Asset managers fear operational headaches from Brexit

Experts warn that Brexit could cause major operational challenges for finance firms.

The operational headache of a potential Brexit for financial institutions including fund managers and market infrastructures should not be underestimated. 

A referendum on the UK’s continued membership of the EU will be held on June 23, 2016 and there is a growing possibility a Brexit could occur. A survey of 104 pension funds and asset managers by NN Investment Partners, a Dutch investment manager, found 27% of respondents believed a Brexit was likely. This represents an increase from 20% in NN Investment Partners’ August 2015 survey. Nearly 75% of investors said in August 2015 that a Brexit would be a negative development while 18% said it would be “extremely” negative. 

The operational implications on financial institutions will ultimately be determined by the precise nature of the Brexit should it materialise, a point made by Paul Ellison, partner at Macfarlanes in London. “We simply do not know how a potential Brexit would pan out, which makes it difficult to speculate on its impact,” said Ellison. 

Should the UK become a European Economic Area (EEA) country, the consequences could be fairly negligible insofar as EU Directives such as the European Market Infrastructure Regulation (EMIR) and the Alternative Investment Fund Managers Directive (AIFMD) would continue to apply albeit the UK would have limited influence in shaping the rules. 

If the UK became a non-EEA third country, the situation would be less clear-cut. The UK would be obliged to attain equivalence with the EU if it became a non-EEA third country. A legal brief by Dechert said the UK is well-positioned to attain equivalence in areas such as UCITS, EMIR, AIFMD and the Markets in Financial Instruments Directive (MIFID) as it has already implemented EU law into national law for these rules. 

However, this is assuming Brexit is not a messy affair. Some hypothesise an aggrieved EU would be reluctant to allow a simple transition for the UK by refusing to grant equivalence in a number of areas. Others argue that shutting out the UK’s capital markets would not be conducive to Eurozone stability. Nonetheless, a Brexit transition will take time allowing room for negotiations. 

There could be major administrative issues for financial institutions despite this. EMIR, for example, gives EU central counterparty clearing houses (CCPs) authorisation across the entire EU. UK CCPs – should Brexit materialise – would require recognition under EMIR. “This may add additional administrative burden without resulting in significantly different regulatory obligations,” said a Macfarlanes legal brief. 

Leonard Ng, partner at Sidley Austin, highlighted EU-wide-US equivalence provisions over CCPs would not apply to UK CCPs in the event of a Brexit. Given the tumultuous negotiations between the US and EC over CCP equivalence over the last few years, authorisation could be a protracted process.

Banks are already bracing themselves for a transition with contingency plans in place to bolster their EU operations if Brexit materialises and if they lose their passporting rights. “UK banks currently providing custody services to certain clients may find that they are no longer able to do so if the UK leaves the EU. AIFMD restricts which entities can act as a depositary for EU-incorporated alternative investment funds (AIFs). EC credit institutions and investment firms automatically qualify but third country entities do not, meaning that an AIF which currently uses a UK-based bank to provide its custody services may be required to move its business elsewhere if that UK-based bank ceases to be an EC credit institution or investment firm,” read a paper on Brexit by Ashurst. 

There could operational challenges for UCITS and AIFMD compliant managers. UCITS must be domiciled in the EU and managed by an EU management company. Any Brexit would force a UCITS based in the UK to relocate to another member state, most likely Ireland or Luxembourg. “This would involve additional cost and administrative burden,” read the Macfarlanes brief. A paper by Morgan Stanley concurred Brexit could have a material impact on UK UCITS managers as most of their assets are derived from EU investors.

AIFMs would also lose passporting rights if the UK became a third country – at least initially or until the European Securities and Markets Authority (ESMA) grants equivalence. At present, Guernsey, Jersey and Switzerland have been told by ESMA that they meet equivalence to utilise the AIFMD marketing passport although the European Commission (EC) has yet to pass a Delegated Act confirming this. Other jurisdictions including the US, Australia, Canada and the Cayman Islands are being reviewed by ESMA although this could take several years. As such, UK AIFMs which had briefly used the passport could be forced to revert to the traditional national private placement regimes if Brexit occurs. 

“A lot of UK fund managers – at present – do not use the AIFMD marketing passport, relying on the private placement regime instead. However, many will find ways to deal with a potential Brexit. They may establish a presence in Luxembourg or Dublin, delegating back to the UK, or look into utilising an already-established management company,” commented Ng. 

One legal professional warned Gibraltar could see its attempt to become an onshore fund domicile wrecked in the event of Brexit. Gibraltar’s funds regime is still small although it has been trying to grow and compete with the likes of Malta. A Brexit would completely torpedo that ambition. 

The macroeconomic impact of a possible Brexit has caused alarm too. MSCI analysis said a Brexit could result in the UK and global stock markets falling by 10% and 2% respectively if the impact was limited. In a worst case scenario, MSCI said the UK stock market could drop by 22% while the global stock market could fall 11%. Societe Generale estimated Brexit could see the UK’s annual GDP falling between 0.5% and 1% for at least a decade while the Eurozone could incur output losses of 0.1% to 0.25%.