UK/EU Investment Management Update (November 2020)

ESMA’s statement concerns the potential situation in which an equivalence decision is not made by the Commission in respect of the UK, meaning in-scope shares traded on a UK trading venue would not automatically satisfy the EU STO. The result is that EU investment firms would have to trade all in-scope shares only in the EU, even if a particular share is mainly traded on UK trading venues.

ESMA has thus announced that the trading of shares with an EEA International Securities Identification Number (ISIN) on a UK trading venue in GBP by EU investment firms is not expected to be subject to the EU STO. This follows ESMA research indicating that such trading by EU investment firms occurs on a non-systematic, ad hoc, irregular, and infrequent basis (i.e., would fall within an exemption under Article 23).

The ESMA statement addresses the specific situation of a small number of EU issuers whose shares are mainly traded on UK trading venues in GBP. ESMA notes this approach to the EU STO will effectively minimise disruption and overlapping requirements only if the UK adopts a complementary approach. This would require the UK to exclude EEA ISINs from the UK STO. Without such an exclusion from the UK STO, the UK STO could conflict with the EU STO when UK and EU counterparties trade in shares with an EEA ISIN. (As noted in the section below, the UK’s approach will in fact be broader than what ESMA considers to be a complementary approach.)

Firms should be aware that, in the absence of an equivalence decision, the application of the EU STO to shares with a different ISIN (i.e., a non-EEA ISIN) should continue to be determined in accordance with ESMA’s 13 November 2017 Guidance. Should the Commission make an equivalence decision in respect of the UK, the EU STO would be satisfied for shares traded on a UK trading venue.

MiFIR share trading obligation — FCA statement

On 4 November 2020, the FCA published a statement setting out its intended approach to the application of the UK share trading obligation (UK STO) to UK firms following the end of the Brexit transition period on 31 December 2020.

In the statement, the FCA states its view that mutual equivalence between the UK and EU “should be easy to agree and remains the best way of dealing with overlapping STOs”. However, in the absence of an equivalence decision from the Commission, the FCA sets out its approach for UK firms.

The FCA rejects the approach taken by ESMA, which (as noted above) focuses on the ISIN and currency of the instrument in determining the scope of the UK STO and remarks that “any restriction on the trading of shares based on currency does not reflect the multicurrency nature of global capital markets and limits the ability of firms to determine how best to use global capital markets to support economic activity. It will cause disruption to investors, issuers and other market participants, leading to fragmentation of markets and liquidity in both the EU and UK.” However, the FCA states that it remains open to dialogue with ESMA and stands ready to review its use of the TTP if conditions change.

In terms of the FCA’s approach, the statement sets out the FCA’s intention to use the Temporary Transitional Power (TTP) to allow UK firms to continue trading all shares on EU trading venues and systematic internalisers (SIs) where they choose to do so, provided that relevant venue has the necessary permissions under either the UK’s longstanding regimes for overseas access or the temporary permissions regime (TPR). 

The FCA also notes that, in the absence of the UK’s current equivalence being recognised, further changes may be needed in future to facilitate best execution by UK firms and to protect the integrity of UK, including potential revisions to MiFID II calibrations from the UK’s perspective.

Post-trade transparency and position limits — ESMA adds UK venues to its opinions

On 27 October 2020, ESMA announced updates to its third-country venues lists to include UK venues, in the context of its opinions on determining third-country trading venues for the purposes of (i) post-trade transparency under Markets in Financial Instruments Directive (MiFID) II/MiFIR and (ii) position limits under MiFID II.

The UK venues received a positive assessment against the criteria established in the relevant opinions, meaning that from 1 January 2021:

• EU investment firms will not be required to make transactions public in the EU via an EU-approved publication arrangement (APA) if they are executed on one of the UK trading venues on the transparency list.
• Commodity derivative contracts traded on UK trading venues on the position limits list will not be considered as economically equivalent over-the-counter contracts for the EU position limit regime.

In addition, ESMA updated its Guidance on the annex to its opinion on post-trade transparency to reflect market participant feedback on the identification of bonds and U.S. treasuries in the case of venues with a positive assessment that excludes either (or both) type(s) of security. ESMA’s updates also set out the treatment of venues without a market identifier code (MIC). The transparency list applies from 10 November 2020, thereby allowing market participants time to implement the changes to the Guidance.

