The Investment Association (IA) – Written Evidence (FRS0029)

Investment Association evidence to the House of Lords EU Financial Affairs Sub-Committee inquiry into Financial Regulation and Supervision following Brexit

1. The Investment Association (IA) is the trade body that represents UK-based asset managers. Our 240 members manage £6.9 trillion of assets on behalf of pension funds, lifetime savers, and individual investors. They manage the pensions of 75% of UK households, provide 60% of capital market financing for UK businesses, funds 40% of initial public offerings, and our industry has contributed an average of 6% of total net service exports over the past 10 years.[1]

2. Every day millions of households entrust our members to put their money to work in global markets. The investment management industry plays a central role in the modern economy as the conduit through which money moves from savers to businesses, with asset managers buying shares and corporate bonds, providing investment in small and medium-sized enterprise (SME) private equity, and funding infrastructure and housing. Asset managers also purchase large amounts of government debt, both from the UK and around the world, facilitating public sector investment.

3. The investment management industry is truly international, both in terms of the clients it serves, and in the way it allocates the money it manages. Approximately one third of the funds managed in the UK (£2.6 trn) come from overseas clients, making the UK the world’s leading centre for international fund management. This international client base is divided fairly equally between European clients (£1.4 trn) and rest of the world (£1.2 trn).[2] Of the estimated €21 trillion of total assets under management in Europe at the end of 2015/16, 36% of this is managed from the UK compared to 17.6% managed in France and 9.4% managed in Germany.[3]

4. The IA welcomes this opportunity to respond to this inquiry into financial regulation and supervision following Brexit. Given the global nature of the investment management industry, maintaining regulatory harmonisation and coherence should be a key priority following the UK’s departure from the EU. Any new regulatory framework must support international business models, and ensure access to global supply chains. Our priorities regarding financial regulation and supervision following Brexit are set out below in greater detail. They are based on three objectives which are shared across the financial services sector:

• First, that the UK successfully negotiates at a technical level with the EU and its Member States to ensure that UK businesses can continue to offer products and services to EU clients;

• Second, that the UK remains an attractive wider international financial centre for inward investment and location of financial services entities; and

• Third, that UK firms continue to be able to successfully serve the interests of savers and investors alike, as well as companies and other projects in need of finance.

Current regulatory regimes

5. The UK’s stable and well-regulated financial services regime is internationally well-regarded, and highly valued by investors. To date, the UK has been relatively successful in influencing European financial services legislation with key elements based on the UK’s approach. The differences between the UK and EU regulatory regimes are small given the considerable amount of harmonisation of financial service regulation achieved in recent years. There are also examples where the UK has gone further than the EU requirements, ‘gold-plating’ particular EU regimes (eg: MiFID and MiFID II), or introducing its own initiatives such as the senior managers and certification regime.

6. Since the global financial crisis, there have been increased efforts to coordinate financial services regulation at an international level, and many of its components are derived from European and UK initiatives. Following the EU’s focus on restoring market stability and confidence in the wake of the 2008/09 financial crisis, it is likely it will continue to concentrate on implementation and supervision of existing regulatory frameworks, rather than introduce new legislation. While it is possible for divergence to occur between UK and EU financial services legislation post-Brexit, the need to maintain consistency with international standards will necessarily restrict the extent to which either the UK or the EU will be able to diverge from one another. While international organisations such as the International Organization of Securities Commissions (IOSCO) do not have binding powers over individual states’ regulatory regimes, they can serve a useful role in informing the development of individual regimes on the basis of internationally accepted ‘best practice’. Where global markets do exist, the UK should therefore seek to increase its support for, leadership of, and willingness to adopt internationally developed standards and the institutions that are responsible for their development.

7. There are also clear practical imperatives to support international regulatory coherence, such as reducing barriers to doing business, lowering transaction costs, encouraging investment flows, and supporting business competitiveness and economic growth. It minimises the risk of regulatory arbitrage, and a ‘race to the bottom’ that may reduce consumer protection and increase systemic risk and market instability. Driving international consistency also helps reduce the cost of regulatory compliance for UK-based firms doing business internationally. Despite the current divergences in international regulation (such as those arising from EU initiatives such as Solvency II), many of our member firms already have international interests and operate under a range of different regulatory regimes. This will not change with Brexit, but the compliance costs of doing so may increase for many critical business functions should further divergence occur.

