Since the 2008 financial crisis, there has been a pronounced shift towards concentration of power and influence at the EU level, away from the regulators in individual member states. In addition, new laws and initiatives at the EU level have tightened regulation of investment banking activities and the securities and derivatives markets.
Until recently, most EU financial laws were effected through directives, which are not directly applicable and must be implemented into the national law of EU member states. Following the crisis, the primary vehicle for financial services rulemaking has been the EU regulation. Such regulations are directly applicable without the need for transposition into national law. As a consequence, the scope for member state discretion in setting and interpreting key regulation has been reduced.
Following a number of years in which successive eurozone banking crises dominated the attention of market participants and regulators, Brexit is now a key factor in the development of new legislation and regulation.
The EU financial services regulatory architecture
Financial services legislation follows the ‘ordinary’ legislative procedure, whereby the European Commission (the Commission), the Council of the European Union and the European Parliament work through various compromise proposals to achieve a final text. The process typically takes at least 12 months, and may drag on for years if the proposed legislation is complex or controversial.
The Lamfalussy process
EU financial services rules usually comprise a package of different types of legislation and guidance under an approach named after a senior EU official, Alexandre Lamfalussy, as follows:
- Level 1: framework legislation in the form of a regulation or a directive setting out the general requirements of the initiative. Individual provisions in that legislation empower the Commission to adopt Level 2 measures.
- Level 2: detailed implementing legislation, usually but not always in the form of a regulation, drafted in the first instance by one of the European Supervisory Authorities (ESAs).
- Level 3: guidance for national regulators prepared by the ESAs. National regulators adopt this guidance on a ‘comply or explain’ basis.
- Level 4: supervision and enforcement practice, usually by national regulators.
Following the financial crisis, the EU institutions concluded that the former committees of national regulators that had been formed to assist in the supervision of cross-border activity had insufficient powers and influence. In response, the EU created a new European System of Financial Supervisors, comprising the following ESAs:
- the European Banking Authority (EBA, currently based in London, then in Paris after Brexit);
- the European Insurance and Occupational Pensions Authority (EIOPA, based in Frankfurt); and
- the European Securities and Markets Authority (ESMA, based in Paris).
Although the ESAs do not generally have direct oversight of individual EU firms (except ESMA for credit rating agencies), they have a number of important powers and duties in relation to EU financial regulation, including:
- the development of binding technical standards in relation to Level 1 legislation (although the Commission actually adopts the standards as Level 2 legislation);
- dispute resolution between national regulators;
- ensuring the consistent application of EU rules by national regulators, including through the issuance of Level 3 guidance and more informal ‘Q&A’ documents for certain legislation; and
- in ‘emergency situations’, the power to intervene directly in the supervision of individual EU firms, or direct national regulators to take certain actions, or both.
Key EU financial services legislation
On 3 January 2018, the recast Markets in Financial Instruments Directive and the Markets in Financial Instruments Regulation (together commonly known as MiFID II) legislative package replaced the original MiFID. MiFID II is the most important piece of EU regulation covering investment banking and securities markets. MiFID-regulated services include many necessary to provide broker-dealer or corporate finance type services, such as underwriting of financial instruments, reception, execution and transmission of orders, and the provision of investment advice.
MiFID II covers, inter alia:
- the authorisation of investment firms;
- the availability of a passport to allow investment firms established in EU member states access to the markets of another without being required to set up a subsidiary or branch and obtain a separate licence to operate as an investment firm in that other member state;
- detailed conduct-of-business rules in relation to investment services and activities, including the reception and transmission of orders, managing investments, the provision of investment advice, underwriting and placing of securities (expanded under the new MiFID II regime to include new rules on conflicts of interest, best execution, product governance, receipt of inducements by asset managers and transparency in relation to mandate and instructions);
- a customer classification regime, dividing clients into ‘eligible counterparties’, ‘professional clients’ and ‘retail clients’. Certain conduct-of-business rules are modified or disapplied in respect of business with professional clients and eligible counterparties;
- the regulation of securities trading venues in the EU, divided into regulated markets, multilateral trading facilities (MTFs) and organised trading facilities (OTFs), with different levels of regulatory requirements applying to each;
- a detailed and complex pre- and post-trade transparency regime applicable to securities traded on those markets;
- rules for systematic internalisers (major traders on a principal basis) obliging them to make public the prices at which they are willing to trade in securities in certain trading venues;
- requirements for algorithmic and high-frequency trading;
- a trading requirement for certain categories of sufficiently liquid derivatives, so that all EU trading in such derivatives must occur on a regulated market, MTF or OTF;
- position limits and reporting for commodity derivatives and new powers for national regulators to intervene in trading in commodity derivatives;
- new powers for national regulators to ban specific investment products or services in certain circumstances; and
- a ‘passport’ for non-EU firms to provide services into the EU in certain circumstances, subject to an equivalence determination by the Commission in respect of the relevant non-EU country and cooperation agreement in place between the non-EU regulator and ESMA.
