It has taken nearly nine months for the UK government to invoke Article 50, thereby setting off the process by which the country will leave the EU. While many financial services firms would have preferred to maintain Single Market access, it became abundantly clear this would not be possible in the face of strong political opposition.
For fund managers, the loss of Single Market access raises uncomfortable questions. Some have openly expressed apprehension about being cut-off from the EU, which will deprive them of the right to sell or market their funds into the mainland without barriers or restrictions. Any firm that set up a UCITS or AIFM in the UK to distribute into the EU will lose their passport.
All UK UCITS or AIFMs will be classified as third country managers irrespective of whether they fully comply with these Directives. A handful of firms explored whether innovative EU master-feeder structures could be created to offset third country designation, but lawyers have roundly dismissed such ideas as fanciful.
In addition, regulators have warned UK managers that substance is unconditional if they wish to continue to take advantage of the passport. Setting up a letterbox entity and delegating processes back into the UK will not be accepted. It is reported regulators in Luxembourg are said to be particularly alert to this risk.
Those major asset managers with large quantities of EU investors are setting up subsidiaries and branches in EU fund domiciles such as Ireland and Luxembourg, but most are sitting tight. The majority of firms are reluctant to add significant costs to their balance sheets by relocating to an EU country.
Brexit is potentially a plethora of hypotheticals, and until there is a degree of clarity over the outcome, firms should avoid rash moves. Most fund managers are nimble unlike the banks and market infrastructures, and can afford to hold off executing their Brexit plan for the time being. However, fund managers ought to have a contingency plan in place to deal with any eventuality.
Talking to lawyers or service providers in EU fund centres is recommended, and investors should be kept fully notified of any conversations. Certain investors – such as EU institutions – will be particularly sensitive to matters on Brexit. A failure to coherently inform and communicate with clients on Brexit could have negative implications.
So what issues should fund managers be thinking about between now, and the supposed 2019 conclusion of Brexit talks? Firms should certainly not be disregarding their EU regulatory obligations. Rules such as the Markets in Financial Instruments Directive II (MiFID II) will be introduced in 2018, and compliance efforts should not be watered down.
The UK Financial Conduct Authority (FCA) has been a key driver behind MiFID II, and it will not be impressed if firms avoid their compliance responsibilities. Testing the FCA’s patience – given recent public statements and reports – would not be a sensible strategy for asset managers.
Nonetheless, there is a problem as to what managers will do when rules are being proposed by the EU during the Brexit negotiation process. Some firms have questioned whether they will need to work towards complying with EU proposals in the interim, which post-Brexit may not be enacted by the UK government, or interpreted in a different way.
This is complicated further as Brexit talks could go on much longer than anticipated. Many believe some sort of transitional arrangement will be negotiated, which should help manage business continuity risk to a degree. As such, it is likely that any transitional requirements will oblige financial institutions in the UK to adhere to EU rules until Brexit is fully realised.
In addition, the UK government has alluded that it is hopeful equivalence for financial institutions can be achieved post-Brexit, and this means domestic law has to be comparable to that of the EU. The UK is unlikely to do away with existing or incoming EU directives if it is serious about meeting equivalence. This implies that post-Brexit, there will be some similarities between UK and EU law. Arbitraging or heavily conflicting regulations post-Brexit will just add to fund managers’ costs, and this is in nobody’s interests.
It is clear that Brexit will be challenging for asset managers and fund managers should be conducting regular assessments and analyses on Brexit outcomes and the impact it will have on their businesses, and this should be shared with investors. Firms should be engaging with regulators during this period of transition and change. Investors will not look kindly on managers who fail to approach their Brexit planning thoughtfully and without due consideration.
The UK Financial Conduct Authority (FCA) has been in a pugnacious frame of mind lately. Its AMMS review published in November 2016 was a stern warning to active managers, criticising their fee structures and return generation in comparison to cheaper passive alternatives. On March, 3, 2017, the FCA issued a robust indictment of commission dealing arrangements, based on a sample study of asset managers.