8. With regard to the possible challenges of incorporating existing EU financial services legislation into the UK’s domestic law, careful consideration will need to be given to how the UK will allocate the various administrative and regulatory functions previously carried out by EU bodies that may not have a direct UK counterpart. Incorporation of the acquis of EU law into UK legislation will not just involve the allocation of functions across the existing UK system, but the development of new mechanisms to support the operation of the newly domesticated EU law. This will raise important questions about the respective responsibilities of regulators and the Government as rule-making processes may change as EU law is domesticated. Much of EU law, even at Level 1, is at a level of detail that, if a domestic initiative, would be within the powers and responsibilities of the regulators. 

9. The International Regulatory Standards Group, a practitioner-led body co-sponsored by TheCityUK and the City of London Corporation, recently launched a report which addresses the domestication of EU law. ‘The Great Repeal Bill’ – Domesticating EU Law[4] provides a clear and comprehensive methodology for domestication, which maximises certainty and ensures a functioning legal system across all sectors. While the approach aims to minimise the number of instances where the law will need to be amended, addressing so-called ‘inoperables’ will likely be a significant challenge. The IRSG has recently launched a new work stream to explore this specific issue and its findings will be published in Q4 2017.

Transition, equivalence, and alignment

Transition

10. Reconfiguring the relationship between the UK and the EU, and the regulatory environment within which UK asset managers operate, will affect the way clients access investment services and businesses are able to raise capital across Europe. Consequently, a transitional arrangement is needed to mitigate the “cliff-edge” of any sudden major change to market access and the ability of the UK to continue operating as an international financial centre. Securing early clarity on the new, post-Brexit arrangements and enforcement regimes is crucial in order to avoid disruption to investors and the wider economy.

11. UK investment management firms do not rely entirely on passporting rights to do business within the Single Market. Therefore, some services may be maintained under EU law immediately upon Brexit even if the UK is outside the Single Market (e.g. under existing rights to delegate business from EU entities to so-called “third country” entities). However, other businesses with customers in the EU will require some time to adapt to Brexit. Either substantially similar access to the EU Single Market as the UK currently enjoys, or new rights of access must apply between such time as the UK ceases to be a member of the EU and the start of the new relationship with the EU. Such access should be reciprocal.

12. UK and EU financial services are deeply integrated, and both have been significant beneficiaries of the Single Market for financial services. There is little industry appetite for the UK to diverge from current EU regulation, at least in the short to medium term. Maintaining regulatory coherence is a key priority for the industry, and deemed essential for ongoing market stability and business certainty. We would not support the development of a ‘two-tiered’ regulatory system - one for domestic purposes and the other for international operations - nor a transitional arrangement that meant businesses had to comply with varying sets of regulation over the course of any transition period.

13. We acknowledge that it may be unrealistic to expect the UK and the EU to agree on a fully bespoke set of mutual market access mechanisms that can be adopted on a transitional basis and agreed by the end of 2017. Such a transitional agreement would likely require the UK to remain a member of the Single Market, or replicate substantially the terms of the Single Market membership until the terms of a future trade deal, to include financial services, can be agreed between the UK and the EU.

14. The value, however, of a transitional agreement diminishes significantly after 2017, at which point some of our members may feel the need to begin implementing contingency plans and possibly relocate some of their operations to either Europe, or other jurisdictions with greater certainty of continued market access into the remain EU27 Member States. Once these contingency plans are invoked, the significant cost and logistical implications involved in moving this business back to the UK means they would not be unwound should a transitional agreement be reached at a later point in 2018. 

15. The duration and the form that any transitional arrangement would need to take will be ultimately dependent on the nature of the settled relationship which the UK and EU27 are seeking to implement. The earliest possible indication that can be provided of this settled relationship would minimise disruption to the asset management industry, and provide the best conditions to prevent pre-emptive contingency action by our member firms. We identify a number of potential “cliff-edge” scenarios for businesses in the UK asset management industry:

• The inability to conclude regulatory cooperation arrangements that are needed by the time of Brexit in order to permit portfolio management to be carried out from the UK to the EU under a delegation arrangement;

• A prohibitive use of ESMA’s new powers to challenge delegation arrangements with third countries after Brexit; and

• The disruption of existing business and contractual arrangements which rely on a licence to operate within the EU.

