On 29 March 2017, the UK Government served formal notice under Article 50 of The Treaty on European Union to terminate the UK's membership of the EU (following the June 2016 UK referendum on EU membership). Based on Article 50, the EU Treaties shall cease to apply to the UK and the UK exit will take effect in March 2019 (subject to the unlikely possibility of the withdrawal agreement being concluded sooner and unless all Member States agree to extend the period). Negotiation of a new trade agreement with the EU could take several years beyond 2019 although the Prime Minister has declared the objective of achieving such an agreement within the two-year period. In the aftermath of the referendum result and notice being served under Article 50, financial services businesses are concerned about the impact of Brexit on London's financial services sector. Will London’s status as a world-leading FinTech hub be affected?
It is difficult to predict what impact Brexit will have on the FinTech scene until the UK has negotiated its reformed relationship with the EU.
However, it is certain that the Brexit vote and notice to leave has generated uncertainty about the future of European integration which creates challenges for FinTech start-ups and incumbent financial institutions (incumbents). There are now question marks over: (1) the UK's continued access to the single market and "passporting" rights; (2) access to top quality talent; and (3) access to investment for FinTech businesses to grow, which we consider in this article.
Accessing the single market and passporting rights
From listening to our clients, one of the key priorities for the UK financial services sector is to retain access to the single market and passporting rights in financial services.
Currently, an incumbent (e.g. bank, insurance company or asset manager) established in any EU or European Economic Area (EEA) member state may exercise a "passport" to provide its services from its home state (where it has obtained authorisation to carry on permitted activities) to any other EU or EEA member state. This means, crucially, that it does not have to obtain individual authorisation in each state.
London's status as a world-leading FinTech hub has taken years to build, with over half of European FinTech "unicorns" (e.g. Transferwise and GoCardless) based in the UK. It is based on a number of factors that are difficult to replicate elsewhere: strong government backing, a pragmatic regulator, excellent workforce, stable legal system and access to liquid capital markets. Consequently, many international banks (EU and non-EU) have established in London, utilising passporting rights to provide services across the EU and EEA.
Once Brexit occurs, unless the UK has secured the status of an EEA state (for many commentators, the next best option after EU membership which will ensure the UK's continued access to the single market) or negotiated a regime equivalent to the current passport to retain access to the single market for financial services, many incumbents that rely on the ability to become authorised to perform certain regulated activities in the UK to then perform such activities across the EU and EEA markets will not be able to do this. They will therefore need to contemplate either creating a subsidiary which becomes independently authorised in an EU state to continue to conduct their European business or look to relocate within the EU.
One of the most important pieces of EU legislation in the world of finance is the Markets in Financial Instruments Directive (MIFID). MIFID allows banks in an EU member state to carry on business and sell services throughout the EU without having to obtain individual banking licences in each state. As a result a lot of international banks (EU and non-EU) have set up in London – they can then access the single market by relying on their UK authorisation.
Whilst access to the single market is undoubtedly a priority, it is (generally-speaking) more of a concern for incumbents. Many FinTech start-ups operate business models that are not reliant on passporting: they operate in domestic or non-regulated markets (or in sectors that are subject to a light-touch regulatory regime such as peer-to-peer lending ) or are reliant on selling products or services to incumbents rather than on being regulated themselves. Even so, a lack of access to the single market is not great news for FinTech start-ups. During this period of uncertainty, many of these businesses may turn their attention to geographies outside the EU, such as Asia-Pacific or the United States, to continue to grow.
Some FinTech start-ups operate more regulatory driven business models. For example, "regtech" start-ups that provide services to banks to ensure they stay on top of their regulatory requirements. If their customers relocate to EU financial centres, these businesses may need to relocate as well to be close to their customers. The silver-lining may be that the uncertainty triggered by Brexit leads to more compliance requirements on their customers, hence more business for the reg-tech start-ups (albeit unanticipated!).
Talent and investment
Continued access to top quality FinTech talent, many of whom are European, and investment needed to scale is more of a concern for FinTech start-ups.
The UK start-up scene has been nurtured by skilled workers' willingness to move to London. Continued access to talent is important for London FinTech businesses to compete with other hubs across the world including New York, San Francisco and Berlin to provide high quality products and services to customers.
Greater control over migration from EU countries may, arguably, help the UK to pick and choose the best people to enter the country. A new UK immigration policy could also open doors to greater migration of skilled people from the Far East and the US – allowing specialists from these markets to help fill skills gaps in the UK. However, the key is not just to ensure that this new policy of continued access to talent is satisfactory, but also to provide assurances to the existing EU citizens living in the UK. It seems highly unlikely that EU citizens living in the UK will be required to leave, but the negative press impact of uncertainty in this area could impact on the UK's ability to attract new talent.
Investment is important to enable start-ups to grow. In the short term, there is an understandable fear that the flow of capital to the UK may slow down as investors worry about investing in FinTech start-ups, especially businesses whose business models are reliant on EU membership and are obstructed from seamlessly scaling into European markets.
However, as mentioned above, many FinTech start-ups operate in non-regulated or light-touch regulatory regimes. Our research indicates that the venture capital market is committed to FinTech and the London ecosystem which, for the reasons set out above, makes it a difficult ecosystem to replicate elsewhere. An investor will be unlikely to reject the opportunity to have a stake in a great business even in an uncertain market. Great business will always get funding that they need: Skype, Google and others were created in the midst of the dotcom crash after all!
The right model
In the short term, the uncertainty over the UK's access to the single market will cause disruption and negatively impact the FinTech market. Uncertainty is never good for businesses and/or regulators and the best option is for the UK Government to lobby for access to the single market and passporting rights in financial services. This means choosing (and agreeing with the EU) the right model to maintain this access and right.
The risk is, if the chosen approach is not advantageous for UK-based FinTech, the UK's competitive advantage will be lost. Access to passporting, talent and investment will be restricted or non-existent. There are plenty of European hubs waiting in the wings to take London's crown: a recent EY survey named Berlin as Europe's start-up capital and Dublin - with its English language, common law regime and skilled workforce - represents a strong alternative. Even the former socialist president of France, Francois Hollande, was batting his eyelashes at London's financial services sector – the potential for many well-paid employees and large banks to move from London to Paris to rekindle the eurozone's second-largest economy is just too massive an opportunity to miss!
In the short term, and assuming the UK adopts a model broadly equivalent to EEA membership to guarantee access to the single market, the UK should aim to ensure convergence with EU regulations to avoid businesses having to comply with a double regulatory regime (one for the UK and another for doing business in the EU). We think convergence is likely: the UK regulators (the FCA and PRA) have been influential in the design of key EU Directives such as Solvency II and will be slow to reject rules they have helped to shape. Also, maintaining regulatory equivalence is the only way UK firms can maintain access to the single market in financial services (membership of the EEA would require this).
In the medium to long term, once certainty is restored in terms of what model the UK will adopt, we expect there will be a restoration of confidence. Then there may be the opportunity for the UK to partner with other regulatory centres that it shares close ties with, such as Singapore and Australia, to create an environment which improves on the EU regulatory regime when doing business between these markets. Another welcome change could be the relaxing of some of the EU rules in favour of a more “regulation-light” environment in areas such as the use of cloud services that many incumbents and FinTech start-ups think is too restrictive. This would allow the UK and these other regulatory centres to make their own policy and build regulatory bridges to the largest financial market in the world – the US. It could also facilitate them forming an influential group to lobby the EU to accept changes to EU regulation to the extent services are provided in the EU market.
This article is part of our Brexit series