Shearman And Sterling

Brexit, London

Mar 30, 2020

ESMA’s Post-Brexit Regime for UK Investment Firms—‘Equivalence’ or Direct Regulation?

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ESMA’S POST-BREXIT REGIME FOR UK INVESTMENT FIRMS—‘EQUIVALENCE’ OR DIRECT REGULATION?

The European Union’s financial regulatory regime for third-country access in many sectors relies on a framework of “equivalence,” whereby institutions based in approved non-EU countries with similar standards may have varying degrees of access to EU markets or investors, depending on the extent to which their laws and regulations achieve equivalent outcomes to those of EU law. The EU’s equivalence regimes have been given increased prominence as a result of Brexit, since they are the means by which the EU’s formerly largest financial centre, in London, would access EU investors and vice versa.

The EU’s Markets in Financial Instruments Directive (“MiFID II Directive”) and Markets in Financial Instruments Regulation (“MiFIR”) (collectively, “MiFID II”), which became effective in January 2018, introduced an equivalency regime for the first time for “investment firms,” which includes investment advisers, brokers, trading facilities, dealers, portfolio managers and other non-bank, non-insurance financial institutions. To date, no countries have been approved as equivalent in these areas, but under the new Political Declaration,[1] the EU and U.K. committed to processing equivalencies across all EU financial services areas of equivalence by the end of June this year.

Under MiFID II, third-country investment firms located in an “equivalent” jurisdiction that want to provide services to “wholesale,” i.e. non-retail, clients in the EU (which are defined in EU law as “eligible counterparties” and “per se professional clients”)[2] can apply for a single registration with the European Securities and Markets Authority. This registration would be valid across all member states as a single point of entry, and in principle is more straightforward than its alternative—obtaining licences or navigating the only partially harmonised “regulatory perimeter” of 27 countries. Firms wishing to provide services to retail clients in a particular member state can establish and obtain national authorisation of an EU branch.[3] Aside from these options, the reverse solicitation regime also allows third-country firms to access EU customers. We have discussed that regime in detail in previous client notes.

The MiFID II provisions on access to the EU markets by third-country firms were amended in early December 2019,[4] to:

  • Introduce a new condition for access for third-country firms relying on equivalence, requiring a firm to have arrangements in place to annually report information to ESMA;
  • Require registered third-country investment firms to annually report information to ESMA;
  • Provide for a more granular equivalence assessment where the firms in a third-country are considered to be of systemic importance to the EU;
  • Give the Commission powers to attach operational conditions to equivalence decisions; and
  • Mandate ESMA to monitor the supervisory and regulatory regimes of equivalent third-countries to ensure ongoing equivalency.

The changes to the equivalence and registration provisions will apply from 26 June 2021.

On 31 January 2020, ESMA published a consultation paper[5] setting out proposals as to how registration under the revised equivalency regime for investment firms would operate. This paper may be one of the most significant Brexit-related regulatory developments so far this year. U.K. firms will lose their EU passporting rights at the end of the implementation period (currently scheduled for 31 December 2020), so they will either need to register under and comply with this new regime, or explore other options such as holding up to 27 separate national licences or using reverse solicitation.[6] Notably, the regime is far more onerous than any other EU equivalency regime in terms of the application process and compliance requirements, raising questions as to whether it will be a practical alternative, especially for smaller firms.

ESMA’s consultation closes on 28 April 2020,[7] and ESMA must submit the final draft Technical Standards to the European Commission by 26 September 2020. This note focuses on the changes to the MiFIR equivalence regime and ESMA’s registration regime for third-country firms providing investment services cross-border to eligible wholesale clients.[8] We discuss ESMA’s onerous proposals for registration and briefly describe certain features of the new EU equivalency regime for third-country investment firms. We also highlight the implications for ongoing compliance for registered third-country investment firms.

Changes to the ESMA Registration Requirements

Under MiFIR, third-country investment firms wishing to provide services to wholesale clients are able to register with ESMA if:

  • The European Commission has adopted an equivalence decision as to the equivalence of the supervisory and regulatory regime of the third-country where the firm is stablished;
  • The firm is authorised in its home jurisdiction to provide the relevant investment services or activities that it seeks to carry out in the EU; and
  • Effective cooperation arrangements are established between ESMA and the relevant third-country regulator.

