Documents considered by the Committee on 28 February 2018 Contents

8Prudential requirements for investment firms

Committee’s assessment

Politically important

Committee’s decision

Not cleared from scrutiny; further information requested; drawn to the attention of the Treasury Committee

Document details

(a) Proposal for a Regulation on prudential requirements for investment firms; (b) Proposal for a Directive on the prudential supervision of investment firms

Legal base

(a) Article 114 TFEU; ordinary legislative procedure; QMV; (b) Article 53 TFEU; ordinary legislative procedure; QMV



Document Numbers

(a) (39397), 16017/17 + ADD 1, COM(17) 790; (b) (39400), 16011/17 + ADD 1, COM(17) 791

Summary and Committee’s conclusions

8.1The European Commission in December 2017 published legislative proposals for a prudential regime for investment firms, after a review found that the current capital requirements for the smaller companies in the industry, based on the prudential regime for banks, was too complex and did not adequately take into account the specific prudential risks faced by investment firms.

8.2The Commission has proposed to create a new classification system for investment firms governed by the Markets in Financial Instruments Directive and Regulation (MiFID II and MiFIR), consisting of class 1 (systemically-important investment banks), class 2 (important but non-systemic firms) and class 3 (small firms). Class 2 and class 3 firms would fall under a new prudential framework calibrated specifically to the risks of the investment industry.

8.3In anticipation of an expected shift of operations by UK-based large investment banks to the Eurozone due to Brexit, the Commission also proposes to make class 1 firms subject to centralised supervision by the European Central Bank’s Single Supervisory Mechanism (SSM), while remaining subject to the same capital requirements as large banks (as they are under the current rules).67 This ties in with a separate proposal to amend the Capital Requirements Directive, which we considered recently, under which UK investment firms which fall into class 1 (as well as large non-EU banks) could be required to establish an independently-capitalised and authorised intermediate parent undertaking (IPU) within the EU after Brexit if they had significant operations within the EU-27.68

8.4The UK’s exit from the EU is also the driving force behind the final element of the proposals, namely to increase the threshold for “equivalence” decisions under MiFIR, which would allow UK-based investment firms to service professional customers within the EU after Brexit without the need to establish a separate, independently-capitalised legal presence within the EU itself.

8.5The Economic Secretary to the Treasury (John Glen) submitted an Explanatory Memorandum on the proposals in January 2018.69 Overall, the Minister has welcomed the approach taken by the Commission, which it says would “provide a good basis for a new prudential regime for investment firms” which could “have significant benefits for UK industry” given the concentration of such firms in the UK. With respect to the proposed changes to the MiFIR equivalence regime, he states only that the Government will seek to “agree stable, reciprocal arrangements” for trade in financial services which would by-pass the need for the UK industry relying on equivalence provisions.

8.6The Government has welcomed the Commission proposals. We agree that it makes sense to rationalise the prudential regime for investment firms in view of their specific business models and the risks they pose to their customers and the wider market. The proposals are clearly of great relevance to the UK given it is home to the majority of Europe’s investment activity, in terms of both businesses and assets.

The implications of Brexit

8.7The investment firm proposals also raise a number of further questions in the context of the UK’s withdrawal from the EU. They are the latest in a series of financial services proposals by the Commission that directly and explicitly reference the UK’s withdrawal from the EU as a driving force.70

8.8Firstly, as with other pending EU legislative proposals, we expect that the UK may have to apply these new rules if they are formally adopted and take effect or have to be implemented before the end of the post-Brexit transition period sought by the Government. Given the continuing uncertainty about the maximum length of the transitional arrangement, the same applies to these proposals (which are unlikely to take effect before 2021).71

8.9Secondly, the substance of the proposals themselves is in part driven by Brexit in two ways:

8.10In the absence of a clear impact assessment by the Government of the decision to leave the Single Market, it is very difficult to assess whether the Commission’s proposals with respect to class 1 investment firms are political posturing, or whether they respond to a genuine likelihood of an economically significant shift of operations from the UK to the EU.

8.11However, the Government has acknowledged that the equivalence regime alone would be insufficient to accommodate current flows of investment services between the UK and the EU-27.72 This is also reflected by the position of the financial services industry itself, namely that the provision of many services—which are currently provided by UK firms cross-border to EU clients under Single Market legislation—will become substantially costlier or even legally impossible after Brexit, unless the UK obtains a specific legal agreement to the contrary.73

8.12Given the UK is the EU’s largest financial centre, the logical conclusion is that the provision of such services to EU-based customers will either become more expensive because British firms will face higher compliance costs when operating as “third country” providers, or because there will be fewer market operators if specific UK firms might decide to cease offering such services to EU customers altogether. This has also been acknowledged by EU financial regulators.74

8.13In the context of the Commission proposals for investment services specifically, we note that UK investment firms could partially mitigate the loss of their MiFID passport through other means, in particular equivalence regimes (see paragraph 8.68 to 8.74), but also potentially through reverse solicitation and outsourcing or delegating of investment activities back to UK entities (see paragraphs 8.82 to 8.84). However, both the European Commission and UK Finance have taken the position that, even cumulatively, these mechanisms cannot amount to substantially the same level of market access as is granted to firms operating from a country within the European Economic Area.