End of Brexit transition period — FCA and PRA “Dear CEO” letter

On 9 October 2020, the FCA and Prudential Regulatory Authority (PRA) published a “Dear CEO” letter on final preparations for the end of the Brexit transition period, emphasising the importance of firms’ continued preparatory work for the various scenarios that may arise come 31 December 2020. In particular, the FCA and PRA mentioned the following key areas of focus.

• Continuity of wholesale banking business and contracts. Firms should proactively engage with clients to complete repapering and on-boarding and novate existing trades to help clients manage risks related to lifecycle events. Firms should consider the impact on each client and whether proposed changes are in the client’s best interest. Where a firm plans to use national licensing regimes and exemptions in EU member states, it should ensure its preparedness to meet compliance obligations.
• Data. To ensure service continuity, firms may need to consider updating contracts involving personal data transfers from the European Economic Area (EEA) or look into other arrangements to comply with EU requirements.
• Trading venues. Firms should consider how they will continue to meet share and/or derivatives trading obligations in both the EU and UK and discuss their plans and assumptions with the FCA.
• EEA passporting. EEA passporting firms entering the temporary permissions regime (TPR) at the end of the Brexit transition period will benefit from deemed permissions to operate in the UK pending permanent authorisation. The FCA has published information on the TPR, including rules for firms using it as well as considerations for firms leaving it, on its website. The FCA is consulting on its approach to the authorisation and supervision of international (whether EEA or non-EEA) firms. The deadline for responses is 27 November 2020.
• Further areas of focus. Firms should continue taking steps to address relevant risks, including changes to reporting requirements, operational continuity, safeguarding of client money and custody assets, and communications to customers.

Finally, the FCA and PRA reminded firms that extensive information on key issues for consideration can be found on the FCA’s website. Firms should ensure they are familiar with these issues.

The FRF Review aims to determine how the UK’s approach to financial services regulation ought to adapt to account for the UK’s new position outside the EU. Phase II will consist of two consultations. The first (and current) sets out an overall regulatory blueprint for financial services, and the second (to follow in 2021) will contain a final package of proposals.

The main principles set out by this first Phase II consultation, which involve divergence from the current EU approach, are as follows:

• Short-term “onshoring.” The “onshoring” of EU legislation into UK legislation will ensure a smooth transition into the UK’s position outside the EU with minimal disruption for firms. However, maintenance of the EU’s approach to financial services regulation (i.e., setting detailed regulatory standards in legislation) is not meant as a long-term measure in the UK.
• Long-term “delegated” model. The UK intends to move towards a new system, built on the existing Financial Services and Markets Act 2000 (FSMA) model, which involves significant delegation of policy responsibility to regulators. Whilst the UK government will be responsible for setting out a “policy framework” for regulators, the FCA and PRA will be responsible for designing and implementing regulatory standards. This maximises the use of regulators’ expertise and allows for flex and efficient updating in reaction to emerging risks. However, the UK government will continue to determine the UK’s regulatory relationship with other countries (e.g., setting out equivalence requirements).
• Activity-specific approach. In contrast to the EU’s “business-specific” approach, the UK long-term approach will follow “activity-specific” policy principles (meaning regulatory obligations will attach principally to types of activities rather than to types of businesses). Responsibility for determining whether an activity falls within the UK regulatory perimeter will remain with the UK government.
• Single rulebook. The UK’s aim will be to create a single, coherent source of regulatory requirements. If successfully implemented, firms will need to look no further afield than the regulators’ rulebooks. 
• Enhanced regulator transparency. The FCA and PRA will be subject to greater transparency requirements and enhanced scrutiny vis-à-vis the UK Parliament. There will also be more systematic consultation between regulators and HM Treasury.

This is in line with an ESMA proposal that the Commission had requested in response to the COVID-19 pandemic (see, further, our August Update). As the Commission notes, the new settlement discipline regime will affect a wide range of market participants and involves substantial adaptations to IT systems. Due to the pandemic’s impact, businesses have generally had to deprioritise such adaptations, as IT resources have been put under increased pressure. Central Securities Depositories (CSDs) (and, to an extent, market players) are therefore unlikely to be ready to implement the new settlement discipline regime on 1 February 2021 without significant disruption and increased risk.

