Financial sector faces uncertainty as UK and EU wrangle over MiFID II

Rishi Sunak

Negotiations over the future relationship between the EU and the UK are not going well. Only limited progress has been made on some of the thorniest issues, from fishing rights to level playing field provisions, just months before the UK’s transition period expires on December 31, 2020.

For the financial services sector, the outlook is even less certain. The ideal of maintaining broad-based financial market access for both sides rests on determinations of regulatory, supervisory and enforcement equivalence. But the obstacles to achieving this outcome are only growing, meaning that the EU-UK financial services landscape will look considerably different in 2021. 

To compound these difficulties, many aspects of the existing regulatory framework are being used as bargaining chips in the wider negotiations, contributing to a situation in which politics is taking precedence over financial market efficiency. As firms from both sides accelerate their no-deal preparations, the prospect of the UK achieving broad-based equivalence appear to be shrinking. “The EU has been clear that at this point it will not simply be granting equivalence to the UK across financial services, and there is clearly a political dimension to this,” says Per Loven, strategic relationship manager at Itiviti, a software and technology company focused on connectivity, trading and compliance. 

Multiple regimes

Currently, a patchwork of more than 40 equivalence regimes define the regulatory landscape between the two sides. The EU’s Markets in Financial Instruments Directive (MiFID) II is among the most important of these because it governs large segments of the wholesale financial services sector – encompassing investment firms and the activities of investment advisers, brokers, trading venues and portfolio managers, as well as other non-bank institutions. Crucially, MiFID II deals with the all-important question of third-country investment firms offering services to the EU. As the UK’s transition period ends, investment firms based in the country will be subject to these third-country terms. 

To date, however, the EU appears to have granted MiFID II equivalency to the UK in just a handful of areas. “In terms of MiFID II equivalence, the current discussions can be broken down into two areas,” says Mr Loven. “The first concerns post-trade clearing and central clearing counterparties, where temporary equivalence has already been indicated to be granted. This is damage control for the underlying financial infrastructure and systemic risk; without it, both the EU and UK would be severely damaged by a no-deal scenario.

“The second, which is more commercially important, relates to passporting and the equivalence of trading and trading venues. The EU has not indicated [that it will] be granting temporary equivalence in this area, as this is clearly forming part of the wider negotiations between the two sides,” he says.  

Indeed, most elements in the MiFID II framework are awaiting an equivalence determination from the EU. Whatever outcome is reached on equivalence, it will likely lead to higher costs and operating complexities for investment firms on both sides, while forcing a wider reorganisation of business and trading structures. “From next year onwards, it will be impossible to do many forms of business that are happening in the UK today,” says Karel Lannoo, chief executive of the Centre for European Policy Studies (CEPS).  

Assessment agreement

These discussions are occurring despite the fact that, at least on paper, both sides remain effectively equivalent. “Financial services really should be the easiest area of the Brexit negotiations. We’ve had 10 to 15 years of financial harmonisation within the EU. We’ve had MiFID I and II, so we’ve effectively aligned the same rules on both sides, UK and EU. On paper, at least, equivalence already exists,” says Mr Loven. 

Nevertheless, as part of a joint but non-binding political declaration signed in January 2020, both sides agreed to complete equivalence assessments of the other’s financial services regime by June. The deadline has since passed, with little sign of these analyses emerging in the near future, though comments in June from Rishi Sunak, the UK’s chancellor of the exchequer, indicated that Britain is ready to offer equivalence and market access to EU firms. However, the European Commission published a communication in early July, stating that it “will not adopt an equivalence decision in the short or medium term” with specific reference to MiFID II.  

“MiFID II equivalence appears to have been caught up in the politics of other issues,” says Thomas Donegan, partner in law firm Shearman & Sterling’s financial institutions advisory and financial regulatory practice. 

To compound these challenges, the EU has introduced several onerous new regulatory requirements as part of its MiFID II framework, which will hit third-country investment firms and ultimately make the provision of cross-border services more costly and complex.

“In recent years, the EU has been engaged in a series of legislative measures that make it more difficult for third-country financial groups to access the union’s financial services market,” says Mr Donegan. “Among other things, these changes include tighter equivalency tests with more conditions, greater powers for the European Securities and Markets Authority (ESMA) over third-country investment firms, while it’s more difficult to use reverse enquiry and reverse solicitation methods to serve the EU market.”  

Forthcoming regulation

In December 2019, the EU introduced a new Investment Firm Regulation (IFR) as part of MiFID II, to be enacted in June 2021. This not only increases capital charges for various entities, through a new prudential framework for investment firms, but also increases the difficulty for third-country firms to maintain equivalence through enhanced reporting and registration standards.

Under the changes, third-country firms providing services to wholesale clients within the EU will be required to register with ESMA and supply information, annually, on the scope of the firm’s activities in the EU, including their turnover, risk management policies, and governance and investor protection arrangements, among other requirements.  