The Benchmarks Regulation
From 1 January 2018, a new regulation, the Benchmarks Regulation (BMR) has applied to the use of, contribution to and administration of indices used as financial benchmarks in the EU.
The Commission published its original proposal for the BMR in 2013 following the settlements reached by regulators with a number of banks concerning the manipulation of the LIBOR and EURIBOR interest rate benchmarks. The Commission aimed to protect investors and consumers and limit the risks of future manipulation by improving how benchmarks are produced and used (it has been estimated that contracts worth at least US$300 trillion reference LIBOR alone).
The BMR consequently defines benchmark widely to include interest rate benchmarks, commodity benchmarks and more bespoke strategy indices, among other things. Administrators are caught by the BMR where indices they produce are referenced in EU-traded instruments or EU-regulated consumer loans or mortgages, and where they are used by EU investment funds to measure performance.
The BMR imposes an authorisation requirement for EU benchmark administrators, in addition to conduct and governance requirements. Most of the BMR’s provisions have applied from 1 January 2018 and EU administrators providing benchmarks in the EU must apply for authorisation under the BMR by 1 January 2020.
The European Market Infrastructure Regulation
Following the financial crisis and the emergence of an international consensus at G20 level, the EU introduced the European Market Infrastructure Regulation (EMIR) to increase transparency in the financial markets. EMIR provides for:
- The prudential regulation of central clearing counterparties (CCPs), including requirements for authorisation, capital, margins, organisational rules and the establishment of a default fund.
- A reporting obligation in respect of all derivatives (not just OTC derivatives) entered into by all EU counterparties, including CCPs, to registered or recognised trade repositories. ESMA is responsible for the registration and supervision of these trade repositories. The reporting obligation has been in place since February 2014. In practice, counterparties have opted either to set up a direct relationship with a trade repository or to establish delegated reporting arrangements with their counterparty or a third-party provider. A trade repository must register with ESMA if it wishes to receive and process reports in accordance with EMIR. Once registered, the trade repository is able to receive reports from counterparties across the EU.
- A clearing obligation applicable to categories of standardised derivatives that meet criteria set out in EMIR Level 2 legislation. This obligation applies to EU ‘financial counterparties’ and EU ‘non-financial counterparties’ whose trading exceeds a specified threshold. This obligation also applies to certain non-EU counterparties in specified circumstances. ESMA and the Commission decided to phase in the application of the clearing obligation depending on the EMIR categorisation of counterparties and the size of their trading activities. The clearing obligation for the most commonly used interest rate swaps denominated in euros, sterling, yen and US dollars began for ‘Category 1’ firms in 2016 with a phased introduction for other types of counterparty until 21 December 2018. A similar approach has been adopted for certain credit derivative swaps (CDS), with a phase-in period running until 9 May 2019.
- The risk mitigation obligations are designed to reduce risk for OTC contracts that are not subject to the clearing obligation, including contractual requirements around portfolio reconciliation and dispute resolution, and a requirement for exchanges of collateral (margin) for certain categories of OTC derivatives. EMIR Level 2 legislation provides for an obligation on counterparties that are in scope (mostly financial counterparties and other counterparties that carry out substantial levels of derivatives trading) to exchange initial and variation margin when dealing with each other. It also sets out a list of eligible collateral for the exchange of collateral and the criteria to ensure that it is sufficiently diversified. EMIR also requires operational procedures relating to margin to be put in place by the counterparties, such as legal assessments of the enforceability of the arrangements for the exchange of collateral.
The Short Selling Regulation
The EU regulation on short selling and certain aspects of credit default swaps took effect on 1 November 2012 and sought to harmonise the short-selling rules across the EU. The key elements of the Regulation include:
- transparency requirements in relation to short positions in shares traded on an EU venue and EU sovereign debt and those with CDS positions in relation to EU sovereign debt issuers, including the flagging of short orders;
- a ban on ‘naked’ short selling – entering into a short sale of EU sovereign debt or shares trading on an EU venue without have borrowed, or entered into an agreement to borrow, the relevant financial instruments;
- disclosure of short positions to national regulators once a short position in the relevant instruments reaches 0.2 per cent, and disclosure to the relevant market once the position reaches 0.5 per cent, of the issuer’s share capital; and
- national regulators may impose temporary (up to three months) bans on short selling and related derivative transactions in some emergency circumstances.