A new condition adds the requirement for a firm to have established the arrangements and procedures to report the information that registered firms will be required to report annually to ESMA. The introduction of this requirement is indicative of the EU’s move towards imposing more obligations on market participants relying on equivalence for access to the EU markets. MiFIR prescribes the annual information to be reported, which includes:

  • The scale and scope of the firm’s EU services and activities;
  • The turnover and aggregated value of the firm’s assets arising from such activities;
  • The risk management policies the firm applies when conducting such activities;
  • Information on whether investor protection arrangements have been made, together with a detailed description of such arrangements;
  • For firms that ‘deal on own account’ (i.e., trade against proprietary capital), their monthly minimum, average and maximum exposure to EU counterparties;
  • For firms that underwrite or place financial instruments, the total value of EU counterparty instruments that they have underwritten or placed over the previous 12 months;
  • The firm’s governance arrangements; and
  • Any other information necessary to enable ESMA (or a relevant Member State national regulator) to carry out its tasks.

Registered third-country firms will also be obliged to keep, at the disposal of ESMA, data relating to all of their orders and transactions in the EU in financial instruments, whether on their own account or on behalf of a client, for a period of five years. ESMA is entitled to access this data at the request of a Member State national regulator and to make it available to the requesting regulator.

ESMA is proposing that a third-country firm applying for registration should provide information similar to what it will be required to report annually once registered. Much more information would be required than is required under the pre-existing MiFID II Regulatory Technical Standards,[9] which require information about an applicant firm’s identity, the activities it is authorised to carry out and for which it is seeking registration. ESMA is proposing that an applicant firm should also be required to provide:

  • Granular details on its governance arrangements including members of the management body and individuals holding key functions;
  • Comprehensive details on the firm’s investor protection arrangements, such as, where appropriate,[10] those relating to suitability and appropriateness of investor advice, best execution, product governance, conflicts of interest, complaints handling and client asset rules;
  •  Details on the firm’s marketing strategy;
  • Information on the firm’s outsourcing arrangements;
  • Information on the structure and organisation of the firm’s compliance, audit and risk management functions; and
  • Any information that the third-country firm considers to be relevant to ESMA.

ESMA is also required to stipulate further the details that registered third-country firms must provide on an annual basis. We set out ESMA’s proposed annual reporting requirements in the annex, mapped against the top-level requirements provided for in MiFIR. The proposals arguably go beyond the mandate that ESMA is given in MiFIR, which aims to facilitate ESMA’s obligation to monitor third-country equivalencies as opposed to granting it powers to supervise third-country firms.

Some of ESMA’s proposals are arguably beyond its remit, especially those requiring a firm to provide information on its global activities, its global client and counterparty numbers as well as global financial information. The specific purpose for which ESMA is seeking all of the information annually is unclear from its consultation paper.

Furthermore, in contrast to the pre-existing MiFIR provisions that differentiate between the level of risk that firms may present, ESMA is adopting a one-size-fits all approach to the annual reporting requirements, forcing “less risky” firms to cope with overly burdensome requirements and potentially overloading ESMA’s own resources.[11] The proposals are also incongruent with oversight of third-country firms already authorised and supervised in their own countries.

Implications for Ongoing Compliance

Once registered, a third-country firm will be subject to ongoing oversight by ESMA, including the annual reporting requirements. This will lead to compliance and IT costs, both at registration and on an ongoing basis that may or may not be offset by the removal of the need for a firm to monitor the different requirements across EU member states. The offset is less likely where conditions attach to equivalence or a limited equivalence is granted, meaning that firms will still need to monitor individual member states’ laws for those activities carried out under the national regimes (see the discussion on Transitional Provisions below).

ESMA will have the power to withdraw a firm’s registration or to temporarily prohibit or restrict its activities if the firm fails to comply with the new reporting requirements. ESMA may take the same actions if a registered third-country firm fails to cooperate in an investigation or on-site inspection.