8.14Therefore, to overcome these new market access barriers while still leaving the Single Market’s regulatory union, the Government has repeatedly indicated that it wants to negotiate a “new process for establishing regulatory requirements for cross-border business between the UK and EU”.75 This, it has said, would render the need for UK firms to rely on sectoral equivalence provisions unnecessary.76 However, nearly a year after formally initiating the EU exit process, it has not formally set out the details of its proposals for a financial services chapter in a future UK-EU free trade agreement.77

8.15As the Government has ruled out the UK formally staying part of the Single Market, the current indications are that the Government will follow the financial services industry’s own suggestions for a new legal framework under which the UK and the EU would operate a system of mutual recognition, allowing financial services authorisations and licences to be recognised by regulators in either jurisdiction without the need for firms to establish a new legal entity in the other territory.78 While regulatory alignment would be encouraged where necessary, the UK would not be under a legal obligation to apply EU financial services law as it would be outside the Single Market.

8.16We recognise the clear benefits of such an arrangement for both UK industry and their EU-based customers, by preventing further fragmentation of Europe’s capital markets. However, we are concerned that, in practice, it could simply require the UK to align itself with EU financial services legislation rather than providing for a truly symmetrical system that gave both sides equal flexibility in setting financial services regulation. Moreover, the EU has expressed scepticism about the feasibility of a mutual recognition agreement without regulatory harmonisation,79 and—even if it did accept it as a premise for a financial services agreement—would likely insist on stringent safeguard measures allowing for unilateral termination of market access in case of regulatory divergence.

8.17It is also unclear to us why the EU would be willing to accept mutual recognition of the UK’s post-Brexit standards in financial services without regulatory harmonisation, while the Council and Parliament—mostly with the UK’s support—have only established the existing financial services passporting regimes (which effectively embody mutual recognition of regulatory and supervisory standards) in conjunction with harmonising legislation.80 We note in this respect that the trend in recent years has been for EU financial services legislation to move from Directives to directly-applicable Regulations, entailing a greater level of harmonisation.81 In addition, such an agreement on mutual recognition could trigger the “Most Favoured Nation” clause in the EU’s trade agreements with other countries, notably Canada, requiring it to extend any preferential market access for UK investment firms to Canadian operators.82

8.18In any event, even if these political and legal obstacles could be overcome in time, negotiations cannot begin until the Government sets out a formal prospectus for consideration by the other Member States. Given the current vacuum in that respect, the EU is clearly operating under the assumption that the UK will become a “third country”, subject to the same market access restrictions (and opportunities to seek equivalence) as all other countries outside the Single Market.

8.19In these circumstances, the only prudent option for the Committee is to assume that the Commission proposals on a prudential regime for investment firms could have a constraining effect on the UK’s regulatory autonomy after Brexit: either under the terms of any agreement on financial services which provides preferential market access in return for continued regulatory convergence, or because it modifies the conditions under which UK firms could obtain market access based on the existing MiFIR equivalence regime. In both scenarios, the proposals are clearly of political and economic importance.

8.20While we await further information about the Government’s overarching approach to a possible new UK-EU financial services agreement, we would be grateful if the Minister could clarify the following issues that arise from the prudential proposals for investment firms:

8.21In the meantime, we retain the proposals under scrutiny, and draw them to the attention of the Treasury Committee.

Full details of the documents

(a) Proposal for a Regulation of the European Parliament and of the Council on the prudential requirements of investment firms and amending Regulations (EU) No 575/2013, (EU) No 600/2014 and (EU) No 1093/2010: (39397), 16017/17 + ADD 1, COM(17) 790; (b) Proposal for a Directive of the European Parliament and of the Council on the prudential supervision of investment firms and amending Directives 2013/36/EU and 2014/65/EU: (39400), 16011/17 + ADD 1, COM(17) 791.


8.22This report sets out the substance and context of recent proposals by the European Commission to create a new prudential regime for investment firms in the European Union. We have paid particular attention to the links between the UK’s withdrawal from the EU and certain elements of the proposals related to third (i.e. non-EU) countries, and the impact this legislation could have on British investment firms even after Brexit.

8.23Investment firms provide a range of services which provide both retail and professional investors with access to securities and derivatives markets, such as investment advice, portfolio management and brokerage. According to the European Banking Authority (EBA), there were just over 6,000 investment firms in the European Economic Area (EEA) at the end of 2015. The UK acts as an important hub for capital markets and investment activities, as approximately half of all investment firms within the EEA are based there. The EBA also estimates that eight investment firms, all based in the UK, control around 80 per cent of the assets of all investment firms in Europe.83

Current EU regulation of investment firms

8.24The Market in Financial Instruments Directive (MiFID), the latest version of which took effect in early 2018,84 sets out the conduct and organisational requirements investment firms must meet to be authorised, and to operate.85

8.25Under MiFID, investment firms can be licenced to perform between one and eight investment services. The Directive, like other pieces of EU financial services legislation,86 also creates a “passport” for investment firms, meaning that—once authorised by any EEA country—they can provide their services throughout the European Economic Area without having to establish a presence, or seek regulatory authorisation, in other countries. In August 2016, there were over 2,200 UK-based investment firms which had applied for a “passport” under MiFID.87

8.26Since 1993 investment firms have also been subject to prudential requirements under EU law.88 They are covered by the prudential regime for created banks, which is currently laid down in the 2013 Capital Requirements Directive89 (CRD) and Regulation (CRR).90 These set out the capital, liquidity and other risk management requirements with which both banks and investment firms must comply with, or lose their authorisation to operate. The logic for investment firms’ inclusion in this prudential framework is that they can compete with banks for the provision of investment services, which the latter can offer under their banking licence.