The Market Abuse Regulation
Since 3 July 2016, the Market Abuse Regulation (MAR) has applied across the EU, replacing the previous market abuse regimes that existed in member states and applied only to instruments traded on EU regulated markets.
Since the advent of MAR, the EU market abuse regime also applies to issuers with financial instruments, such as debt securities, admitted to trading (or for which a request for admission to trading has been made) on an MTF or an OTF. MAR also applies to derivatives or other instruments whose price or value depends on or has an effect on the price of certain financial instruments, regardless of where those related instruments are traded. This last category of instruments potentially widens the scope of MAR further, to include instruments traded outside the EU that could have a price effect on the instruments admitted to trading on an EU trading venue.
As a result, MAR prohibits insider dealing, unlawful disclosure of inside information and market manipulation in respect of a much wider range of securities. The regime also provides for a range of obligations on issuers and, in certain cases, those institutions who act on their behalf.
Key issuer obligations under MAR include the following.
Disclosure of inside information
An issuer with securities (debt or equity) admitted to trading on an EU venue must disclose inside information to the market as soon as possible, except where it is in the issuer’s legitimate interests to delay disclosure. Under MAR, this disclosure obligation applies to a much wider range of instruments than previously. MAR also requires an issuer to inform the national regulator of the trading venue of any such delay, and issuers must also retain a record of how they determined that the delay in disclosure was in their legitimate interests. In addition, MAR provides that, once disclosed, inside information must be available to the public on the issuer’s website for five years.
MAR also requires an issuer to maintain, in a prescribed format, insider lists detailing those persons working for it (either inside or outside the business) who have access to inside information relating directly or indirectly to it.
MAR requires persons discharging managerial responsibilities (PDMRs), and persons closely associated with them, to disclose to the issuer and the national regulator certain notifiable transactions in the issuer’s financial instruments. The issuer must ensure that any such notification is also disclosed to the EU market. In addition, MAR generally prohibits PDMRs from dealing when in possession of inside information or in a ‘closed period’, namely 30 days before an announcement of interim or annual results.
Under MAR, a market sounding comprises the communication of information, prior to the announcement of a transaction, to gauge the interest of potential investors. Where sounding-out investors involves disclosure of inside information, the issuer can benefit from a ‘safe harbour’ where it follows a specific market sounding procedure and maintains certain records. Although the clear policy focus of the market soundings regime is on the selective disclosure of inside information, a market sounding can also encompass situations where no such disclosure occurs prior to the announcement of a transaction (eg, in a roadshow where only public information is disclosed).
The Acquisition Directive
The Acquisition Directive provides for a harmonised regime for the acquisition of control in financial firms (including investment firms, banks and insurers) in the EU. Persons wishing to acquire control in such firms must seek prior regulatory approval before completion. ‘Control’ for these purposes is defined as being 10 per cent or more of the share capital or voting rights in the relevant firm or in its parent undertaking. The Acquisition Directive also contains provisions providing that where parties are acting in concert with one another, their interests may be aggregated for the purposes of the control threshold.
The CRD IV package
In the EU, the principal regulation of the banking sector is contained in the Capital Requirements Directive and the Capital Requirements Regulation (together known as the CRD IV package). The legislation sets out, inter alia:
- an authorisation regime for ‘credit institutions’ (broadly, deposit taking entities);
- prudential rules for banks and larger investment firms on a solo and consolidated basis, including detailed rules around capital requirements, including capital ratios;
- passport rights for credit institutions across the EU;
- liquidity standards in the form of a liquidity coverage ratio;
- rules on capital conservation and counter-cyclical capital buffers, to be maintained in addition to minimum regulatory capital requirements;
- rules on counterparty credit risk;
- rules on corporate governance and risk management; and
- remuneration limits and disclosure requirements (including a ‘bonus cap’ whereby the variable remuneration of certain bank staff (senior managers, material risk takers and certain compliance staff ) is limited to 100 per cent of their fixed remuneration. The cap can be increased to 200 per cent with shareholder approval).