Registered firms will also have to maintain a record of all of their orders and transactions conducted in the EU, whether by themselves or a client, for at least five years. Moreover, in order to register with ESMA in the first place, third-country firms will have to supply all the information usually included in their annual assessments plus other details. As such, the measures go well beyond existing MiFID II requirements and will clearly present serious obstacles for smaller firms in the UK and other third countries that wish to serve the EU market.  

“If the UK is granted MiFID II equivalency, it will benefit the larger players with big compliance functions, because they can just deal with ESMA as one additional regulator. For smaller firms, it will be tougher because ESMA has proposed technical standards that aren’t really about equivalency but more about direct regulation for third-country investment firms, which impose a high cost burden,” says Mr Donegan. 

Indeed, the IFR has won few supporters, but many critics, among those advocating for more market-friendly reform. In its response to ESMA’s consultation paper on its draft technical standards for third-country investment firms under the IFR, the Association for Financial Markets in Europe (AFME) notes that: “Many of the information requirements appear disproportionate not just in relation to ESMA’s tasks under [MiFID II]/Markets in Financial Instruments Regulation, but also in relation to the activities provided by relevant third-country firms.” 

ESMA is expected to deliver its final draft standards to the European Commission for review in September 2020. It remains unclear, however, how the commission will respond to the new powers being proposed by ESMA as part of its oversight of third-country investment firms.  

“ESMA put out a similar paper concerning its new equivalency powers under European Market Infrastructure Regulation 2.2 that basically did the same thing. It was a very onerous proposal, with ESMA giving itself all sorts of new powers and requiring a line-by-line imposition of EU laws on non-EU operators. But it got slapped down by the commission in a way that I have never seen before, and replaced with a more principles-based regime,” says Mr Donegan.  

UK-EU divergence

Meanwhile, regulatory divergence is beginning to manifest on both sides of the negotiations. For its part, the UK – which pursued an exit from the EU partly in an effort to gain control of its own regulatory frameworks – has made it clear that in the coming years, aspects of its existing (and EU aligned) financial services rulebook will be improved and tailored to meet the needs of a non-EU member state.

In a written ministerial statement to the UK parliament published in June 2020, Mr Sunak noted: “Now that the UK has left the EU, the EU is naturally already making decisions on amending its current rules without regard for the UK’s interests. We will therefore also tailor our approach to implementation to ensure that it better suits the UK market outside the EU.” 

Any divergence is likely to cover a range of equivalence frameworks. But in terms of MiFID II, it will almost certainly include adopting an independent stance on some aspects of the prudential regime governing investment firms under the IFR. More specifically, according to an analysis by law firm Eversheds Sutherland, the UK is unlikely to reauthorise investment firms as credit institutions. “The British have made it clear that they are not in favour of that,” says Mr Lannoo. 

Indeed, regulatory divergence is expected to accelerate in the coming years as the UK carves out an independent framework. “I think there will be regulatory adaption emerging from the UK. Initially, there will only be marginal changes because it will be difficult to diverge too quickly. But after the first three to four years, I think greater regulatory differentiation will emerge,” says Boujemaa Khaldi, a director and head of product at Vermeg, a specialised financial services software company. “The UK and the EU basically have two different philosophies when it comes to doing business more generally, and the financial services market more specifically.” 

Open or closed

How the story of EU-UK regulatory divergence plays out, particularly in the context of MiFID II, could have profound implications for the shape of a new global financial regulatory landscape that has started to emerge in the wake of the last financial crisis and amid the onset of the Covid-19 pandemic.  

“If you think about it, geopolitically, the UK is an open market and it allows cross-border institutional business essentially without restriction. Most other EU countries are all closed economies for financial services. They only allow third-country institutions to do business with local institutions that are licensed locally, and for these reasons, Paris and Frankfurt are primarily domestic marketplaces,” says Mr Donegan. 

As a result, no matter what outcome emerges from discussions between the EU and the UK regarding financial services equivalence, as well as the nature of their broader relationship, the EU will become a more difficult place for third countries to do business. “When you take the UK out of the mix, many of the remaining EU economies will go for protectionism, which means regulating everybody who does business with their local market. So there is now a big shift towards protectionism and away from open international financial markets as a result of the UK’s departure,” says Mr Donegan.  

The direction of travel for MiFID II seems to confirm this point of view. Even if the UK was to secure broad equivalence, it seems likely that divergence will be on the cards, regardless of current events. Given that the EU only needs to provide 30 days’ notice to third countries if they are deemed to be non-equivalent with the bloc’s regulatory frameworks, the uncertainty facing UK-based financial investment firms is unlikely to diminish any time soon.

The experience of other third countries, particularly with the MiFID II framework, bears this out. “Over the last four to five years, [the EU’s] equivalence regime has definitely become more complex. The Swiss are also having big problems [in this regard], as well as the US,” says Mr Lannoo at CEPS.