Brexit end game: state of play for financial firms

On 31 December, a new regime will begin for market participants in the European Union and the UK operating in each other’s jurisdiction when the Brexit transition period comes to an end.

From this date, the UK will become a third country to the EU and the EU will become a third country to the UK, meaning the provision of financial services and access to financial market infrastructure will rely on applicable third country rules. “Equivalence”, which enables recognition of the regulatory regime in third countries, is a key component of continued cross border access.

In preparation for the end of the transition period, regulators and authorities in the EU and the UK have taken steps to minimise disruption and provide firms with much-needed certainty for operational continuity and market access, including the adoption of certain equivalence decisions. However, some risks and unresolved questions remain.

In this update, FIA outlines the state of play for financial firms operating in the cleared derivatives markets as the transition period draws to a close, and which issues remain outstanding.

Exit process: an overview

The UK left the EU on 31 January 2020 with a transition period running until 11pm GMT on 31 December 2020.

During this transition period, EU law has continued to apply in and to the UK. The UK has also undergone a process of “onshoring” EU legislation and regulatory requirements into UK law, while some key equivalence assessments have been determined on both sides.

Decisions made by the EU and the UK on equivalence are technically separate to the free trade agreement between the two jurisdictions currently being negotiated, which does not cover financial services to any significant extent.

At the end of the transition period, EU law will cease to apply in and to the UK. This means the UK will become a third country under EU law (and vice versa) and onshored legislation will take effect in the UK.

It also means UK financial institutions not holding a valid authorisation from the supervisory authorities in the EU will lose the right to provide financial services in the EU. Based on the assessment of the supervisory authorities in the EU, most of the UK financial institutions that are actively planning to continue offering their services in the EU have obtained adequate authorisations for their EU-based activities, according to the European Banking Authority, and are in the process of ‘ramping up’ their EU operations.

For more information on the exit process, see FIA's Primer on Brexit and its Impact on Cleared Derivatives Markets.

The UK's temporary regimes

To minimise disruption for EU firms operating in the UK, the Financial Conduct Authority announced in October that it would use Temporary Transitional Powers (TTP) to grant firms time-limited exemptions from onshored legislation in order to smooth the journey after the transition period.[1]

These powers will remain in force until the end of March 2022, during which time firms can continue to comply with their existing EU requirements and prepare for new UK-only rules. The FCA expects firms to use the duration of the TTP period to prepare for full compliance with the onshored UK regime by 31 March 2022.

While the FCA will apply TTP broadly, it is not granting transitional relief in certain key areas after December. These include reporting obligations and certain Market Abuse Regulation requirements. The FCA has updated its Handbook website to give firms a view of what rules will look like after the transition period.

In addition to the TTP, transitional provisions and regimes such as the Temporary Permissions Regime (TPR) and the Temporary Recognition Regime for non-UK CCPs (TRR) will operate in the UK from the end of the transition period.

The TPR is available to European Economic Area (EEA)-authorised firms that rely on “passporting” to continue operating in the UK for up to three years while they seek UK authorisation or recognition. The TRR will last for three years, extendable by HM Treasury, and allows eligible non-UK CCPs to continue to provide clearing services in the UK before recognition is granted.[2]

The European Commission has not put in place a similar arrangement, and UK firms intending to provide investment services and activities in EU member states must apply for authorisation in the relevant member states where they wish to conduct business. 

CCP and other equivalence

Equivalence is an autonomous mechanism by which one jurisdiction can recognise that aspects of the regulatory or supervisory regime of a third country is equivalent to their own. 

Equivalence is important for the cross-border functioning of derivatives markets and preventing fragmentation of liquidity, increased financial, commercial and operational costs, and potential level playing field consequences. EU financial services law includes around 40 areas for equivalence decisions.

In the Political Declaration on their future relationship, the  EU and the UK aimed to conclude equivalence assessments of each other’s regulatory and supervisory frameworks for financial services by the end of June 2020. This deadline was not achieved, but regulators in both jurisdictions have taken steps since then to minimise disruption.

