Brexit and the future of the Capital Markets Union

Banking & Finance analysis: Peter Workman, partner at PwC, discusses the impact of Brexit on the UK’s participation in the Capital Markets Union (CMU) project.

What is the CMU?

CMU is an initiative launched by the European Commission back in 2014.

  1. reduce the existing barriers to cross-border investment in the EU
  2. increase the funding options available to companies (in part by reducing the existing over-reliance on bank lending), and
  3. reset the post-financial crisis regulatory framework which governs European capital markets

Deeper and more integrated capital markets should lower the cost of funding and make the financial system more resilient in the event of another financial crisis.

There is no single measure that will deliver CMU. Instead, there will be a series of steps that, cumulatively, will achieve CMU. The Commission intends to implement measures to systematically identify and then remove the existing barriers that stand between investor’s capital and investment opportunities, and the obstacles that prevent businesses from reaching investors. CMU intends to make the market for movement of those funds as efficient as possible, at both the Member State and EU level. The Commission intends to use a mixture of legislation, regulation, supervision, enforcement, and market-led response to remove the existing barriers.

Following the UK’s historic decision to leave the EU, question marks are now raised as to:

  1. whether the CMU is likely to remain a political priority for both the UK and EU
  2. the likely impact on the CMU project of the UK’s vote to leave the EU, and
  3. assuming the CMU project does proceed, whether the UK will still be able to participate

How will the UK’s vote in favour of Brexit impact the CMU?

As the bloc’s largest financial centre the UK (specifically the City of London) was expected to play a central role in the EU’s CMU project, as well as being one of its biggest beneficiaries. The UK’s vote in favour of Brexit has a range of potential impacts on CMU.

Market uncertainty and volatility

In the immediate aftermath of Brexit, stock indices in the UK and across the EU tumbled. Although markets have to some extent recovered from the initial losses, and, although some stability has been restored in the UK by the Conservative Party acting quickly to form a new government, uncertainty remains and will persist until the terms of the UK’s exit from the EU have been finally settled. The time line for the terms of the UK’s exit being agreed is itself uncertain. However, it will be at least two years from the date on which notice to leave the EU is formally served by the UK under Article 50 of the Treaty on European Union. The effects of this uncertainty are unclear, however, one of the inevitable consequences is that any associated costs will be passed onto consumers.

Uncertainty over the future of the CMU project

Efforts to achieve a bigger and more integrated European capital market under the banner of the CMU project will inevitably be disrupted by the UK’s Brexit vote. The resignation of Lord Hill, the UK’s EU Commissioner who had been leading the CMU project, in the immediate aftermath of the Brexit vote was a dramatic illustration of the potential disruption that lies ahead for CMU. At this stage it is impossible to predict how CMU will progress from this point. Whether CMU gathers pace, changes direction or stalls completely, in each scenario inevitably there will be disruption for investors, issuers and the UK and European economies. In addition, whereas previously the UK had been the driving force at the heart of CMU, going forward the UK’s ability to influence the agenda, shape and direction of CMU is likely to be significantly diminished and, therefore, the UK is likely to find itself in the undesirable position of having no say in regulation that it will still have to adopt in order to maintain access to the single market.

Potential loss of passporting rights

A number of financial institutions (including banks, asset managers, private equity houses and hedge funds) quickly identified the potential loss of passporting rights as one of the most challenging aspects of the Brexit vote. Passporting allows firms authorised and incorporated in one EU jurisdiction to set up and conduct business in other EU jurisdictions without being subject to additional regulatory burdens. As a result, many firms are already looking at how to mitigate the effects of the loss of such rights by exploring options such as setting up subsidiaries in other EU Member States.

