The UK government has finally revealed its Brexit position. Any chance of a soft Brexit or retained membership of the Single Market has apparently been removed. The UK will almost certainly pull out of the Single Market although some hope policymakers will negotiate a transitional arrangement to avoid a cliff-edge Brexit.
The risk of a cliff-edge Brexit – that is an abrupt UK departure from the EU with no interim set-up – is something service providers and fund managers need to be awake to. Nonetheless, a cliff-edge Brexit scenario would have systemic implications for the broader EU and many countries will try to avoid such a shock to their financial services industry.
Legislation aimed at UK fund managers such as the Alternative Investment Fund Managers Directive (AIFMD) and UCITS could cease to apply for UK managers in this scenario although they may remain on the UK statute books. UK fund managers look set to lose their AIFM or UCITS designation under Hard Brexit and may be unable to manage funds in other EU countries.
Depositary is one of the major components of AIFMD and UCITS V, but these Directives require depositaries to be located in the same EU member state as the fund. Some UK-headquartered depositaries have multiple branches and offices throughout the EU, and Brexit will require such providers to reorganise themselves if they service onshore EU AIFs and UCITS. This may be through increasing their headcount in certain EU countries at the expense of the UK.
However, the UK is probably not going to abrogate depositary rules. Any access to European markets may rest on the concept of equivalence. If the UK revokes depositary standards, this would probably result in the European Securities and Markets Authority (ESMA) rejecting the UK’s regulatory regime as non-equivalent. Even so, it may still be necessary for the depositary to be domiciled in the EU member state where the manager conducts most of its marketing (i.e. the AIFMD member state of reference rules which apply to non EU managers).
Equally, the UK is likely to expect domestic managers marketing non-EU funds into the UK itself to comply with something akin to the current depositary-lite model. The same may also be true for EU managers of EU funds selling to UK investors. There is a good chance that the depositary requirements will be retained by the UK although there may be some nuances that emerge over time.
In the short term, national private placement marketing regimes (NPPR) will continue to enable the marketing of non-EU funds in Europe. However, if third countries receive AIFMD equivalence and the ability to passport funds freely, NPPR will be phased out as will depositary-lite with firms needing to migrate to a full depositary model. Originally, this phase out was due to take place three years after the initial extension of the passport.
However, one of the many implications of Brexit is that AIFMD passport talks with third countries have been kicked into the long grass. There is likely to be a correlation between Brexit negotiations and equivalence discussions. In other words, if Brexit/equivalence talks drag on indefinitely, depositary-lites could continue to remain a feature for longer than originally anticipated.
But if Brexit talks conclude quickly and NPPR is halted without passports being offered for whatever reason, the depositary-lite set-up could be finished in the EU. The same applies if equivalence negotiations are successful and the passport is introduced for third countries.
The absence of predictability puts UK depositaries and depositary-lites in an awkward situation. Some may look to establish fully capitalised entities in the EU and some depositary-lite businesses may seek to become full depositaries. This requires forward planning and firms are advised to begin the process soon given the time it takes to register and obtain regulatory authorisation for setting up a depositary in the EU. Other businesses could question the value of remaining a depositary/depositary-lite and follow the lead already taken by one large administration group to exit depositary altogether.
The depositary margins for some firms, particularly those that have not attained critical mass of clients, are not high. These types of organisations are the ones most likely to exit from depositary work, especially if they do not feel comfortable taking on the extra cost and risk. Exiting depositary-lite would give those firms a chance to focus on other, more profitable and predictable parts of their business. Fund administration – unlike depositary – is less likely to be affected by Brexit.
But are there any positives to be gleaned from Brexit? Some have proposed creating a credible alternative investment funds regime in the UK which could compete with offshore centres such as the Cayman Islands, but not subject to the same level of regulation as onshore EU funds. Equally, NPPRs have been beset with confusion and administrative headaches in the EU and this has deterred third country fund managers from marketing to EU investors. The UK was already one of the simplest jurisdictions for third country firms to use NPPR, and this is likely to continue going forward.