8.27However, considering that the two types of institutions have very different business models, the EU has always exempted smaller investment firms from some of the capital requirements which apply to banks. In practice, investment firms which conduct a broad range of services are therefore subject to the same requirements as banks in terms of capital requirements for credit, market and operational risk, and potentially liquidity, leverage, remuneration and governance rules. Over time, the prudential framework and the various exemptions for investment firms have become more complex. Currently, such firms can be grouped into eleven categories, with their classification determined primarily by the investment services they are authorised to undertake under MiFID, and whether they hold money and securities belonging to their clients. On a basic level, however, the capital requirements for investment firms are still determined by a system designed to “secure the lending and deposit-taking functions of credit institutions through economic cycles”, and not the specific prudential risks faced by investment firms.

8.28In light of the complexities of the current system and the lack of a prudential regime calibrated specifically to the investment industry, the 2013 Capital Requirements Regulation required the European Commission to review the options for an “appropriate application of capital, liquidity and other key prudential requirements” for investment firms.

The review of the prudential framework for investment firms

8.29To fulfil its obligations under the CRR, in December 2014 the European Commission asked the European Banking Authority (EBA) and the European Securities & Markets Authority (ESMA) to assess whether the EU’s prudential requirements for investment firms were “appropriate or whether they should be modified, and, if so, how”.

8.30By the end of 2015, the two Authorities published the outcome of their review. They concluded that the current regime was not fit for purpose:91

8.31The two Authorities therefore recommended that the EU should create a new prudential regime for investment firms based on three statutory classes for firms, ranging from systemic “bank-like” firms which would remain subject to the strictest prudential requirements, to the smallest investment firms which would be exempt from many risk management requirements.

8.32In June 2016, having considered these recommendations, the Commission accepted them on a provisional basis, and asked the EBA and ESMA to develop the exact criteria and thresholds for each of the three proposed classes of firms. It also asked them to provide a proposal for a new prudential framework applicable to class 2 and class 3 investment firms.92 The EBA and ESMA published their advice to the Commission on the design and calibration of the new prudential regime, including initial and on-going capital requirements and a liquidity regime, in September 2017.93 That same month, the European Commission announced that it was in the final stages of preparing “a more effective prudential and supervisory framework for investment firms”.94

8.33Following the UK’s formal notification of its withdrawal from the EU in March 2017, the EBA also issued a separate Opinion in October 2017 on the need for any UK-based systemic investment firms, which relocate part of their activities to a Eurozone country after Brexit, to be supervised by the European Central Bank as part of the Single Supervisory Mechanism and not by the national regulator of their new EU host country.95

The Commission proposals

8.34The European Commission published legislative proposals for a prudential framework for investment firms, based on the EBA’s recommendations, in December 2017. The package consists of a Directive and a Regulation for consideration by the European Parliament and the Council under the ordinary legislative procedure.96

8.35Having concluded that the EBA’s recommendations were an “appropriate and proportionate means” of establishing a “prudential framework for investment firms that can both ensure that they operate on a sound financial basis while not hindering their commercial prospects”, the Commission has mostly followed them except for the methodology for identifying systemic investment firms (see paragraphs 8.45 to 8.54).

8.36As set out in more detail below, the proposals:

8.37The Commission proposals refer repeatedly to the need for adjusting the capital requirements and prudential supervision regime for investment firms in the light of Brexit, given the concentration of investment activity in Britain. In particular, it has assumed that that some investment activity, including that of systemically-important firms, will relocate to the EU when the UK leaves the Single Market and its financial services industry loses the ‘passport’ under MiFID.

8.38In particular, the Commission goes further than the EBA’s recommendations by also tabling amendments to the EU’s “equivalence” regime under MiFIR, which governs market access for non-EU investment firms which do not relocate their activities but provide their services to EU customers (retail and wholesale) cross-border or through branches.97 The Commission is seeking to introduce new disclosure obligations for third-country firms carrying out investment activities within the EU to allow it to monitor the extent to which UK firms are accessing the Single Market in this way after Brexit, and tighten the requirements before the UK’s prudential regime could be recognised as “equivalent” after Brexit (which would provide more extensive market access rights for UK firms; see paragraphs 8.68 to 8.74).

8.39The new prudential regime would become applicable 18 months after its formal adoption by the Council and the European Parliament. This means it is likely to take effect no earlier than late 2020, and possibly even later.

8.40The Economic Secretary to the Treasury (John Glen) submitted an Explanatory Memorandum on the proposals in January 2018.98 Overall, the Minister has welcomed the approach taken by the Commission, which it says would “provide a good basis for a new prudential regime for investment firms” which could “have significant benefits for UK industry” given the concentration of such firms in the UK. The Government is also “satisfied that no subsidiarity concerns arise as a consequence of these proposals”.

8.41We have referred to the Government’s position in our summary of the individual elements of the proposed legislation below.

Classification of investment firms

8.42The Commission proposal would create a new categorisation of investment firms authorised by an EU Member State.99 Rather than the 11 existing categories, there would be three classes as per the EBA’s December 2015 recommendation:

8.43The consequences of the proposals for each class of investment firm are set out in more detail below.