The Alternative Investment Fund Managers Directive (AIFMD)
The AIFMD regulates the authorisation, operations and transparency of managers of alternative investment funds (AIFMs) who manage or market funds in the EU. The scope of the AIFMD is wide and regulates the provision of risk management and portfolio management services in relation to an alternative investment fund (AIF). The definition of an AIF is very broad and includes a wide range of structures and fund types. Both open-ended and closed-ended vehicles and listed and unlisted vehicles can be AIFs, as can investment structures not typically thought of as being ‘funds’.
The AIFMD applies to:
- EU managers who manage one or more AIFs (wherever they are based);
- non-EU managers who manage one or more EU AIFs; and
- non-EU managers seeking to market AIFs (wherever they are based) to investors in the EU, subject to some limited exemptions.
The AIFMD does not directly apply to the AIFs themselves, although AIFs remain subject to applicable member state law and regulation, if any.
EU managers are subject to an authorisation requirement under the AIFMD. As a consequence of being authorised, a manager may market units or shares in the AIF it manages across EU member states under a passport regime. Authorised managers are subject to a range of obligations including in relation to governance and conduct of business standards, capital requirements, enhanced disclosure and transparency requirements and remuneration policies. In addition, authorised managers must appoint a depositary on behalf of each AIF that they manage. Authorised managers are also subject to limitations on leverage and face restrictions in relation to ‘asset stripping’ (meaning restrictions on distributions and capital reductions in certain portfolio companies) for two years following acquisition.
Member states may allow non-EU managers to market units or shares in the non-EU AIFs that they manage to professional investors under national private placing regimes. There is a degree of harmonisation in relation to these regimes, as managers using this route for marketing must comply with elements of the AIFMD disclosure regime, and there must be suitable cooperation arrangements between the relevant member state and the regulator of the home states of the manager and the AIF. In addition, the jurisdictions of establishment of the non-EU manager and any non-EU AIFs that it manages must not be listed as a non-cooperative country and territory by the Financial Action Task Force. European Union member states are, however, free to ‘gold-plate’ their national private placement regimes to add in other requirements before marketing can begin.
Most national regimes continue to permit ‘reverse solicitation’ and passive marketing without the need for compliance with the AIFMD or private placement regimes. The availability and boundaries of this concept vary widely across member states.
Future developments, including Brexit
Given the importance of London as the EU’s largest centre for financial services, it is expected that Brexit will have a disproportionate impact in relation to the financial sector. The shape of, or whether there will be, a final deal between the EU and UK on a future trading relationship is still, at the time of writing, far from being settled. In broad terms, the key financial regulatory issues arising from Brexit include:
- UK financial services institutions, including subsidiaries of US and other non-EU parent companies, would no longer be able to benefit from passporting (unless single market membership is maintained post-Brexit, which seems unlikely at the time of writing). Although a ratified withdrawal agreement could allow for transitional arrangements where financial services firms would be able to rely on passporting rights in the UK and the EU27 until the end of the transitional period, if a withdrawal agreement is not ratified (a no-deal Brexit), passporting rights relating to the UK will cease once the UK leaves the EU. If the UK becomes a third country for the purposes of EU legislation, the fundamental basis of market access in the future will be equivalence under some existing EU financial services laws. UK financial services firms would be treated in the same way as firms from other non-EU third countries. Rights under third-country equivalence regimes are not a full substitute for passporting rights and do not cover all areas of business carried on by international banking groups.
- The UK government has set out certain proposals to minimise the potentially disruptive impact of a no-deal Brexit. To combat the sudden loss of passporting rights for UK firms providing services in the EU as well as for EU firms servicing clients in the UK, which has the potential to cause significant market disruption, the UK has introduced the temporary permissions regime (TPR), which will allow firms based in the EU that currently access UK clients and markets via passporting rights to continue operating in the UK for three years after the UK exits the EU. During the three-year transitional period firms relying on the TPR could apply to become fully authorised in the UK or wind down their activities in an orderly manner. The TPR is available to banks, insurers, investment firms, electronic money and payment institutions, UCITS schemes and alternative investment funds.
- In order to avoid significant disruption for financial and non-financial counterparties across the EU, which could occur if UK financial institutions are restricted from providing derivatives-dealing services to EU counterparties and if London-based CCPs (which currently fulfil a critical role in the clearing of derivatives in the EU as a whole) are also prevented from providing clearing services to EU counterparties post-Brexit, the European Commission has adopted two temporary equivalence decisions that will apply if there is a no-deal Brexit. These equivalence decisions will prolong the access of EU27 firms to UK central clearing counterparties and UK central security depositories, for 12 and 24 months respectively. The European Commission will also, for a period of 12 months following withdrawal, preserve the regulatory treatment of derivative contracts currently exempted from the clearing obligation and the bilateral margin requirements that EU law imposes, when such contracts are transferred from the UK to the EU27.