Product Intervention Measures

Third-country firms that want to provide services or that already do so will also become subject to the EU’s product governance rules from 26 June 2021. These give ESMA powers temporarily to prohibit or restrict the marketing, distribution or sale of financial instruments or types of financial activity. National regulators in EU member states are able to adopt permanent measures. At the moment, national measures are in place to restrict the marketing, distribution or sale of CfDs to retail clients and to ban the marketing, distribution or sale of binary options to retail clients. Firms that only provide services to professional clients and eligible counterparties are not affected by these measures. However, the powers to implement these measures are not restricted to retail clients, and third-country firms will need to monitor the situation. If any national measures were brought in that applied to products for clients other than retail clients, firms will need to analyse the differences in requirements to ensure compliance with each member state’s rules. ESMA has recommended that the Commission provide clarification on how the product intervention regime should operate for all firms providing services on a cross-border basis.[12]

Changes to the Equivalence Regime

For a third-country firm to be registered with ESMA, certain arrangements must be put in place and the European Commission must adopt an equivalence decision regarding the supervisory and regulatory regime of the third-country where the firm is established. As mentioned, so far the Commission has not adopted any MiFIR equivalence decisions.

The changes to the equivalence regime purportedly aim to address the EU’s concern about how it can ensure continued financial stability and investor protection while also granting access to third-country firms. Under the revised regime, where the European Commission identifies that the activities of a third-country investment firm is of systemic importance to the EU, a more detailed and granular assessment will be undertaken of the third-country’s regime as well as an analysis of the similarity of the supervisory approach taken by the third-country’s regulators to that of the EU’s approach. This will likely be the case for the U.K.[13]

In addition, the Commission will be able to “attach operational conditions to equivalence decisions,”[14] underlining the EU’s inclination to limit the services and activities that large complex third-country firms can provide in the EU. These conditions would aim to ensure that ESMA and national regulators are able to prevent regulatory arbitrage and can ensure that the third-country firms comply with requirements that seek the same outcome as the EU’s:

  • Post-trade disclosure requirements;[15]
  • Transaction reporting requirements;[16] and
  • Trading obligation for shares and derivatives.[17]

Transitional Provisions

Since the equivalence regime under MiFIR is not yet triggered, third-country firms have been able to provide services to eligible counterparties and per se professional clients under the various national member state rules (or using reverse solicitation). A transitional provision provides that once an equivalence decision is made, these firms would be able to continue to operate under the applicable national regimes for a further three years. Helpfully, the recent changes to MiFIR also clarify that Member States may allow third-country firms to provide services in their jurisdictions under the national regime in the absence of an equivalence decision, or, if there has been a decision, when it is no longer in effect. In addition, a firm may continue providing any services under the relevant national regime where these are not covered by an equivalence decision.

Interplay With the Future EU-UK Partnership Negotiations

The European Commission has published a draft of the proposed agreement between to U.K. and the EU to govern the future relationship between the two. The text includes provisions on financial services. The list of in-scope services includes all MiFID services as well as others currently regulated under the EU Capital Requirements legislation, the European Market Infrastructure Regulation and other legislation. Another clause brings market developments in scope and ensures that U.K. financial institutions can provide, subject to certain conditions being met, new services and products in the EU.

Notably, the Commission’s draft text provides a carve-out that allows either side to adopt prudential measures for financial stability reasons or for the protection of investors, depositors, policy-holders or persons to whom a fiduciary duty is owed by a financial service supplier. The extent of ESMA’s proposed reporting obligation on the basis of investor protection or financial stability may be indicative of the EU’s thinking behind this particular provision.

Another provision ensures that both parties implement the standards set by the global standard setting bodies, such as the Financial Stability Board, the Basel Committee on Banking Standards, the International Organization of Securities Commissions, the Financial Action Task Force and the Global Forum on Transparency and Exchange of Information for Tax Purposes.

Concluding Remarks

U.K. firms (and firms in other non-EU countries) will need to assess whether an ESMA registration is appropriate taking into account their business model and the onerous application process for registration as well as the unprecedented and extraordinary ongoing compliance burden. Many firms may opt for another way to access the EU markets, put off by the in-depth information requirements, compliance burden and business restrictions that would result from effectively being subjected to direct supervision by ESMA.

This can be compared and contrasted to the more limited set of information that must be submitted by EU-based applicants, who remain outside of ESMA’s direct supervisory remit. For larger U.K. firms with a large EU client base and substantial compliance “machine,” faced with the prospect of 27 cross-border licenses after Brexit, probably even this onerous regime will remain a least worst option. However, for smaller firms, the alternatives of country-by-country licenses or reverse solicitation are likely to remain somewhat attractive.