Class 1: systemic firms

8.44In addition to its proposals to replace the current fragmented prudential regime for investment firms with a more streamlined, bespoke version, the European Commission also took the view that the EU’s regulatory architecture needed to be modified to take into account the UK’s decision to withdraw from the EU. In particular, the Commission expects that class 1 firms—which are eight UK-based systemic investment firms, “typically subsidiaries of US, Swiss or Japanese banking groups/broker-dealers”—are “likely” to relocate part of their activities to the EU as a consequence of Brexit by establishing a new legal, capitalised entity in one of the 27 remaining Member States.104

8.45It is unclear to what extent the UK’s largest investment firms are considering relocating activities to subsidiaries within the EU to maintain their MiFID ‘passport’ after Brexit. However, a separate proposal to amend the Capital Requirements Directive could require some British firms which fall into class 1 to establish an intermediate parent undertaking (IPU) within the EU after the UK’s withdrawal, if they had significant operations within the Union.105 Any such IPUs would be subject to independent prudential requirements, and need authorisation from an EU regulator.

8.46This, the Commission argues, raises an issue of prudential supervision and the potential for regulatory arbitrage. Even though these firms, insofar as they relocate activities to the EU, would remain subject to the same prudential obligations as they are at present under the Capital Requirements Regulation, their authorisation and prudential supervision would be carried out by the national regulator of their chosen host EU country. By contrast, systemically important banks established within the Eurozone are subject to the centralised “Single Supervisory Mechanism” (SSM) within the European Central Bank, not a national regulator.106

8.47The Commission has taken the view that systemic investment firms within the Eurozone should also be subject to the SSM, because:

8.48Therefore, the Commission wants the new prudential framework to make any systemic investment firms relocated to the Eurozone subject to the SSM, which it believes has the capacity to take a stricter and more effective supervisory approach.

8.49To achieve this, it has made one simple but significant alteration to the recommendations by the European Banking Authority for the new prudential regime: it wants to lay down the criteria for “class 1” firms in the Capital Requirements Regulation directly, rather than—as the EBA had suggested107—using an Implementing Regulation for the identification of systemic investment firms. The EBA’s approach would have postponed the determination of the exact criteria for “class 1” firms until after the legal basis for the new prudential framework had been agreed between the Member States and the European Parliament.

8.50Instead, the Commission has proposed to amend the definition of “credit institution” in the CRR to include the “most risky and systemically critical investment services”.108 The new definition would essentially cover investment firms which carry out the riskiest investment services and hold assets at individual or group level exceeding €30 billion (£27 billion). This latter criterion mirrors the proposed threshold for the IPU requirement for non-EU credit institutions and investment firms under the Capital Requirements Directive.109 As a result:

8.51Although the Commission proposal would not make class 1 investment firms subject to the Single Supervisory Mechanism if they relocated from the UK to a non-Eurozone EU country, the Commission says that “based on anecdotal information, at this stage the indications are that the preferred locations for these firms’ EU27-operations are in financial centres in Euro Area Member States (Germany, Ireland, Netherlands, Luxembourg, France)”.

8.52In his Explanatory Memorandum on the proposals, the Minister supports treating systemically important investment firms as bank-like and continuing to make them subject to the full Capital Requirements Regulation, as they “pose similar risks to banks and that therefore a bank-like treatment is important for financial stability”. However, the Minister has said the Treasury will “seek to ensure definitions and designations in the EU text work for UK financial stability”, without specifying the nature of the amendments sought.

8.53The Minister has also not commented on the assumption underpinning the Commission proposal that systemically important investment firms will relocate part of their activities to the EU after Brexit. This is curious as the EU would not need to legislate for them to be subject to the Single Supervisory Mechanism if no relocation takes place, since no such firms are currently established in any EU country except Britain, and the new prudential framework is not expected to take effect until after the UK ceases to be bound by EU law (see paragraph 8.8).

Prudential requirements for class 2 investment firms

8.54The Commission has proposed that investment firms would fall into “class 2” if they exceed any one of a number of size thresholds, such as assets under management valued at more than €1.2 billion (£1.1 billion) or a balance sheet higher than €100 million (£88 million). Firms would also fall into this category if they administer any client assets or hold any client money.

8.55The prudential requirements for these firms would be different from those applying to banks under the Capital Requirements Regulation. For the class 2 firms with the least risky business model, the minimum capital would be set as for the smallest (class 3) investment firms (see below). For the others, their capital requirements would be calculated according to a new “K-factor approach” for measuring risks in three categories (to the firm, to its customers and to the market) from the services and activities undertaken. The necessary capital buffer would be derived from the volume of each activity.

8.56The European Banking Authority has stated that the impact on capital requirements for investment firms in Class 2 could be “substantial”, as it would capture certain risks and set concomitant prudential requirements for the first time.110 However, it takes the view that the largest impact “would be concentrated in a relatively small number of individual firms”, likely to be investment advisors, execution brokers, firms which place securities and portfolio managers. Conversely, the new regime is likely to decrease capital requirements for trading firms and custodians.

Class 3: Prudential requirements and supervision

8.57For firms in Class 3, the minimum capital would be either the level of initial capital required for their authorisation in line with the new prudential regime—€75,000 (£67,000)—or a quarter of their fixed costs (overheads) for the previous year, whichever is higher. The EBA has said that most Class 3 firms “ought to comfortably meet the new requirements based on their existing levels of own funds”.

