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31 July 2017

Brexit: ESMA tightens screw on Asset Manager cross-border delegation rules

ESMA has provided new guidance for national regulators on how to treat the delegation of functions post Brexit. With Asset Managers facing the loss of passporting rights, the prospect of delegating crucial front office roles back to London from an EEA entity offered the industry insulation from the Brexit challenges faced in other financial sectors; most notably in Banking and Markets and Trading.

However ESMA’s new guidance for regulators seeking to regulate the Undertaking for Collective Investment in Transferable Securities (UCITS) and alternative investment fund manager (AIFM) companies appears to contradict this assumption. The guidance strengthens the requirements for Asset Managers to maintain a significant presence within the EEA and reduces the size and significance of activities capable of being undertaken by a delegate.

ESMA’s guidance can be condensed into three demands:

  1. Effective Oversight -The guidance ensures that any EEA entity wishing to outsource critical functions, such as portfolio management, to a delegate in London must maintain sufficient resources and expertise to ensure effective oversight of the outsourced function. The guidance thus precludes the removal of critical supervisory functions and demands a presence of significance and experience in regards to its directors and middle office capabilities.
  2. Letter Box Provisions - ESMA sets out more colour in regards to its “Letter box” provision. Both UCITS and AIFMD explicitly rule out the hollowing out of EEA entities, via the outsourcing of functions, to the extent that they become mere brass plague or “letter box entities.” The guidance delivers more detail in regards to what constitutes a letter box entity by articulating that firms should not outsource substantially more portfolio management activity than is undertaken by the EEA entity itself. This, by definition, would seek to limit the amount of front office activity outsourced to a UK delegate in a post Brexit world.
  3. Justified and Objective Criteria - Concerningly for UK-based investment firms, ESMA also demands that national regulators question whether the delegation of activities to non-EU entities is “objective and justified” given the geographical location of the firm’s clients. As such, UK-based Asset Managers with a large percentage of EU clients may struggle to justify funds being managed from outside of the EU post Brexit.

Dissecting the Guidance

The importance of “delegation” has grown significantly since the UK’s intention to leave the Single Market ruled out the continuation of the passporting regime post Brexit. Passporting rights enable UK-based Asset Managers to market funds on a cross-border basis to clients across the EEA without the need for alternate presences or authorisations.

The widespread use of the delegation model, whereby funds domiciled in EEA locations such as Ireland and Luxembourg are managed from a London delegate, offered an alternate method of cross-border supply; seemingly insulating the industry from much of the Brexit fallout.

What does this mean for Asset Managers?

As the wider political landscape continues to provide little certainty, Asset Managers now face additional considerations on how to respond. 

ESMA’s guidance on delegation appears to limit the ability of UK-based Asset Managers to access EEA clients from London. As such, the size and significance of any Brexit-induced EEA entities may need to be reconsidered in order to ensure compliance by 2019.  Firms should expect tougher authorisation processes and a renewed emphasis on the “substance” of any delegated functions. Firms should, therefore, prepare for potentially higher levels of role moves and employee disruption.