Four years have elapsed since the UK financial services regulator published its “Dear CEO” letter, and over two years have passed since the FCA outlined changes to COBS 11.6 covering the use of dealing commissions. These changes required asset managers to minimise customer charges via commission payments, and prevent firms from obtaining non-eligible goods and services from sell-side brokers in exchange for client dealing commissions.
Despite this, the FCA believes the majority of asset managers in its study have fallen short of expectations. In a strongly worded statement, the FCA said firms had not met its standards in a number of areas including verifying whether research goods or services are substantive; attributing a price or cost to substantive research if they receive it in exchange for dealing commissions, and recording their assessments to demonstrate they are meeting COBS 11.6.3R, and not spending excessive client money.
“We expect to see clearly documented evidence to support the acquisition of permitted goods and services. In subsequent reviews we will also seek confirmation of boards demanding satisfactory management information on the subject. Firms are required to have adequate systems and record keeping processes,” read the statement.
The FCA also said that many firms were unable to demonstrate meaningful improvements to their processes. In extremis, the FCA said a handful of firms were still deploying dealing commissions to purchase non-permissible items like corporate access and market data services.
“The majority of firms continued to treat the receipt of corporate access from brokers as a free provision. Where these firms also operated limited controls and record-keeping over research expenditure, this leaves them exposed to the risk that corporate access or other non-permissible services might still influence the allocation of dealing commission expenditure. Some firms failed to record details of corporate access meetings and in some cases, had to rely on estimates when responding to our questions,” it read.
The FCA warned that continued breaches would be met with regulatory intervention. A failure to act could result in serious reputational damage for impacted managers. The FCA also criticised the research budgeting process at asset managers, citing firms with an absence of a research budget process had research spending levels closely correlated with trading volumes.
Nonetheless, the FCA acknowledged improvements had been made with 79% of organisations in the regulator’s sample using research budgets compared to 34% in 2012. A failure to budget researching spend properly can lead to wastage, and may result in firms being in breach of FCA rules requiring organisations to act in the best interests of their customers. “Greater scrutiny around budgetary requirements, including a comprehensive approach to valuing research, could result in lower costs and/or a more efficient use of dealing commission. This in turn may lead to better returns for investors,” read the FCA statement.
The FCA did have praise for firms where thoughtful research budgeting was implemented, with some organisations benchmarking their spend against external sources to validate value for money. Other firms, added the FCA, switched to execution-only arrangements once their periodic research budgets hit a certain threshold.
A handful of firms cover the cost of externally produced research from their own resources as opposed to using dealing commissions. The FCA said this reduces conflicts of interest, and enhances transparency about the charges clients pay. Such a policy also helps ensure best execution, while research will only be purchased if warranted. This means firms will buy better albeit less research.
Smaller firms are naturally concerned by the likely added research costs, not to mention the provisions outlined in the Markets in Financial Instruments Directive II (MiFID II). Asset managers have a fiduciary duty to work in the best interests of clients, but if firms are unable to afford quality research, it could deter them from executing certain trades. This would potentially undermine performance and investor returns.
Most UK fund managers are trying to reconcile quite what leaving the Single Market – as outlined by Prime Minister Theresa May – means for their business. Single Market withdrawal means the right to unequivocally distribute funds – whether they are UCITS or AIFMs – into the 27 EU member state countries looks precarious, and this concern has understandably dominated Brexit discussions among managers at industry events. This is fair enough but a growing band of buy-side firms with heavy OTC exposures are now fretting about the impact of euro-denominated swaps clearing moving from London to the EU – possibly Paris or Frankfurt.
The vice-chairman of BlackRock recently told Reuters that he could not visualise euro-denominated clearing taking place in a non-EU jurisdiction. Any forcible resettlement of these transactions would hurt the UK, particularly as it controls around 70% of euro denominated clearing, far more than second placed Paris, which holds just 11%, according to Bank for International Settlements (BIS) data from 2013. The UK has fought off similar challenges from the ECB before – successfully – having argued in European courts that location policy went against the EU’s Single Market principles allowing for free movement of goods, people, services and capital.