Annex

ESMA’s Proposed Requirements

Revised MiFIR, Article 46 – Annual Reporting Requirements After Registration

ESMA Proposals – Registration Application Information Requirements

ESMA Proposals – Annual Reporting Requirements After Registration

 

 

The reporting period.

The name and contact details of the person in charge of submitting the information.

 

Information identifying the third-country firm.

Name and contact details of the person in charge of the application.

Competent authorities of the third country that are responsible for the supervision of the third–country firm.

Any change to the information previously provided.

(a) The scale and scope of the services and activities carried out by the firms in the Union, including the geographical distribution across Member States

Information on which investment services, investment activities and ancillary services the third-country firm is authorised to provide in the third-country where it is established, together with the list of any other services or activities provided.

Any change to the information previously provided.

The total number of clients and counterparties of the third-country firm globally.

Information on the investment services, investment activities and ancillary services to be provided in the Union, together with the expected numbers of clients and/or counterparties and total net turnover [see point (d) in the first column]

For each Member State where the third-country firm provides investment services, investment activities or ancillary services, the list of investment services, investment activities and ancillary services provided by the third-country firm, together with the number of clients and total net turnover

(b) For firms performing the activity referred to in point (3) of Section A of Annex I to Directive 2014/65/EU, their monthly minimum, average and maximum exposure to EU counterparties

 

Where the third-country firm performs the activity referred to in point (3) of Section A of Annex I of MiFID II, information on the exposure of the third-country firm to counterparties in the Union, together with a breakdown of such number per Member State where the third-country firm carries out dealing on own account.

(c) For firms providing services referred to in point (6) of Section A of Annex I to [MiFID II], the total value of financial instruments originating from EU counterparties underwritten or placed on a firm commitment basis over the previous 12 months

 

Where the third-country firm provides the services referred to in point (6) of Section A of Annex I of MiFID II, the total value of financial instruments originating from counterparties in the Union and underwritten or placed on a firm commitment basis, together with a breakdown of such number per Member State where the third-country firm carries out underwriting or placing on a firm commitment basis.

(d) The turnover and the aggregated value of the assets corresponding to the services and activities referred to in point (a)

Information on the investment services, investment activities and ancillary services to be provided in the Union, together with the expected numbers of clients and/or counterparties and total net turnover [see point (a) in the first column]

The total net turnover of the third-country firm globally.

(e) Whether investor protection arrangements have been taken, and a detailed description thereof

Description of the investor protection arrangements of the third-country firm, including:

i. details on the planned use of languages by the third-country firm with its clients in the Union;

ii. details on the arrangements of the third-country firm to comply with its information requirements under Article 46 of MiFIR;

iii. where the third-country firm provides services (4) or (5) of Section a of Annex I of MiFID II, the arrangements of the third-country firm to ensure that such investment services and activities provided to its clients are suitable;

iv. where the third-country firm executes orders for its clients, the arrangements of the third-country firm to execute such orders on terms most favourable to the client;

v. where the third-country firm executes orders on behalf of clients, the arrangements of the third-country firm for the prompt, fair and expeditious execution of client orders;

vi. where the third-country firm manufactures financial instruments for sale to clients, the product governance arrangements of the third-country firm, including the arrangements of the third-country firm to identify target investors and for the ongoing monitoring of distribution activities;

vii. the arrangements of the third-country firm to identify, prevent and manage conflicts of interest;

viii. the arrangements of the third-country firm to handle complaints;

ix. the membership of the third-country firm in an investor compensation scheme;

x. the arrangements of the third-country firm to protect and manage the funds and assets of its clients;

xi. any other arrangements that the third-country firm may deem relevant to the provision of investment services and performance of its investment activities in the Union in an honest, fair and professional manner that promotes the interests of clients.

Information about complaints received by the third-country firm in the Union.

Information on the marketing activities of the third-country firm in the Union, including, at least: (a) the description of the marketing strategy of the third-country firm in the Union, including its geographical scope and details about the marketing means the third-country firm is using or plans to use; (b) the list of trading names to be used by the third-country firm in the Union together with the Member States in which they will be used, the investment services and activities and financial instruments in respect of which they will be used as well as the categories of clients in relation to which the third-country firm will use them; (c) for any agents or similar used by the third-country firm in the Union, the name of the individual or entity; and (d) the website(s) that will be used by the third-country firm in the Union, together with the relevant weblink(s).

