ESMA Sets the Ground Rules for the Post-Brexit Gold Rush

Could ESMA’s ground rules for UK firms relocating to the EU unintentionally disrupt the UCITS ecosystem?

It has become increasingly clear that all roads are leading to a hard Brexit. As UK financial services firms begin their Brexit contingency plans, one of the most important decisions many need to make is where to establish an office in the remaining EU countries—the EU 27. This has created a bit of a Brexit gold rush as the likes of Dublin, Luxembourg, Frankfurt, and Paris jockey for position to become the next European financial center. EU policymakers fear that this fierce competition could lead to a regulatory race to the bottom as countries may loosen rules in order to attract business, which could lead to “regulatory arbitrage” among the  EU 27 countries.

Enter ESMA

To head off any potential issues, ESMA published its opinion for the supervisory approach to relocations from the UK. The opinion primarily relates to the three key pieces of EU asset management regulation: AIFMD, UCITS, and MiFID. The opinion is designed to ensure consistency across the EU NCAs (National Competent Authorities) in the authorization, supervision, and enforcement related to the relocation of UK firms and activities.

ESMA has set out nine principles for the NCAs to follow:

  1. No automatic recognition of existing authorizations
  2. Authorizations granted by EU27 NCAs should be rigorous and efficient
  3. NCAs should be able to verify the objective reasons for relocation
  4. Special attention should be granted to avoid letter-box entities in the EU27
  5. Outsourcing and delegation to third countries is only possible under strict conditions
  6. NCAs should ensure that substance requirements are met
  7. NCAs should ensure sound governance of EU entities
  8. NCAs must be in a position to effectively supervise and enforce Union law
  9. Coordination to ensure effective monitoring by ESMA

While there appears to be some overlap in the nine principles, fundamentally they underline ESMA’s two core positions on Brexit relocations. The first is that the EU rulebook must be applied consistently across Europe to avoid regulatory arbitrage. The second is that letter-box entities are prohibited: UK firms relocating to the EU must establish local substance. These two core positions have been generally understood in the industry but the publication of the paper cements them as official policy.

Potential Backdoor UCITS Regulation?

One of the most contentious issues around Brexit is how much access the UK will have to the EU when the breakup is final. There is a vocal faction of EU policymakers who want to ensure that the UK does not have an unfair advantage post-Brexit. One way to do this is to restrict access to the third-country regimes. This is why the fifth principle, “Outsourcing and delegation to third countries is only possible under strict conditions”, may raise some eyebrows.  As we’ve discussed before, there is no third-country equivalence under UCITS rules. It is left to the individual NCA to determine what activity can be delegated outside of the EU. This is why UCITS funds domiciled in Ireland or Luxembourg are often managed in places such as Milwaukee, Montreal, or Melbourne. Depending on how it’s interpreted, the fifth principle could be used as a backdoor to essentially create a third- country regime for UCITS. In their zeal to restrict the UK, EU policymakers may unwittingly disrupt the whole UCITS ecosystem and impact all non-EU managers.

While there is reason to be concerned, it’s important to remember that ESMA’s opinion is non-binding. Ultimately, it will be up to the individual NCAs to interpret the principles as they see fit.

Additional Guidance Is Coming

ESMA has indicated that it will develop further guidance specifically for asset managers and MiFID investment firms. Hopefully, this guidance will clarify the UCITS third-country issues. In the meantime, as asset managers look to design and enact their Brexit plans, they should keep ESMA’s opinion in mind. Additionally, engaging with the local EU regulators as part of Brexit planning should help ensure that firms’ Brexit plans conform to regulators’ expectations.