Despite the uncertainty that still surrounds the final date and terms on which the UK will leave the EU, many firms are already looking ahead to how they might optimise their post-Brexit business. Future EU market access, and the associated equivalence regimes, will be a fundamental consideration in this.

In part influenced by the prospect of Europe’s largest capital market leaving the EU, the European Parliament has recently adopted three legislative packages which include revisions to third-country firms’ access to the EU, and which we expect to enter into force in the second half of this year:

  • a revision to the European Market Infrastructure Regulation makes changes to Central Counterparty (CCP) supervision (EMIR 2.2), introducing a new, tiered approach to the recognition of third-country CCPs;
  • the Investment Firm Review Regulation and Directive (IFR and IFD), in addition to revamping the prudential regime for investment firms, revise the MiFID II/MiFIR third-country regime for investment services/activities; and
  • the Review of the European Supervisory Authorities (ESAs’ Review) introduces wide-ranging changes to the powers and responsibilities of the ESAs, including provisions on the equivalence process and coordination.

These changes are potentially very significant for third-country firms. First, EMIR 2.2 provides powers, if the EU chooses to exercise them, which could lead to the relocation of some euro-clearing to the EU. This would have significant implications for affected CCPs, clearing members and their clients, as well as the markets as a whole. Second, IFR/IFD strengthen the MiFIR equivalence regime and introduce additional requirements for third-country firms. Finally, while the ESAs’ Review changes are not as significant for third-country firms as under initial European Commission proposals, they still have the potential to place third-country firm activity under the supervisory spotlight.

The implications also go further. Many of the provisions signal the EU’s future approach to third countries. Judging by FCA CEO Andrew Bailey’s recent speech on the future of financial conduct regulation, the EU looks to be moving in a different direction to that which the UK would like to take.

This blog looks at the commonalities across the three pieces of legislation, and how they compare to what the UK would like to see, seeking to determine what lies in store for third-country firms’ access to the EU in a post-Brexit world.

An impact-based approach will target “systemic” firms, giving the EU significant discretion

The Commission and the European Securities and Markets Authority (ESMA) will be taking an increasingly impact-based approach to the recognition, regulation and supervision of third-country CCPs and firms providing investment services in the EU. This approach seems to focus on the impact of these entities’ activities on the EU, rather than on the risk that they pose. Given the prominence of UK capital markets activities within Europe, this impact-based approach is likely to affect the UK and its firms in particular.

EU authorities have long been concerned about the scale of clearing in euro-denominated derivatives that takes place outside the Eurozone, in particular at UK CCPs. Under EMIR 2.2, third-country CCPs deemed not systemically important by ESMA will be classed as Tier 1, and third-country CCPs deemed systemically important, or likely to become so, will be classed as Tier 2. While Tier 1 CCPs will see minimal changes, Tier 2 CCPs will face additional requirements in order to be recognised, and will be subject to enhanced EU supervision. Third-country CCPs, or some of their clearing services, if deemed to be of “substantial systemic importance”, could be denied recognition and would need to relocate all or part of their business to continue services in the EU.

Under the IFR, where third-country firms’ activities are likely to be of systemic importance for the EU, Commission third-country equivalence assessments should be “detailed and granular” and the Commission will be able to attach specific operational conditions to the equivalence decision. The Commission will also be able to limit equivalence to specific investment services or activities. However, on the plus side, where services or activities are not covered by a Commission equivalence decision, national regimes can continue to apply. This could potentially increase the chances that the Commission will grant some third countries some form of equivalence, which may be preferable to none at all.

A key question is how systemic importance will be assessed. We will have to wait for Commission Delegated Acts (DAs) under both EMIR 2.2 and IFR to find out further detail on this. Overall, however, equivalence will remain very much a political process and the Commission will be left with significant discretion in terms of denying or limiting access to the EU. Only time will tell how the Commission chooses to exercise this discretion. Optimists might take comfort from the fact that the EMIR 2.2 powers over “substantially systemically important” third-country CCPs are intended as “a measure of last resort”.