These include:

• The European Commission adopted a time-limited equivalence decision to protect financial stability, allowing UK CCPs to continue to provide clearing services in the EU for 18 months after the expiry of the Brexit transition period. The Commission also said it wants EU financial institutions to use the extra time to reduce their exposure to UK market infrastructures.
• In tandem, ESMA announced that the three UK CCPs – ICE Clear Europe, LCH Ltd and LME Clear – will be recognised as third country CCPs eligible to provide their services in the EU after the end of the transition period.
• The European Commission announced its decision to extend temporary equivalence to enable the continued operation of UK-based Central Securities Depositories for EU entities until 30 June 2021.
• The UK government announced it would grant EEA states, including the EU member states, a series of unilateral equivalence decisions in 22 areas after the Brexit transition period ends. These include equivalence for EU CCPs and equivalence decisions for EEA regulated markets under UK EMIR Article 2a, which will enable UK firms to continue to treat derivatives traded on EEA regulated markets as ETDs rather than OTC derivatives. 
• On 30 November, FIA co-signed a joint trade association letter asking the European Commission to also issue an equivalence determination under EMIR Article 2a for UK regulated markets. In the absence of equivalence, ETDs traded on UK regulated markets will be re-classified as OTC derivatives, resulting in adverse impacts for some financial and non-financial counterparties including the potential for transactions to be subject to the EMIR clearing obligation for the first time.
• The Bank of England extended the deadline for submission of recognition applications by non-UK CCPs in the TRR from six months to 18 months after the end of the transition period.
• The European Supervisory Authorities proposed to adapt the EMIR implementation timelines for intragroup transactions, equity options and novations to EU counterparties.

A non-exhaustive list of recent UK and EU regulatory announcements can be viewed here.

Share and derivatives trading obligations

To date, mutual equivalence of trading venues has not been granted by the UK or the EU, resulting in issues for firms satisfying the Share Trading Obligation or Derivatives Trading Obligation in both the EEA and UK.

In October, ESMA issued a public statement on the application of the EU trading obligation for shares (EU STO) following the end of the transition period, explaining that only the trading of shares with an EEA ISIN on a UK trading venue in UK pound sterling by EU investment firms will not be subject to the EU STO.

In November, the FCA set out its approach to the STO, saying it will continue to allow UK firms to trade shares on EU venues after the transition period ends. The FCA will use the Temporary Transitional Power to implement this approach if the UK and EU haven't reached agreement on mutual equivalence by 31 December.

In terms of the Derivatives Trading Obligation (DTO), some "cliff edge" risks remain. In November, ESMA announced that the DTO will continue to apply without any changes after the end of the transition period. The DTO requires EU investment firms to conclude transactions in certain derivatives on EU regulated markets or third-country venues in jurisdictions benefiting from an EU equivalence decision. The UK has not granted EU trading venues equivalence for the purposes of the DTO, either.

With no agreement in place, UK and EU firms will be unable to use trading venues in the other jurisdiction for contracts within scope of the DTO. As it stands at present, the option available to them, if they want to trade with each other, is to use US swap execution facilities, which are recognised by both jurisdictions.

On 9 December, FIA co-signed a trade association letter requesting that the European Commission recognises the equivalence of UK trading venues for the purposes of the DTO before the end of the transition period. If this doesn't happen, the consequences will include reduced access to liquidity and increased costs and complexity for end-users, while the long-term consequences for use of market infrastructure are uncertain.

Remaining "cliff edge" risks

Despite the efforts to soften the effects of the transition, some risks remain. These include:

• Equivalence decisions are still outstanding in critical areas of financial services. For example, without mutual equivalence for the Derivatives Trade Obligation, firms’ ability to trade derivatives in either jurisdiction is hampered.
• Anyone transferring personal data from the EU/EEA to the UK after the end of the transition period will do so on a third-country basis. The EU is conducting a data adequacy assessment of the UK. In the absence of such a decision by 1 January, firms will need to have an alternative transfer mechanism, such as Standard Contractual Clauses in place with EU/EEA counterparts to ensure they can keep personal data flowing lawfully from them. The UK government has already determined that it considers all EU and EEA member states to be adequate for the purposes of data protection, ensuring that data flows from the UK to the EU/EEA remain unaffected.
• UK firms may not be able to continue servicing EEA-based customers from the UK, as there is no EU-wide version of the UK’s Temporary Permissions Regime. Many of the temporary measures which EEA countries had put in place to prepare for a “no deal” exit ahead of 31 January 2020 have lapsed. UK firms hoping to continue servicing customers in the EEA from 1 January 2021 will, therefore, have to comply with local law as it applies to the provision of investment services by third-country firms, and meet regulators’ expectations by then.