- Most of the UK’s financial services regulation is based on EU law. That said, substantial further EU legislative work is expected to modify a number of these laws, so it is possible that the regimes could diverge rapidly after Brexit. In general with financial services legislation, an assessment will need to be made in the UK whether to align with EU legislation or diverge; the greater the divergence, the more the dual burdens on cross-border firms.
- The UK will likely not be part of the ESA framework after Brexit and will have no influence in the development of primary or secondary EU legislation or guidance. The UK has been a significant force in the area of financial services legislation, so its withdrawal may impact the legislative agenda and ultimately the quality of the legislation produced.
- In addition to the formal legal measures envisaged by the UK and, to a lesser extent, the European Commission, national regulators in the UK and EU may be required to exercise a significant degree of regulatory forbearance in the event of a no-deal Brexit, given the lack of clarity about how thousands of EU-derived rules would apply. It is also predicted by many economists that a no-deal Brexit would have significant negative economic effects on the wider UK economy; conceivably this could pose a financial stability threat to the UK banking system requiring swift intervention by regulators.
Even before the Brexit referendum a number of new regulatory initiatives were in progress or under consideration, in part to recognise the need to reflect newly agreed international standards (such as the Financial Stability Board’s total loss-absorbing capacity standard (TLAC) for global systemically important banks) as well as building on the EU’s own policy priorities around building a banking union within the eurozone and the creation of a capital markets union. Important recent EU regulatory initiatives in financial services include:
- The banking reform legislative package published on 23 November 2016, which is expected to be adopted by the European Parliament and the Council of the European Union in 2019, consisting of:
- a set of amendments to the CRD IV package, including amendments to the leverage ratio, the net stable funding ratio and capital standards and new proposals for a requirement to establish intermediate EU holding companies where two or more banking institutions established in the EU have the same ultimate parent in a non-EU country;
- a proposal to amend the Single Resolution Mechanism Regulation as regards loss-absorbing and recapitalisation capacity for credit institutions and larger investment firms; and
- proposals to amend the existing Bank Recovery and Resolution Directive in relation to TLAC requirements and regarding the ranking of unsecured debt instruments in the insolvency hierarchy.
- The proposal to amend EMIR, published on 13 June 2017. This would amend, inter alia, the procedures involved for the authorisation of CCPs and requirements for the recognition of third-country CCPs or equivalent. The proposal aims to address challenges in derivatives clearing as it grows in scale and seeks to reflect a pan-European approach to the supervision of EU and non-EU CCPs, to ensure further supervisory convergence and to enable closer cooperation between supervisory authorities and central banks in the EU and in non-EU countries. Despite ESMA suggesting that the reforms are consistent with ensuring the robust supervision of CCPs as systemically important institutions, the proposals have been criticised by some UK policymakers who view them, post-Brexit, as a means of forcing the clearing of euro-denominated financial instruments from the UK to the EU. It is expected that trialogue negotiations between the Parliament, the Council of the European Union and the European Commission on the proposals to amend EMIR will commence in 2019.
- The ESAs and the European Central Bank have, on a number of occasions, issued opinions and expressed views in speeches regarding the impact of Brexit on the licensing of financial services firms in the EU. For example, on 31 May 2017, ESMA published an opinion on general principles to support supervisory convergence in the context of authorised firms relocating from the UK. The opinion addresses regulatory and supervisory arbitrage risks that may arise from such relocations and sets out general principles for a common supervisory approach across the member states. The opinion is underpinned in the EU by a concern that a regulatory ‘race to the bottom’ may occur among European regulators to win business post-Brexit. To guard against such arbitrage, the opinion encourages progress in supervisory convergence to improve integration and ensure financial stability across the EU and make clear that ‘substance’ requirements will have to be met, with the full force of EU regulation applying to firms that choose to move from the UK. ESMA has promised to maintain its focus on supervisory convergence and assessing risks in financial markets during 2019.
The legislative proposals described above continue to grind their way through the EU legislative process. The Commission and the ESAs continue to adopt a position that advocates ‘more EU’ as the solution to financial regulatory issues that arose during the crisis and beyond. The direction of travel is therefore towards more powers for the ESAs and the ECB, with even less discretion available to national regulators. The impact of Brexit will likely have a material impact on the operation and regulation of the EU’s financial markets, given the critical importance that London currently holds.