Ongoing uncertainty may affect long-term business decisions

Once equivalence is granted, it will be very much the beginning, rather than the end of the story. Under the ESAs’ Review, each ESA should monitor developments in equivalent third countries and report to key EU authorities on the continued validity of existing equivalence assessments. EMIR 2.2 and the IFR also introduce specific monitoring and reporting requirements in relation to equivalence decisions, as well as additional provisions on how third-country firm registration can be restricted or withdrawn.

All this means ongoing uncertainty for third-country firms, which may make relying on equivalence decisions as a means of conducting long-term business in the EU difficult. In particular, third-country CCPs will face an ongoing risk of re-classification under EMIR 2.2.

Maintaining rule-making autonomy likely to be more difficult

Tier 2 CCPs will have to comply with certain EMIR rules, unless ESMA determines that the third-country regime has “comparable compliance” and waives their direct application. The “operational conditions” that the Commission may attach to equivalence decisions under the IFR may also tie third-country firms more closely to complying with MiFID II/MiFIR. Combined with the additional provisions on ongoing ESA monitoring described in the section above, this is likely to make it more difficult for the UK to pursue an outcomes-based approach to equivalence with the EU. This will, in turn, limit its autonomy in rule-making, assuming it seeks to make use of equivalence for market access.

Increased coordination among EU institutions over third-country activities

The ESAs’ Review establishes the concept of “coordination groups” to promote supervisory convergence in relation to specific market developments and it is possible that such a group could be set up to enhance supervisory convergence in relation to third-country firms. Further, EMIR 2.2 establishes a permanent CCP Supervisory Committee within ESMA, with responsibilities in relation to the recognition and supervision of third-country CCPs. ESMA will also establish third-country CCP colleges to facilitate information sharing and co-operation between itself and relevant national supervisors.

In some respects, increased coordination could be positive for third-country firms, if it results in a more harmonised EU supervisory approach. However, firms may also find that some of their activities come under a bigger and brighter supervisory spotlight.

Lack of clarity on timing of equivalence decisions

While EMIR 2.2 sets out clear timelines for reviewing recognition decisions adopted prior to its entry into force (coming out with an approximate maximum deadline of Q2/3 2022), the timeline for recognition of UK CCPs post-Brexit is unclear, as it will depend on a number of factors, such as whether a deal is agreed.

Regarding the IFR/IFD, it is not yet clear how long it will be before the Commission starts equivalence assessments (as the Commission will first need to adopt a DA in relation to the determination of “systemic”), how long the process could take, and which third countries will be prioritised in assessments.

How does this square with the UK’s preferred approach to equivalence?

Andrew Bailey’s recent speech on the future of financial conduct regulation set out his desire that the post-Brexit UK regime should be “same outcome, lower burden”. He takes the view that, “left to our own devices… the UK regulatory system would evolve somewhat differently” and would “be based more on principles that emerge from experience in public policy and somewhat less on detailed rules”.

Bailey argued that the UK should not be held to a higher standard because it has large financial markets that are close to the EU, but that, instead, there should be a focus on outcomes which, where possible, flow from global standards.

While, as Bailey notes, the Commission has pursued a Better Regulation agenda, the UK’s preferred approach differs from the EU’s rules-based regulation and its increasingly “impact-based” approach to equivalence assessments. While EU rules on equivalence assessments still specify that they should be outcomes-based, its increasing propensity to subject third-country firms to EU rules and more granular equivalence assessments appears to take the EU in a different direction. And the idea of “lower burden” UK regulation could potentially set alarm bells ringing with EU institutions seeking to build deeper and more integrated capital markets in the EU.

On the equivalence process, Bailey was of the view that there needs to be a “common agreement on the ‘rules of the game’”, with a procedure for reaching unilateral judgements and a mechanism for dealing with disagreements or withdrawal of equivalence. This may be potentially difficult to achieve given the EU’s continued patchwork of equivalence regimes and the political nature of assessments.

It will be some time before the dust starts to settle on Brexit and we have clarity on how the recognition, regulation and supervision of third-country firms and CCPs accessing the EU will work in practice, as well as the shape of the UK-EU future regulatory relationship. In the meantime, firms should take note of the themes discussed in this blog, which we explore further in our paper, as part of their “Day 2” and beyond Brexit activities. Our recent blog also explores the extent to which wider post-Brexit regulation is taking the high road or the low road.