.
In 2015, 12 countries including Switzerland, Guernsey, Hong Kong, the US and the Cayman Islands were given the initial green light from the European Securities and Markets Authority to use the EU marketing passport. But the Brexit referendum caused Brussels to put the brakes on plans to open its market to these countries as it reassessed its approach to third countries.
Five years later, the countries have still not been granted access to the EU, despite the fact they are technically equivalent, and many believe the commission will use the upcoming AIFM directive review to scrap the EU marketing passport altogether.
“It was the UK that originally pushed for third-country access for alternative managers but very few other countries wanted it,” says Ms Swinburne. “Without the UK there, I can’t see how it is going to survive.”
This change raises questions about the future of the £45.5bn of EU investor money invested in UK-domiciled retail funds. The lack of the third-country passport limits the options for managers that want to continue to service these clients and forces them to rely on the patchwork of national private placement regimes across Europe.
David Doyle, EY’s senior European financial regulatory adviser, expects EU policymakers to push for greater oversight and intervention powers over non-EU funds sold in their jurisdiction post-Brexit. “The question of reviewing the roles of home and host country supervisors could potentially transcend all the revisions,” he says.
Mr Doyle notes that such a shift could “radically alter asset managers’ cross-border business model”.
Although Esma has partially assuaged cross-border managers’ concerns by confirming that non-EU groups can access the bloc without establishing a local branch, the regulator recently proposed tough new hurdles in terms of equivalence standards and reporting obligations for groups from outside of the bloc.
Few City fund managers would be sad to see the back of Mifid II, which was a mammoth task to comply with when it came into force two years ago.
But one element of Mifid II seems sure to remain on the UK’s rule books. The UK was the main architect of the requirement for fund managers to split the cost of investment research from that of buying and selling securities, and the Financial Conduct Authority has vigorously defended the regime since it came into force, despite backlash from the industry.
The FCA’s position contrasts sharply with that of regulators on the continent. Criticisms from France and Germany over the rules’ impact on research coverage has prompted the European Commission to begin a review of the regime, which is expected to result in changes.
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Divergence between the EU and UK on the regulations governing research payments would introduce headaches for cross-border asset managers, the majority of whom have implemented a single system for procuring research worldwide.
Any move by the EU to water down the research unbundling rules could also prompt the US regulator to phase out an arrangement that allows European asset managers to circumvent a US rule prohibiting fund groups from paying brokers separately for research. This would leave global fund managers having to operate one system in the UK and another in the rest of the world.