Other prudential requirements for class 2 and class 3 firms

8.58Other elements of the Commission proposals for the new regime for class 2 and class 3 firms are that:

8.59In his Explanatory Memorandum, the Minister supports the proposals for the new prudential regime for non-systemic (class 2 and class 3) investment firms. However, he added that the Government would discuss the specific implications of the new capital requirements with industry, given that some firms may need to hold more capital than they do at present. The Economic Secretary also welcomed “the absence of a bonus cap” for investment firms, and will seek to ensure that “the thresholds for applying other remuneration tools are appropriately calibrated so that there is sufficient proportionality in their application”.

8.60The proposals also appear to have the support of the European investment industry itself, with AFME—the Association for Financial Markets in Europe—commenting that it welcome the Commission’s proposals, as “prudential rules that are specifically tailored to the business models and risks assumed by investment firms should further the development of the Capital Markets Union” while the “introduction of direct ECB oversight of such firms for their Euro area activities is also welcome as it will foster a supervisory level playing field”.113

Treatment of third country firms

8.61The final element of the Commission proposals relates to the treatment of non-EU investment firms which operate within the EU. As we have noted, the new prudential regime is partially driven by the UK’s exit from the EU, to “ensure that third-country firms providing services cross-border in the EU do not enjoy a more favourable treatment than EU firms in terms of prudential, tax and supervisory requirements”.

8.62Firstly, the Commission argues that the new, less convoluted classification system for investment firms—and in particular the allocation of centralised supervisory responsibilities to the European Central Bank for any systemic investment firms which relocate activities from the UK to the Eurozone—will reduce the opportunities for “regulatory arbitrage” by British firms seeking to establish a subsidiary within the EU (see paragraphs 8.45 to 8.54).

8.63Secondly, the Commission is also making “targeted amendments” to the provisions of MiFID (on branches) and MiFIR (equivalence) that govern access for non-EU firms seeking to provide investment services to EU-based customers. The conditions for such access depend on the type of customer the firm is seeking to deal with (i.e. a retail or professional investor). We have described the current regulatory framework for third country access to the Single Market, and the changes proposed by the Commission, below.

Cross-border investment services for retail and elective professional clients

8.64Under article 39 of MiFID, EU Member States can authorise non-EU investment firms intending to provide services to retail or elective professional clients114 within their territory to establish a branch (i.e. a presence that has no legal personality of its own). A branch, since it is not an EU establishment, does not have the right to “passport” its services to other EU countries.

8.65The UK does not currently avail itself of this option to require a branch. For Member States that do, third country investment firms that do not want to establish an independently-capitalised and authorised subsidiary in the EU may have to establish branches in every EU country where they wish to service retail or elective professional clients, subject to national laws. Different rules apply where the investment firm wants to provide services to other types of professional or sophisticated clients (see below).

8.66Under MiFID, there is no mandatory reporting requirement on the activities of non-EU branches in the Union. In light of Brexit, and the concerns ESMA and the EBA have expressed about British firms attempting to establish “letter-box” entities in the EU after they lose their “passporting” rights under MiFID,115 the Commission has proposed to require third country branches under Article 39 MiFID to report annually on the scale and scope of their activities; their turnover and assets; the arrangement for investor protection; and their risk management policy. The information gathered in this way would then be used to assess to what extent investment services were provided subject to effective supervision within the EU itself.

Cross-border investment services for eligible counterparties and per se professional investors

8.67MiFID II also allows non-EU investment firm to provide investment services to EU-based per se professional customers,116 including eligible counterparties,117 without establishing a subsidiary or branch within the European Union. However, this is only possible where the following conditions are met:

8.68If all these conditions are met, the investment firm can provide investment services in any EU country without needing to establish a branch or subsidiary. However, it is restricted to dealing with eligible counterparties or per se professional clients based. To provide services to retail or elective professional clients, individual EU Member States can still require the establishment of a branch (see above), and even an equivalence decision does not allow these types of clients to be serviced from a single EU-based branch.

8.69The Commission has now proposed to modify the conditions before equivalence can be granted, to take into account the concentration of Europe’s investment firms in the UK.

8.70Specifically, it wants to attach more stringent conditions to the equivalence process by requiring a “detailed and granular assessment” that also takes into account the third country’s “supervisory convergence”.119 It is unclear what the practical effect of this amendment would be if the UK were to apply for equivalence under Article 47 MiFIR, as the regime is untested: the Regulation only took effect in January 2018, and the Government insists that the post-Brexit UK-EU free trade agreement will obviate the need for relying on equivalence in any event (see below). However, the clear purpose is to give the Commission more leeway to reject the request or seek to put pressure on the UK to keep its regulatory regime for investment firm aligns with that of the EU after Brexit.

8.71Separately, the Commission has also proposed a reporting requirement for third country firms registered with ESMA under the equivalence regime which mirror those for branches of non-EU firms under article 39 MiFID. They would have to inform the Authority annually about the scale and scope of their activities; their turnover and assets; the arrangement for investor protection; and their risk management policy.

8.72In his Explanatory Memorandum, the Minister states:

“The Government notes the amendments to MiFIR equivalence provisions. What our future relationship with the EU will look like in financial services is subject to negotiation, but we are confident that we can agree stable, reciprocal arrangements based on close cooperation with our EU counterparts as part of an ambitious economic partnership”. This hypothetical new financial services agreement with the EU would by-pass the need for relying on equivalence provisions under MiFIR.”