Where the third-country firm provides the service referred to in point (4) of Section a of Annex I of MiFID II, information about the value of the assets under management for clients in the Union, together with a breakdown of such number per member state where the third-country firm provides portfolio management services.

Where the third-country firm provides the service referred to in point (5) of Section a of Annex I of MiFID II, information about the value of the assets under advice for clients in the Union, together with a breakdown of such number per member state where the third-country firm provides investment advice.

Where the third-country firm provides the ancillary service referred to in point (1) of Section b of Annex I of MiFID II or is holding client funds, information on the value of the assets (including cash) held by the third-country firm for clients in the Union, together with a breakdown of such number per member state where the third-country firm provides investment advice.

(f) The risk management policy and arrangements applied by the firm to the carrying out of the services and activities referred to in point (a).

Information on the outsourcing arrangements of the third-country firm, with a focus on the operations of the third-country firm in the Union.

Information on the arrangements (including IT arrangements) set up by the third-country firm for algorithmic trading, for high frequency trading (HFT) and for direct electronic access (DEA).

Information on the structure, organisation of and monitoring by the compliance function (or equivalent) of the third-country firm.

Information on the structure, organisation of and monitoring by the internal audit function (or equivalent) of the third-country firm.

Information on the structure, organisation of and monitoring by the risk management function (or equivalent) of the third-country firm.

Any material change to information previously provided.

Information on the activities of the compliance function (or equivalent) of the third-country firm, with a focus on the operations of the third-country firm in the Union, including, at least, (a) any relevant regulatory changes; (b) the manner of monitoring and reviewing of the compliance function; (c) the findings of the compliance function; (d) an overview of the correspondence between the compliance function of the third-country firm and competent authorities; and (e) information as regards any deviation by senior management from important recommendations or assessments issued by the compliance function.

Information on the activities of the internal audit function (or equivalent) of the third-country firm, with a focus on the operations of the third-country firm in the Union, including, at least: (a) information on the controls carried out by the internal audit function (or equivalent) of the third-country firm; and (b) information on the findings of the internal audit function (or equivalent) of the third-country firm.

Information on the activities of the risk management function (or equivalent) and the risk management policy of the third-country firm, with a focus on the operations of the third-country firm in the Union, including, at least: (a) information on the risk management policy of the third-country firm; (b) the manner of monitoring and reviewing of the risk management function; and (c) information on the findings of the risk management function (or equivalent) of the third-country firm.

(g) The governance arrangements, including key function holders for the activities of the firm in the Union.

Description of the governance arrangements of the third-country firm, including:

i. the members of the management body of the third-country firm and any other persons who effectively direct the business of the third-country firm;

ii. information on the key function holders for the activities of the third-country firm in the Union with, notably, the CFO and CEO when they are not members of the management body, the heads of internal control functions responsible for the oversight of the activities of the third-country firm in the Union and the individuals responsible for the day-to-day operations of the third-country firm in the Union; and

iii. the reporting lines between the key function holders and the senior management and management body of the third-country firm.

Any change to the information previously provided.

(h) Any other information necessary to enable ESMA or the competent authorities to carry out their tasks in accordance with this Regulation.

Any other information that the third-country firm considers relevant to ESMA.

Any other information that the third-country firm deems relevant to ESMA.

 

Information on how the activities of the third-country firm in the Union will contribute to the strategy of the third-country firm or, where relevant, its group.

Any material change to the information previously provided.

 

Description of the marketing strategy that the third-country firm plans to use for the investment services, investment activities and ancillary services provided in the Union.

 

 

Whether the firm has established the necessary arrangements and procedures to report the information set out in Article 46(6a) of MiFIR to ESMA, with a brief description thereto.