As the UK has confirmed it no longer wants to be party to the Single Market and those governing principles, the ECB is naturally having another stab at redrawing the boundaries for euro-denominated clearing. Benoit Coeure, a member of the ECB’s executive board, said that euro-denominated clearing’s presence in the UK was contingent on whether the country developed a sufficiently robust regulatory framework, something he conceded would be challenging. He added the UK’s market dominance was a result of solid cooperation with the Bank of England and the ECB, which was based on a foundation of EU law under the authority of the European Court of Justice (ECJ). The rejection of the ECJ by the UK puts this at threat.
The ECB is certainly within its remit to make a play for euro-denominated clearing, but it could have negative ramifications elsewhere. Firstly, the euro – like the USD, Pound Sterling and Japanese Yen – is a global reserve currency meaning it is traded and cleared all over the world. If euros can only be cleared in mainland Europe, it could result in tit for tat reprisals, which will simply exacerbate protectionism. A land-grab for euro denominated swaps clearing by a Eurozone economy would infuriate non-Eurozone EU countries. It could also prompt legal action from aggrieved non-EU banks and CCPs. In short, any regulatory attempt to prise business away from the UK – which is clearly where the derivatives market wants to be – would be counterproductive and highly complex.
Most importantly, a protectionist OTC clearing policy by the ECB would be very costly for derivative users, particularly if markets become fragmented. The costs would not just be borne by UK asset managers, but firms and investors within the EU, and globally. Unfortunately, rational behaviour should never be taken for granted, particularly given the factitious disorder that may result through Brexit. Asset managers and their investors will face a massive rise in operating costs of euro denominated swaps clearing if the process is decentralised. The European Market Infrastructure Regulation (EMIR), which the UK has fully enacted, obliges firms to clear vanilla OTC contracts through CCPs. As part of this, fund managers need to post initial and variation margin to CCPs so that transactions are fully collateralised were a counterparty to fail. Collateral must be high quality and variation margin calls will be cash only.
A fragmented clearing set up would mean firms would have to make more margin calls to a greater number of CCPs. Obtaining collateral that is suitable for CCPs is not always easy, and it is particularly challenging during stressed markets. As such, firms would see a jump in their clearing costs to potentially unsustainable levels. The lack of a centralised clearing venue would also mean cost benefits through netting and portfolio compression could be lost. The costs may be so great that some managers exit OTCs, or worse stop hedging transactions properly. Others may simply enter OTC transactions in lesser regulated markets.
Optimists believe the UK – having implemented EMIR to the letter of the law – ought to have no problems obtaining equivalence. Even so, equivalence is far from perfect as it can be arbitrarily taken away by EU policymakers. If UK CCPs do not receive recognition, the costs of clearing will increase for European banks as they must centrally clear OTCs through qualifying CCPs or face increased capital charges. Again, this would be a major blow for Eurozone banks and may be an unsustainable stance for EU policymakers to adopt. Any challenges to the UK’s position as a centre for clearing would be hugely damaging for both UK financial institutions including asset managers, as well as those in the EU.
Investor protection is at the core of the Financial Conduct Authority’s (FCA) Asset Management Market Study Interim Report published in late 2016, but some of its proposals could have unintended and adverse consequences for the industry. The FCA has laid down a number of recommendations including enhanced transparency of fund charges and performance and a revamping of governance standards.
Perhaps the most critical component of the FCA’s report was that it said active asset manager charges did not correlate with performance and that the sector as a whole had underperformed benchmarks after charges. It pointed out that while competition in the passive funds space had led to a race to the bottom on fees, the same had not occurred in active asset management.
Investors ultimately are paying for performance. A failure to deliver returns to investors should not be rewarded with generous fees. That being said, smaller active managers have generally outperformed larger managers for a variety of reasons. Small firms are more agile meaning they can execute trades seamlessly, something that is not always possible at a major firm. Those managers which consistently beat benchmarks and deliver good returns for investors should not be bucketed with organisations that fail to produce gains.