16. Because UK asset managers fall within the scope of MiFID regulations by virtue of the UK’s current membership of the EU, the management of segregated mandates for EU institutional clients is currently carried out under a MiFID passport, and, generally, not under a ‘third-country’ delegation arrangement from an EU27 MiFID firm back to UK. 

17. The ability to delegate is not derived from an EU passport. Rather, it is an international convention frequently used to offer, among other services, investment management expertise, and is a key enabler for efficient global capital markets. For example, delegation of portfolio management to the US and Asia is frequently used to ensure investors have access to the best portfolio management expertise, wherever it resides. It is also used so that investment managers are able to centralise their resources to the benefit of the investor – mitigating risk, allowing for diversification and choice in investment, and reducing transaction costs.

18. The UK’s departure from the EU is, however, raising important concerns within EU27 Member States about the increased amount of portfolio management activity that will be carried out on behalf of EU clients’ post-Brexit. Because of the UK’s dominant position in the investment management industry, on leaving the EU, a much greater proportion of portfolio management of EU investors (including funds) will be carried out by ‘third country’ firms here in the UK under delegation. We estimate that up to 12% of all Luxembourg funds, and 35% of all Irish funds (1st and 2nd largest fund domiciles in the EU) are managed from the UK. Delegation arrangements are currently the focus of the EU’s proposals to increase supervisory coherence in the EU and the Commission proposed in its legislative initiative to review the European Supervisory Authorities to give ESMA enhanced powers to monitor and challenge delegation arrangements with non-EU jurisdictions.

19. Current EU regulations permit portfolio management to be delegated to back to the UK, subject to specific conditions including that the FCA has first entered into a cooperation agreement with the relevant EU Member State regulator.  These cooperation agreements are needed well before the UK leaves the EU. Without these agreements in place, member firms whose business will need to move all their portfolio managers to the EU, or countries (such as the US) that already have cooperation agreements in place. To support the FCA, the IA has prepared a draft ‘Heads of Terms’ which could serve as the initial basis for these Cooperation Agreements.

20. Any transitional arrangement should seek to cover new as well as existing business. Grandfathering would minimise disruption to the UK economy, and ensure EU27 clients can contract with UK firms before Brexit without undue concern. Given the strong links between UK and EU, many existing contracts will likely extend beyond the date of Brexit. It is in the mutual interest of the UK and the EU that early agreements are struck on the ability of these commercial contracts to be grandfathered. To provide additional certainty, any ‘grandfathering’ provision should be for the duration of the contract entered into, rather than the length of any potential transitional arrangement.

“No deal” Scenario

21. A range of different market access routes may, in theory, be available to investment managers if no general agreement is reached between the UK and the EU to retain membership of the Single Market and passporting rights for UK firms. We understand that a number of our member firms are already taking steps to establish the necessary permissions to operate within EU Member States should no agreement be reached on the UK’s withdrawal from the EU. Such arrangements, however, rely heavily on the willingness of the EU or EU Member States to permit access to UK firms – either through a formal equivalence assessment by the Commission (eg: for the MiFID II third country passport), or through cooperation agreements that permit delegation.

22. Such a position would, however, leave the UK vulnerable to future changes in EU regulation, under which future divergence in regulation between the UK and the EU, as well as political matters, may result in loss of equivalence. This risk would be heightened in the event there was no appropriate mechanism for UK views on regulatory developments to be registered. Without appropriate measures to safeguard regulatory coherence between the UK and the EU over the longer-term, and the mutual recognition of regulatory regimes in the UK and the EU, the UK could be seen to be lacking the stability in its regulatory framework to safeguard long-term business planning.

23. An example of this is existing EU rules on delegation of functions to third countries. The asset management industry relies heavily on international supply chains that provide investors with appropriate levels of diversification and access to specialist investment expertise all over the world. These supply chains require regulated firms to be able to delegate functions to third parties, while retaining overall responsibility and under appropriate levels of supervision by national regulators. It has been suggested that the EU should tighten rules on delegation in the future. Current legislative work to review the role of the European Supervisory Authorities and to enhance ESMA’s role with regard to delegation provisions could develop into a threat while future changes in other European legislation (where the UK has no influence) have the potential too.