The Delegated Regulation is now subject to a three-month nonobjection period. Should neither the Council of the EU nor the European Parliament object during this time, it will be published in the Official Journal and enter into force three days later (i.e., in advance of the 1 February 2021 commencement date that otherwise applies).

New FCA webpage for reporting net short positions

On 28 October 2020, the FCA published a new webpage on net short positions reporting and preparing for Brexit. This explains what needs to be done during and after the Brexit transition period by firms that report net short positions.

• During the transition period. The EU SSR continues to apply in the UK, and holders of net short positions should continue to report to the FCA at existing reporting thresholds — for which, see our Update on ESMA’s temporary reduction to the net short position reporting threshold. Position holders should consult the ESMA Financial Instrument Reference Data System (FIRDS) and ESMA exempted shares list to assess whether a notification needs to be made to the FCA.
• After the transition period. The “onshored” SSR (UK SSR) will apply to position holders, with the net short position reporting threshold set at 0.2%. Reporting thresholds for UK sovereign debt, alongside uncovered positions in UK sovereign credit default swaps, will remain the same. Firms should consult the FCA FIRDS and UK exempted shares list (which will be published on 1 January 2021) instead of their ESMA equivalents.

Given that the current FIRDS and exempted shares list, even today, are not always accurate, it seems likely that from 1 January 2021 there will be instances where a position holder will need to report net short positions both in the UK and in an EU member state in relation to certain issuers.

Of relevance to investment managers, the Policy Statement confirms that the original deadline of 9 December 2020 for the following requirements is being extended to 31 March 2021:

• the date the conduct rules come into force for staff who are not senior managers, certification staff, or board directors;
• the date by which relevant employees must have received training on the conduct rules;
• the deadline for submission of information about directory persons to the Financial Services Register; and
• references in the FCA's rules to the statutory deadline for assessing certified persons as fit and proper.

The FCA also updated its SMCR webpage, noting that solo-regulated firms must submit their Directory Persons data via Connect by 31 March 2021 using the single-entry submission form. The FCA will begin to incrementally display data from solo-regulated firms as it is submitted; the data will start to be published from 14 December 2020. (Dual-regulated firms, i.e., those regulated by the FCA as well as the PRA, must submit their Directory Persons data via Connect by no later than 13 November 2020.)

Increased primary market activity caused by the pandemic creates large volumes of inside information, which must be appropriately handled. Hoggett stressed the need for dynamic risk assessment and warned that while it may be tempting to use “out of the box” alerts offered by technology providers, “it may not provide assurance that you have effective controls in place to mitigate the risks that you actually face.”

The FCA expects home-working arrangements to be as robust as office arrangements. Firms should be able to demonstrate that they have updated policies, refreshed staff training, and introduced rigorous oversight, particularly regarding the use of privately owned devices. Firms are encouraged to “consider how they can reiterate, and reinforce their expectations. Staff should be in no doubt about the standards expected of them” regardless of their location.

Hoggett further stressed the importance of good reporting and acknowledged the role that technology and data play in the fight against different forms of market abuse. Hoggett noted that firms should aim to submit suspicious transaction and order reports (STORs) without delay. If a STOR is filed outside the normal timeframe, firms should advise of the reasons for the delay.

The SEC had previously delayed approval of UK and EU managers indefinitely, due to concerns the EU’s General Data Protection Regulation (GDPR) would impede the SEC’s ability to collect data from, and thus supervise, such managers. The SEC is now comfortable that the GDPR in its current form contains broad enough exceptions to allow it to access UK-based registered investment advisers’ books and records. Notably, this comfort does not currently extend to EU-based advisers, and so, at present, the SEC is not considering registration of firms located in EU27 jurisdictions.

For further discussion, and details on the steps UK-based potential registrants ought now to take, please see our Update on this topic.

The delay is due to disruption caused by the COVID-19 pandemic on what has always been an ambitious and challenging timeline. In particular, the deadline for the public consultation on the draft RTS had to be extended to enable sufficient stakeholder involvement.