Divergence of EU and UK regulation

While the current regulations governing EU capital markets and financial institutions may well be far from perfect, the alternatives in a post-Brexit world look even less attractive. There appears to be a general consensus that, despite its imperfections, EU financial regulation broadly provides a predictable and consistent regime which on the whole gives clarity and certainty for market participants. Certainly, the current EU regulatory landscape is more palatable than 28 different rule books or even separate EU and UK regimes—both of which would increase the costs and complexity of doing business on a pan-European basis. Although wholesale repeal of EU financial regulation by the UK is unlikely, what may happen in practice is a gradual divergence of UK and EU regulation which would increase costs for market participants. There is also then an associated danger of divergent approaches to enforcement of regulation not only between the UK and EU but even as between Member States of the EU.

Reduced access to talent

Free movement of labour within the EU allows access to a wider pool of talent for businesses without the need for visas or work permits which reduces costs for customers. Brexit now casts doubt over whether EU nationals would retain current rights to work in the UK should they change or lose their jobs.

Is the CMU project likely to remain a political priority?

Whether the CMU project in its current form remains a political priority post-Brexit remains to be seen. CMU aside however, given how interconnected and interdependent the UK and EU capital markets have become what will remain a political imperative (for both the UK and EU) is to ensure that these capital markets continue to function effectively and harmoniously in the post-Brexit world. The CMU itself is not a single piece of legislation or regulation, rather a framework for proposed reform to remove existing barriers to a harmonised European capital market one-by-one. As such, whether CMU continues or not isn’t binary and there are certain aspects of CMU which look to be beneficial and worth continuing. The overriding aim of CMU is to break down barriers, reduce costs and increase competition and choice which can only be a good thing for businesses and consumers alike. CMU also serves as an overdue stocktake of the raft of legislation and regulation that has been implemented in the period following the 2008 financial crisis to determine that such legislation is working as intended and that it is still required. Certain specific areas have also been identified by CMU as potentially benefiting from revival and reform including:

  1. the facilitation of cross-border venture capital activity
  2. the revival of the European securitisation market, and
  3. harmonisation of the currently vastly differing European insolvency regimes

The process of redrawing the lines between the UK and EU capital markets promises to be a lengthy, costly and complex exercise. Although CMU may not continue in its present form and direction there are undoubtedly worthwhile principles and proposed reforms at the heart of CMU which may prove useful when it comes to the UK and EU reshaping the capital markets regime in the wake of Brexit.

Assuming the CMU goes ahead will the UK be able to be a party to it?

As already stated, CMU is not a single piece of legislation or regulation and as such the level of the UK’s involvement in CMU is likely to be driven by what post-Brexit model for relations with the EU the UK is able to negotiate. Many market participants would support a model similar to that of Norway. The main reason offered in support of a Norwegian model is that it would represent the closest level of access to and integration with the single market to that which the UK enjoys today. In theory, the Norwegian approach promises to cause the lowest levels of disruption, uncertainty, volatility and costs and could be relatively speedily negotiated with the EU.

On closer examination, however, in return for the level of access to the single market, Norway allows free movement of labour from the EU, makes significant contributions to the EU budget and is forced to implement EU regulation without the ability to have very much say into the content of such regulations. Query therefore whether the UK government would in reality seek to negotiate a deal that would in substance be very similar to the one which the British public rejected in the referendum of 23 June 2016. An alternative may be an approach similar to that of Switzerland whereby access to the single market is negotiated separately for different sectors on a bilateral basis. The benefits of the additional control this approach would bring may, however, be outweighed by the amount of time such negotiations would take and the associated additional prolonged period of disruption and uncertainty this would cause.

Regardless of whichever approach the UK takes what seems certain is that it will be forced to broadly follow the EU regulatory framework in order to retain access to the single market. As such some level of continued participation in CMU, at least in terms of any regulatory reforms, seems inevitable regardless of the UK’s actual preference.

Peter Workman focuses on buyouts, buy-ins and general M&A, in sectors including retail and leisure, telecoms, technology and media, and energy and infrastructure. Peter advises a broad range of clients, including corporates, private equity sponsors, management teams and financial institutions.

Interviewed by Barbara Bergin.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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