 

 

Footnotes

[1]  The revised Withdrawal Agreement and Political Declaration were agreed in October 2019. The Withdrawal Agreement is legally binding and has been transposed into EU and U.K. law—Council Decision (EU) 2020/135 of 30 January 2020 and the European Union (Withdrawal Agreement) Act 2020. The EU has published the Political Declaration in the Official Journal of the European Union (2020/C 34/01).
[2]  Eligible counterparties are banks, investment firms, insurers, asset managers, funds, other institutional investors, non-EU equivalent regulated entities and large undertakings meeting a certain size threshold (not yet specified) consenting to be treated as an ECP.
Per se professional clients are: banks, investment firms, insurers, asset managers, funds, commodity dealers, other institutional investors and non-EU equivalent regulated entities; national and regional governments, central banks, bodies managing public debts and international and supranational institutions; large companies (whose size meets any two of: balance sheet total: EUR 20 million, net turnover: EUR 40 million and own funds: EUR 2 million) and other institutional investors whose main activity is to invest in financial instruments including those that mostly securitise assets and finance transactions.
Elective professional clients (“opt-up”) are public sector bodies, local public authorities, municipalities and private individual investors who may opt to be treated as a professional client either generally or for a particular service or transaction. The investment firm will need to assess the expertise, experience and knowledge of its client, including whether the client satisfies at least two of the following: (i) the client has traded significantly ten times on average in the last four quarters; (ii) the client has cash and investments exceeding EUR 0.5 million; and (iii) the client has been a financial services professional for over a year.
Retail clients are clients that are neither professional clients nor ECPs.
[3]  For details of the existing MiFID II regime, you may like to see our client note, “MiFID II: Access to EU Markets for Third Country Investment Firms,” 9 May 2016.
[4]  The changes were made in the new Investment Firm Directive (Directive (EU) 2019/2034) and Investment Firm Regulation (Regulation (EU) 2019/2033).
[5]  ESMA Consultation Paper, Draft technical standards on the provision of investment services and activities in the Union by third-country firms under MiFID II and MiFIR, 31 January 2020, ESMA35-43-2131
[6]  For details of the reverse solicitation regime, you may like see our client note, “On the Existence of a Pan-European Reverse Solicitation Regime under MiFID II, and its Importance on a ‘Hard’ Brexit,” 19 February 2019.
[7]  The original deadline for consultation responses was 31 March 2020, however, in light of COVID-19, ESMA extended the deadline. ESMA has also extended other consultation deadlines, as have numerous other regulators in response to the pandemic. More on the regulatory response to COVID-19 and related topics can be found on our COVID-19 Resource Center.
[8]  The changes to the branch regime will mean third-country firms with EU branches need to report additional information to the national regulator of the Member State in which the branch is established. ESMA is proposing, to the extent possible, to align the reporting requirements with those of firms providing services under the equivalence regime, but to adapt the requirements appropriately.
[9]  Commission Delegated Regulation (EU) 2016/2022.
[10]  There exemptions from certain of these investor protection requirements for firms providing services to eligible counterparties.
[11]  MiFIR includes a provision to look at ESMA’s resourcing for oversight of third-country firms, including the potential to require third-country firms to pay fees. The report is due at the end of 2021.
[12]  You may like to see our blog on ESMA’s recommendations for the product governance regime under the MiFID 2.1 review.
[13]  The Commission is empowered to adopt legislation on the circumstances in which the scale and scope of the services provided and activities performed by third-country firms are likely to be of systemic importance. There has not yet been any indication from the Commission as to what that legislation might stipulate.
[14]  Art 47(1a), MiFIR, as amended by Art 63(5), Investment Firm Regulation (Regulation (EU) 2019/2033).
[15]  The post-trade transparency requirements are in Articles 20 and 21, MiFIR.
[16]  The transaction reporting requirements are in Article 26, MiFIR. This would only apply where that information cannot be obtained directly through a Memorandum of Understanding with the third-country regulator.
[17]  The trading obligation for shares and derivatives are in Articles 23 and 28, MiFIR, respectively. The Commission must also assess whether the third-country’s framework provides criteria for designating trading venues as eligible for compliance with the trading obligation and which have a similar effect to those in MiFID and MiFIR.

Authors and Contributors

Barnabas Reynolds

Partner

Financial Institutions Advisory & Financial Regulatory

+44 20 7655 5528

+44 20 7655 5528

London

Thomas Donegan

Partner

Financial Institutions Advisory & Financial Regulatory

+44 20 7655 5566

+44 20 7655 5566

London

Sandy Collins

Professional Support Lawyer

Financial Institutions Advisory & Financial Regulatory

+44 20 7655 5601

+44 20 7655 5601

London