8.73Given that the Government has not been forthcoming with details about these “stable, reciprocal” post-Brexit market access arrangements for the financial services industry, we have summarised several other options for post-Brexit access to the EU market for UK-based investment firms in more detail below.

Access to the EU market for UK investment firms after Brexit

8.74Opinions vary about the likely impact that the loss of the MiFID “passport” will have for the UK’s investment services industry and therefore the potential value of an equivalence decision. As noted, the European Commission in its proposals refers to research by the Brueghel think tank, which estimated that up to 17 per cent of assets held by the UK’s investment industry could relocate as a result of Brexit.

8.75However, various other mitigation mechanisms have also been put forward to replace the ‘passport’, including equivalence; reverse solicitation; and use of delegation or outsourcing by EU-based branches and subsidiaries to UK-based sister entities.


8.76To some extent, for provision of investment services to wholesale customers, a significant and formal level of market access could be preserved through an equivalence decision under article 47 MiFIR (see paragraphs 8.68 to 8.74 above). However, given this provision has only recently taken effect, there is no precedent for the process of obtaining equivalence in this area, and there are likely to be technical as well as political hurdles.120

8.77For example, the European Commission is clearly intent on making any post-Brexit equivalence decision with respect to the UK’s prudential and conduct requirements for wholesale investment firms dependent on continued regulatory alignment with the EU (see paragraph 8.71). The potential for the politicisation of the equivalence process is demonstrated by the recent decision by the Commission to grant equivalence to the Swiss stock exchange under MiFID II for only one year, to exert pressure on Switzerland in the protracted negotiations over a new institutional framework for the bilateral EU-Swiss relationship.121

8.78The equivalence regime under MiFIR is also unusual in that it specifically creates a market access regime for cross-border operations where the relevant conditions are met. Most other equivalence regimes under EU financial services law instead provide derogations rom the typically stricter requirements when EU-based companies deal with foreign financial services providers. UK Finance has referred to the example of the Capital Requirements Directive, under which EU-based banks which enter into transactions with banks in countries that have been found equivalent by the EU for the purposes of prudential bank regulation “may generally hold less capital against that risk than for banks from countries that have not”.122

8.79Relying on equivalence also has other general drawbacks, as the industry itself has pointed out:123

“Equivalence is not a substitute for the operational rights created by the EU passporting system for [investment] banks. It operates in fewer areas, covers fewer services and is inherently less secure. Some of the more significant equivalence regimes for foreign banks will not come into effect for several more years. (…)

“Equivalence is not negotiated, but requested. Assessments are launched at the EU’s discretion. It can also be withdrawn, along with any rights that depend on it, at the EU’s discretion if a country is judged to have diverged from EU standards for any reason.”

8.80Despite these drawbacks it is the only legal mechanism currently available under EU law to provide statutory relief from certain prudential requirements, or to provide preferential access into the EU market for firms without a separate legal presence in an EU Member State (with the exception of specific trade arrangements that require the full application of EU financial services legislation).124

Reverse solicitation

8.81Some analysts have argued that a lack of formalised cross-border access into the Single Market could be mitigated under the MiFID “reverse solicitation” provision, which allows EU-based customers to seek out non-EU investment services providers directly.125 However, UK Finance expects this to only offer limited opportunities as it cannot be used where a non-EU firm advertises in the EU to inform clients about the services it offers, and at Member State level national legislation restricts its use.126

Delegation and outsourcing

8.82After Brexit, the EU-based subsidiaries of British firms could outsource substantive operations back to related parties or to branches in the UK. MiFID II only allows outsourcing this if the arrangement does not “impair materially the quality of [the firm’s] internal control and the ability of the supervisor to monitor the firm’s compliance with all obligations”.127

8.83The potential for subsidiaries of UK investment firms outsourcing their operations back to the UK after Brexit has been a particular point of concern for the EU’s financial regulators. ESMA, the EU body responsible for overseeing the implementation of MiFID, has expressed concerns that extensive delegation or outsourcing of operations back to the UK after a nominal subsidiary has been established in the EU could result in “letter-box entities”:

“In the course of the UK withdrawing from the EU, UK-based market participants may seek to relocate entities, activities or functions to the EU27 in order to maintain access to EU financial markets. (…) These market participants may seek to minimise the transfer of the effective performance of those activities or functions in the EU27, i.e. by relying on the outsourcing or delegation of certain activities or functions to UK-based entities, including affiliates. (…) Outsourcing or delegation arrangements, under which entities confer either a substantial degree of activities or critical functions to other entities, should not result in those entities becoming letter-box entities.”128

8.84Similarly, the European Commission has expressly stated EU investment firms which delegate operations to a UK-based branch need to base this decision “on objective reasons linked to the services provided in the non-EU jurisdiction” and “not result in a situation where such non-EU branches perform material functions or provide services back into the EU”.129 The full extent to which this supervisory approach will restrict delegation or outsourcing of investment services from the EU to UK-based entities is not yet clear.

8.85In view of the inherent limitations on market access for UK firms of all these alternatives to the Single Market’s ‘passporting’ arrangement, the Committee has asked the Government to clarify without delay the details of its proposal for a new UK-EU financial services agreement. While negotiations on the future economic partnership are not yet concluded, and in light of the continued application of the EU acquis during the transitional period, the Committee will continue to assess the political and legal implications of new EU financial services legislation.

Previous Committee Reports


67 The Single Supervisory Mechanism applies to large banks in the so-called “Banking Union”, which is compulsory for Eurozone countries but voluntary for non-Eurozone countries. At present, none of the latter have chosen to participate.