So what is the FCA proposing? One idea is for an “all-in fee model” covering transaction costs. The manager would – in this scenario – have to pay for additional transaction costs in the event of them being higher than anticipated. Such an approach does pose challenges, and could disadvantage investors as it may lead to some managers executing fewer trades.
While the FCA has said firms could charge for transactional costs in extremis, the likelihood is that fixed fees will increase. This will make active asset managers more expensive for end investors and potentially even less competitive. Proposals around governance are fairly prosaic and include the appointment of a board comprised overwhelmingly of independent directors. This is hard to falter as strong governance oversight is a complement to fund managers and their operational integrity.
Increased transparency forms the bedrock of EU regulations including the Markets in Financial Instruments Directive II (MiFID II) and the Packaged Retail and Insurance linked Investment Products (PRIIPs) rules. Both PRIIPs and MiFID II demand managers disclose their charges, although the FCA – according to Deloitte – is now demanding that asset managers explain more clearly the impact charges have on returns on an on-going basis and to identify the total cost of investment – including distribution – on both a pre-sale and continuous cycle.
Deloitte highlighted the FCA’s proposals would make summary cost figures more prominent and remove confusion between fund and distribution charges. Performance disclosure is another theme of the FCA, and it wants managers to be wholly transparent about whether they are meeting their target benchmarks to investors.
Competition is core to the FCA, and the regulator wants it to become easier for investors to switch products more easily if they feel they have not received value for money. Switching, however, is not always straightforward for investors and can incur charges and taxes, thereby disincentivising many from doing so. Managers point out that obtaining permission from investors to switch products is not always assured, a point that has been clearly on-boarded by the FCA.
The FCA is consulting on these proposed remedies with the industry and feedback must be submitted by February 20, 2017. The New City Initiative recommends that all of its members participate in this discussion and provide written or oral feedback to the FCA as part of this consultation.
The Alternative Investment Fund Managers Directive (AIFMD) is bedded down, and the costs have generally beenabsorbed by the asset management community without too much disruption. The European Commission (EC) is obliged to review AIFMD’s progress in 2017, but managers should not brace themselves for radical change. It is hoped that uncertainties about asset segregation rules will be settled, but remuneration provisions are unlikely to be amended. Reporting requirements under Annex IV could be reassessed although the specificities have not been laid out.
Anecdotally, there is talk that liquidity risk management and leverage rules are being tightened or at least synchronised with policy guidelines due to be outlined by the Financial Stability Board (FSB) and International Organisation of Securities Commissions (IOSCO). AIFMD is already pretty robust on liquidity risk management and requires firms to carefully document and manage it, through stress testing, for example. As such, any additional requirements should be fairly straightforward for firms to deal with.
In the meantime, it is becoming obvious that third country passporting rights are not going to happen, or at least not anytime soon. Third country equivalence – as the regimes of Guernsey, Jersey and Switzerland will not dispute – has been an exercise of endurance. Affirmation from the European Securities and Markets Authority (ESMA) that these countries met equivalence way back in 2015 has not led to any meaningful developments or substantive progress. A handful of large fund markets including the US, Hong Kong and Singapore, have subsequently been reviewed by ESMA and given a broadly positive opinion although there were some conditions.
The structure of the EU is such that approvals are required from multiple policymaking entities before anything can be actioned. Even before the market shake-up that was Brexit and the election of Donald Trump, the process was unwieldy. Brexit has prompted EU regulators to put the brakes ongranting equivalence. The AMF, the French regulator, has publicly said the EU should reopen negotiations with certain countries to guarantee reciprocity, an issue that has not been discussed in several years. In short, the passport extensions look to be on shaky ground.
The shock election of Donald Trump, who has promised a raft of deregulatory measures, could also provide an excuse for the EU to slow down on equivalence. Promises to scrap Dodd-Frank should be taken with a degree of scepticism but the mood in the US is certainly gearing towards less government intervention in capital markets as evidenced by some of the cabinet appointments in the new administration. Any revisions to the US fund regime could put AIFMD equivalence on the backburner.