Equivalence

24. The current EU third-country regimes provide limited market access based on ‘equivalence’. These regimes are not adequate for maintaining current levels of investment management business between the UK and the EU in the longer-term. Critically, there is no single notion of equivalence, or a central point for negotiating equivalence. Regulatory ‘equivalence’ is granted to third countries on a regulation-by-regulation basis, allowing access to some elements of the Single Market. Equivalence is only granted following an assessment and decision by the EU Commission and can be rescinded at any time. It is a political, rather than criteria-led, process. It applies differently in different contexts and different bodies, and gaining equivalence can therefore be both time-consuming and resource intensive.

25. However, it is important to note that the UK will import the EU’s ‘acquis communautaire’ and regulatory framework into UK domestic law through the EU (Withdrawal) Bill. In most instances, the UK will start from a position of ‘complete equivalence’ – a much greater alignment between the UK and the EU regulatory regimes than the current test applied by the EU to permit cross-border access under the EU’s existing third-country regimes. Equivalence was not designed to facilitate access to European markets for a neighbouring country with such close ties to the EU as the UK. However, in limited cases the UK has decided not to follow ESA guidelines. These areas will likely come under increased scrutiny for the assessment of equivalence. The UK Government has also made it clear that it will seek a comprehensive Free Trade Agreement (FTA) which will cover financial and related professional services.

26. The US has instructive experience of establishing equivalence with the EU. For example, the European Commission took four years to determine that US regulation of CCPs was equivalent to EMIR. This is despite the differences between US and EU regulation being confined to relatively minor technical issues and the existence of a long-standing forum for regulatory discussions between the EU and US.

27. Delegation is not equivalence. The EU supervisor that has the necessary enforcement powers directly oversees the entity contracting with EU clients, as well as the delegation agreement with the third country itself.

Alignment

28. Even if a formal assessment of regulatory alignment between the UK and the EU post-Brexit is not required, it will be necessary to have a defined process to determine whether at any time in the future the respective regimes of the EU and UK have diverged to an extent that there is no longer a basis for mutual market access.

29. Regulatory divergence could arise for a number of reasons, such as where each party seeks to develop rules independently which are tailored to its domestic circumstances, or where the EU or UK develop specific new areas of regulation in response to developments (such as those relating to FinTech). Any process to determine the extent of regulatory divergence will need to be sufficiently flexible to accommodate these varied circumstances.

30. Assuming ’equivalence’ with the EU regime was agreed, the scope for adapting the UK’s regulatory regime would have to be assessed on a case-by-case basis, depending upon whether divergence was considered material or not. It might also depend upon the scope of the future UK-EU Free Trade Agreement (FTA) and whether, for example, it was specifically set out in the Agreement that a degree of divergence could take place without breaching it.

31. The key feature of a UK-EU FTA negotiation is that it will be about managing the eventual divergences between the UK and the EU. It should be emphasised that these changes can come from best regulatory practice and not attempts to “race to the bottom” in standards or create light-touch jurisdictions – that is why the concept of alignment is important to the future success of the FTA.

32. Formal mechanisms for consultation and co-operation between the respective regulatory authorities of the UK and EU will be required in order to ensure ongoing alignment, and manage issues of divergence as and when they arise. For example, one proposal put forward by the IRSG’s FTA working group is that the EU and UK establish a ‘Joint Regulatory Alignment Forum’ that could oversee these issues. The concept is that the party proposing to introduce a regulatory change would have to assess its impact on alignment and would notify the Forum if it was substantial. The Forum would then consider whether the change could have an adverse impact on regulatory alignment based on its potential impact. Alternatively, another mechanism proposed is one that would actively monitor the areas where divergence might arise, and be empowered to assess the materiality of any divergence and advise the respective parties accordingly. In any event, the process should be transparent and based on a technical assessment.