68 See our Report on Banking Reform of 21 February 2018. The proposed IPU requirement would apply to both banks and investment firms insofar as they are covered by the Capital Requirements Directive.

69 Explanatory Memorandum submitted by HM Treasury (22 January 2018).

70 The others include recent proposals on location requirements for clearinghouses, additional capital requirements for large UK banks with EU operations, and centralised EU-level supervisory responsibilities for non-EU providers of capital markets services seeking to access the EU market.

71 The EU has proposed the transition should end by 31 December 2020, but both the Prime Minister and the Secretary of State for Exiting the EU have indicated a longer period may be needed.

72 Letter from John Glen to Sir William Cash (31 January 2018): “The Chancellor has been clear that these [equivalence] regimes would not support the scale and complexity of trade in financial services that exists between the UK and the EU. (…) The UK and the EU will need to agree a new process for conducting cross-border business”.

73 E.g. UK Finance, “What is ‘passporting’ and why does it matter?“ (accessed 20 February 2018).

74 See for example “Collaboration instead of rivalry: thoughts on a digital financial centre of Europe“, a speech given by Professor Joachim Wuermeling, Member of the Executive Board of the Deutsche Bundesbank on 15 February 2018: “Financial institutions domiciled in the United Kingdom must be prepared to shift any continental business that can no longer be carried out from there to the EU. (…) Large foreign institutions could also move parts of the value chain back to their home countries, or business with continental European clients could simply be discontinued entirely if an EU presence is not worthwhile. (…) As a result, Brexit could, at least in theory, reduce the range of financial intermediation services available in the EU, weaken institutions’ productivity, and reduce market depth. In a nutshell, it could entail higher costs.”

75 Mansion House Speech by Philip Hammond (September 2017).

76 Letter from John Glen to Sir William Cash (31 January 2018): “The Chancellor has been clear that these [equivalence] regimes would not support the scale and complexity of trade in financial services that exists between the UK and the EU. (…) The UK and the EU will need to agree a new process for conducting cross-border business”.

77 Financial Times, “UK aims to keep financial rules close to EU after Brexit“ (16 February 2018).

79 See for example: Similarly, for the German Bundesbank, Dr Andreas Dombret, “The future relationship between Germany and the UK in finance after Brexit“ (8 February 2018). The latter said: “I am sceptical as to whether the mutual recognition framework proposed is actually 100 percent feasible. By giving substantial powers to technical cooperative committees of supervisors, it would most likely undermine national sovereignty and democratic legitimacy—thereby crossing the UK’s red lines and also infuriating those critical of the EU for undermining national parliaments.”

80 The EU does operate a non-harmonised mutual recognition principle for goods, under which any product not subject to harmonised Single Market rules which is lawfully sold in one EU country can be sold in another. This is possible even if the product does not fully comply with the technical rules of the other country. Most trade in goods within the EU is in harmonised goods for which EU technical rules exist, such as chemicals, pharmaceuticals and vehicles. There is no general principle of mutual recognition of services within the EU.

81 For example, the Credit Requirements Regulation; the Markets in Financial Instruments Regulation; the Market Abuse Regulation; and the Prospectus Regulation.

82 Notably, CETA’s MFN clause would be triggered unless the EU’s preferential agreement with the UK created an internal market (which would have to encompass services, capital and persons); creates a right of establishment, which in itself does not entail a right to provide cross-border services as sought by the UK; or requires the approximation of legislation (either the UK’s acceptance of EU law, or a process for setting regulation jointly).

83 See for more information the EBA’s 2015 Report, “Report on Investment Firms“ (Other important host countries for EU-based investment firms are Germany, France, the Netherlands and Spain.

85 Banks which provide investment services are also subject to MiFID, aligning the conduct of business requirements for the provision of investment services between investment firms and credit institutions.

86 UK Finance has identified nine different passports, “each covering a different sort of financial service, including core banking services such as lending and deposit taking, market services such as sales and trading, asset management, payments services and electronic money services”.

88 Investment firms have been subject to EU prudential rules since 1993, the year in which the first EU framework governing the activities of investment firms entered into force. See Council Directive 93/22/EEC on investment services in the securities field.

89 Directive 2013/36/EU on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms.

90 Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms.

91 EBA, “Report on investment firms“ (15 December 2015).

95 See European Banking Authority Opinion EBA/Op/2017/12 (12 October 2017).

96 This mirrors the structure of the capital requirements framework for banks, which also consists of a Directive and a Regulation.

97 A branch in this context is a place of business which is a part of an authorised investment firm, but which has no legal personality of its own and is not subject to separate authorisation.

98 Explanatory Memorandum submitted by HM Treasury (22 January 2018).

99 The EFTA-EEA countries Norway, Iceland and Liechtenstein will be expected to incorporate the legislation under the EEA Agreement after it is adopted by the EU.

100 €1 = £0.88723 or £1 = €1.12710 as at 29 December.

101 Underwriting is a commitment to take up on own books financial instruments when others do not buy them.

102 An investment firm deals on own account when it trades in financial instruments against its own proprietary capital.

103 However, the EBA has stated that its data is biased towards Class 2 firms since smaller firms (prospective Class 3 firms) contributed less data to its survey of the investment firm population in the EEA.