While the RTS will specify detailed requirements as to the content and presentation of disclosed information and transparency, the Commission notes that the SFDR’s application is not conditional in terms of substance on the adoption of RTS. The Commission further observes that many firms are likely already required by other relevant sectoral legislation to be compliant in terms of substance with many of the SFDR’s obligations. Accordingly, the Commission confirms that all application dates set out in the SFDR are maintained. This means it expects firms to comply with the SFDR’s “high level and principle based requirements from that time.”

As such, firms subject to the SFDR disclosure obligations — which would include non-EU AIFMs marketing AIFs in the EU — should generally prepare to meet the majority of their obligations (if any) under the SFDR by 10 March 2021. These include integrating sustainability risks in the investment decision-making process, entity-level disclosures, product-level disclosures, and disclosures for sustainable investment products.

For more on what the SFDR means for asset managers, and on which firms are affected, please see our Update on ESG disclosures for asset managers.

ISDA fallbacks will be the adjusted versions of the risk-free rates (RFRs) identified as alternatives to the benchmarks in the relevant jurisdictions (e.g., secured overnight financing rate (SOFR) for USD and sterling overnight interbank average rate (SONIA) for GBP). The fallbacks take effect if the relevant benchmark becomes unavailable while market participants continue to be exposed to that rate. For derivatives referencing LIBOR only, the adjusted RFR in the relevant currency would also apply as a fallback following the FCA’s determination that LIBOR in that currency is no longer representative, even if it continues to be published.

Fallbacks are not intended to be a primary means of moving away from respective benchmarks. ISDA recommends that once the fallbacks are in place, market participants voluntarily transition before the cessation of key interbank offered rates (IBORs).

Further information on the new derivatives fallbacks is available on ISDA’s website here and here. Information on how to adhere to the protocol is available on ISDA’s protocols webpage.

On the same day, the FCA, the Bank of England and the Bank of England’s Working Group on Sterling Risk-Free Reference Rules (Working Group) issued a joint Statement welcoming ISDA’s announcement. This strongly encourages early adherence to the ISDA Fallbacks Protocol.

Global Transition Roadmap for LIBOR

On 16 October 2020, the Financial Stability Board (FSB) published a Global Transition Roadmap for LIBOR (Roadmap) that outlines a timetable of actions that firms should take to ensure a smooth LIBOR transition by end-2021. This follows FSB’s July Statement confirming that LIBOR transition remains an essential task, despite the impact of the COVID-19 pandemic on the global financial system. The Roadmap sets out the following steps.

• Firms should already have:
  • identified and assessed all existing LIBOR exposures, as well as LIBOR dependencies outside of financial contracts;
  • agreed a project plan to transition before end-2021, incorporating recommended best practices in relevant jurisdictions;
  • assessed required changes to supporting systems and processes in order to enable use of alternative reference rates in contracts, including through fallbacks; and
  • started to implement a plan for communicating information about the transition to end users of LIBOR referencing products maturing beyond end-2021.

If firms have not already done the above, they should do so promptly.

• By end-2020, lenders should be in a position to offer non-LIBOR-linked loan products.
• By 25 January 2021 (the effective date of the ISDA Fallbacks Protocol), firms should
  • adhere to the ISDA Fallbacks Protocol or consider alternative appropriate arrangements; and
  • in the case of providers of cleared and exchange-traded products, ensure that these products incorporate equivalent fallback provisions.
• By mid-2021, firms should:
  • have determined which of their stock of legacy contracts can be amended ahead of end-2021, and formalise plans to do so;
  • where LIBOR-linked exposure extends beyond end-2021, discuss its effect on existing contracts and steps to transition to alternative rates with other firms concerned;
  • have implemented system and process changes to enable transition to robust alternative rates;
  • aim to use robust alternative rates in contracts; and
  • take steps to execute plans to convert legacy LIBOR-linked contracts to alternative reference rates in advance of end-2021.
• By end-2021, firms should:
  • conduct all new business in alternative rates or be able to switch to alternative rates at limited notice;
  • have discussed and taken steps with respect to the implications of LIBOR cessation on any legacy contracts which the firms have been unable to amend; and
  • run all business critical systems and processes without reliance on LIBOR or be able to switch at limited notice.