Dispute Resolution

33. Like all sectors, it will be necessary to have an agreed dispute resolution mechanism in case disputes cannot be resolved through the relationship management structures created by a FTA. While largely dependent on the nature and scope of any future dispute resolution mechanism, we do not consider it necessary for there to be a separate process specifically for financial services.

34. For investors, possible dispute resolution options include:

• Investor State Dispute Settlement (ISDS) with its arbitration clause, like the one found in most bilateral investment treaties. However ISDS is out of favour with the EU. The UK though should not rule it out because an ISDS clause is a requirement for FTAs with states like Japan and the United States.

• An investment court proposal similar to the one used with the EU’s Canada and Vietnam FTAs. While the court is currently an untested innovation, its inclusion is a precedent showing that the EU can agree to be bound by third party determination. 

35. However, along with portfolio investment (considered to be investments of less than 10%), dispute resolution is deemed by the CJEU to be a competence shared by the EU with its Member States – an approval process requiring unanimous support from national and regional parliaments and assemblies in addition to gaining EU approval itself. The alternative is to fast-track a treaty by excluding dispute resolution and portfolio investment.

36. The absence of these provisions would be obstacles to developing a comprehensive EU investment policy and would not be beneficial for investors. The UK should not treat their possible absence as a precedent for the development of its own independent trade policy.

The future environment

37. Together with other G20 Members, the EU and some of its Member States, including the UK, contribute to setting international standards for financial services. They work with bodies such as IOSCO, the International Association of Insurance Supervisors (IAIS) and the Financial Stability Board (FSB). Elements of the regulatory regime that will apply in both the UK and EU after Brexit will be derived from globally agreed texts and recommendations. 

38. The UK and EU should therefore consider in detail the separate global standards that are available and determine whether to include adherence to them in any criteria for market access should they prove appropriate for the unique UK/EU circumstances post-Brexit. They should also consider whether to enshrine in the FTA the principle that the parties should seek to incorporate global standards into the agreement where appropriate or consider where global standards will be a factor indicating alignment. There may well be areas in the future where the UK might wish to develop rules independently, tailored to domestic circumstances – such as in relation to the development of FinTech. In investment management, innovation in areas such as product choice will be encouraged.

39. The global implications for the future environment, post-Brexit, should also be considered. The EU now has Brexit-related proposals to change the recognition regime for third country CCPs. The proposal is that CCPs which are of "specifically substantial systemic significance" for the EU financial system cannot be recognised but would need to be authorised and established in a Member State. This could affect some UK CCPs. If suitable arrangements can be agreed, the EU may not consider it necessary to impose such requirements in relation to UK CCPs. However, given that the EU's proposed changes would apply to all third-country CCPs generally (and not just UK CCPs), it is also possible that the EU may continue to insist on the introduction of the new CCP regime.

40. The US response is to note that the G20 leaders pledged their efforts to the consistent implementation of global standards rather than identical implementation. For the US it follows that the best route to “consistent implementation” is through mutual deference to comparable foreign regulatory frameworks. The development of “mutual deference” for the US-EU debate may have an effect on the UK-EU FTA.

Supervision

41. An increasing amount of regulatory coordination is now conducted at international level through the FSB and IOSCO. The Bank of England and the FCA should maintain and enhance their leadership roles at this level. We view supervisory cooperation favourably, and it is already a feature of existing cooperation agreements between the UK and third countries. An agreement on supervisory cooperation will need to establish procedures for onsite supervision between the UK and EU bodies.

42. This will also apply to other jurisdictions as the UK’s own regulatory networks come in to play. Geography is not an issue for international supervision and examination and we note the Commodity Futures Trading Commission Chairman’s observation, “to date, the US has not deemed a body of water – even as large as the Atlantic Ocean – as an impediment to effective CCP supervision and examination.”

43. As regulatory regimes evolve in the future, the FCA should seek to continue to coordinate and cooperate closely with the European Supervisory Authorities. There are three possible options in regards to continued engagement of the FCA with the ESAs:

• Continuation of membership of the European Supervisory Authorities;

• A complimentary system of associated membership or observer status; or

• Complete overhaul of the current system.

44. Within the third option is the recommendation for a formal framework to be created to co-operate and coordinate supervisory matters. This could be through the proposed ‘Joint Regulatory Alignment Forum’.

29 September 2017