104 Regarding the scale of the activities which are expected to be relocated to the Eurozone, the Commission says there are “some indications to suggest that over time this will constitute a sizeable share”. It refers to research published by the Bruegel think tank, which estimates that “35 percent of London wholesale banking is related to EU27-based clients, varying from about one fifth for UK-headquartered banks to a third for US-headquartered banks and half for EU27-headquartered banks. Thus, about €1.8 trillion (or 17 percent) of all UK banking assets might be on the move as a direct consequence of Brexit”.

105 See our Report on Banking Reform of 21 February 2018.

106 See for more information on the Single Supervisory Mechanism our Report of 21 February 2018 on the European Deposit Insurance Scheme.

107 EBA Opinion on investment firms (September 2017), Recommendation 4: “In order to identify Class 1 firms, the EBA should develop dedicated Level 2 Regulatory Technical Standards in order to carry out such identification, taking into account the specificities of investment firms”.

108 The Commission also considered amending the criteria for being identified as a global or other systemically important institution (G-SII/O-SII), which should continue to fall under CRR/CRDIV could be tightened to ensure systemic firms are effectively caught and Member States’ discretion to designate them is reduced. However, it concluded that, while this would have the advantage of making the G-SII/O-SII criteria more tailored for investment firms, “it could involve an extensive and lengthy examination of the criteria, with little work and consensus achieved so far on what these changes should consist of. It would also involve revisiting provisions which were difficult to agree in the current framework. Even if the changes did not affect the designation of banks and were limited to investment firms, tightening the O-SII criteria to minimise some more subjective and discretionary elements could be controversial for many Member States keen to retain the flexibility of the current framework. The current level of discretion was a conscious choice by the legislators considering that the O-SII framework was conceived as a macroprudential tool.”

109 Under a separate legislative proposal to amend the capital requirements framework for banks (which currently also covers investment firms), non-EU systemically-important institutions (i.e. including class 1 investment firms) would be required to establish an intermediate parent undertaking (IPU) within the EU, if they held assets exceeding €30 billion. See our Report of 21 February 2018 on banking reform for more information.

110 See Commission Impact Assessment SWD(2017) 481, p. 20. New risks included, which are not covered by the CRR, include assets under management; client money held; and daily trading flow.

111 Class 3 firms will remain subject to the governance requirements laid down in MiFID II, but would not face any additional requirements in this area under the Commission proposals.

112 For example, firms whose capital requirement would more than double under the new rules would be able to initially limit that increase to double their current capital requirement for a period of five years after the new regime takes effect.

113 AFME, “AFME welcomes Commission proposal for new prudential regime for investment firms“ (20 December 2017). AFME’s members include Bank of America, Deutsche Bank, HSBC and Standard Chartered.

114 Under MiFID, retail investors can elect to be treated as a “professional client”, which would allow them to invest in certain types of products that are not open to retail investors because of their risks or complexity. However, in doing so they also waive some of the regulatory protections afforded to retail investors.

116 Per se professional clients are those “who possesses the experience, knowledge and expertise to make their own investment decisions and properly assess the risks that it incurs”. They include large companies, national and regional governments, and financial institutions. They typically enjoy less regulatory protection than retail clients. See section I of Annex II to Directive 2014/65/EU.

117 Eligible counterparties under MiFID are the most sophisticated type of market participant, including most types of regulated financial institution (e.g. banks, insurance companies and investment firms).

118 There is not currently any equivalence decision under article 47 MiFIR, as the Regulation only took effect in January 2018.

119 Article 61 of the proposed Regulation: “Where the services provided and the activities performed by third-country firms in the Union following the adoption of the [equivalence] decision (…) are likely to be of systemic importance for the Union, the [the third country’s] legally binding prudential and business conduct requirements (…) may only be considered to have equivalent effect to the [EU’s] requirements (…) after a detailed and granular assessment. For these purposes, the Commission shall also assess and take into account the supervisory convergence between the third country concerned and the Union.”

120 This view is shared by UK Finance, which has said: “Securing an equivalence judgement from the EU can be a time-consuming and complicated process potentially lasting a number of years. Nor is it entirely divorced from political considerations”.

121 This decision was approved by the Member States only because an equivalence regime needed to be in place before MiFID II took effect in early January, or cause disruption to existing arrangements. It has since been reported that a number of EU countries have complained to the European Commission about forcing through the temporary equivalence decision at short notice.

122 UK Finance, “What is ‘equivalence’ and how does it work?“ (accessed 16 February 2018).

123 Idem.

124 For example, Annex IX to the EEA Agreement with Norway, Iceland and Liechtenstein and Appendix XVII-2 to the EU-Ukraine Association Agreement both provide for full Single Market participation but in return for acceptance of EU law. With respect to the latter, once Ukraine has fully applied the EU financial services acquis, it can be granted “internal market treatment“ which would effectively give its financial services providers the same passporting rights as EU-EEA firms.

125 Under MiFID, where a client which requests services on their own exclusive initiative, there is no requirement for a third-country investment firm to set up a branch (in the case of a retail or elective professional client) or register or be authorised by ESMA (in the case of professional clients or an eligible counterparty). For its potential use post-Brexit, see for example

126 See Although the paper focuses on reverse solicitation for the banking sector, its overall conclusion is that “the combination of outright prohibition, legal uncertainty and regulatory hostility does not provide a sound foundation on which to base a business model for banking”.

127 See Article 16(5) of Directive 2014/65/EU.

5 March 2018