APAC markets who are big buyers of UCITS will be particularly frustrated by the delays, and were notably incensed by their initial exclusion back in 2015 following ESMA’s first AIFMD equivalence opinion. This second set-back could embolden regional regimes to push more vigorously ahead with pan-APAC fund projects such as the ASEAN CIS and ARFP. Competition should always be supported, although if these fund schemes draw inflows over the next few years, some UCITS with Asian clients could struggle to win further mandates.
The EU’s renewed opposition to equivalence presents a huge issue for the UK. Admittedly, the terms of Brexit are unknown and predicting anything in today’s market is rife with challenges. However, if single market access for the UK was withdrawn, UK-based UCITS and AIFMs would effectively be excluded from passporting. It is highly probable that National Private Placement Regimes (NPPR) are going to end with markets moving towards the German model (i.e. a total ban). Non-EUfirms may struggle to access EU markets when this occurs, although some could use reverse solicitation. It is true EU investors do call upon non-EU managers on occasion,but it is not something to be counted upon and itcarries with it huge regulatory risk.
These political changes will probably force some UK firms to move parts of their infrastructure to onshore domiciles such as Luxembourg or Malta to maintain access to the EU investor base. The general trend in the EU appears to be moving towards protectionism and this will only grow once the UK leaves EU bodies such as ESMA post-Brexit. Again, it is foolish to rush to any conclusion. Firms should delay any structural alterations until there is greater clarity, although they ought to have a rough idea of how to act if Brexit does leave UK managers isolated from the EU.
Regulation has been at the forefront of asset managers’ agendas over the last few years, and a number of rules and obligations will take effect over the coming 12 months including the byzantine Markets in Financial Instruments Directive II (MiFID II). To complicate matters further, there is a very strong possibility that asset managers (certainly those with a lot of capital derived from EU-based clients) will have to implement logistical and operational changes to their business depending on how Brexit talks conclude. The UK’s Senior Managers and Certification Regime (SM&CR) is yet another regulatory requirement which the industry needs to prepare for.
SM&CR came into play on March 7, 2016 and applied initially to banks and any financial institution regulated by the Prudential Regulation Authority (PRA). In June 2015, the Fair and Effective Markets Review (FEMR) report outlined a number of recommendations to improve fairness and efficiency in the fixed income, currency and commodity (FICC) markets, including an extension of SM&CR to firms operating in the FICC market. This obviously would have implications for asset managers. The extension of SM&CR to asset managers was confirmed by the Financial Conduct Authority (FCA) and PRA in May 2016. SM&CR will be imposed on asset managers from 2018. This extension was not an unexpected development particularly given the political and public outrage over the LIBOR scandal and FX rate rigging.
Put simply, SM&CR imposes the following:
SM&CR Key Points
The most Senior Managers in firms will be subject to pre-approval and supervision by the FCA or PRA. Certain responsibilities prescribed by the FCA or PRA will be allocated to the Senior Managers and their individual responsibilities will need to be set out in a "statement of responsibilities" (or "SORs") which must be submitted to the regulator with the Senior Manager's approval application.
Firms will have to prepare and maintain a Governance or Responsibilities Map showing the key roles within the firm, the people responsible for them, their responsibilities and lines of accountability.
Senior Managers will be accountable to the regulator if they breach Conduct Rules prescribed by the FCA or PRA, are knowingly concerned in a breach by a firm of a regulatory requirement, or fail to take reasonable steps to prevent such a breach by a firm in their area of responsibility, as set out in their Statement of Responsibilities and the Responsibilities Map.
Senior Managers will have a statutory duty of responsibility to take reasonable steps to avoid the firm breaching a regulatory requirement in the Senior Manager's area of responsibility.
Firms must ensure that Senior Managers and other staff who could cause significant harm to the firm or its customers are at all times fit and proper, and must certify them as such at least annually.
Firms must also ensure that employees comply with certain Conduct Rules, in respect of which firms will have notification, training and record keeping obligations.
The criminal offense applied to banks of recklessly causing a financial institution to fail will not be applied under the Extended SMCR.
The current version of SM&CR has retreated from some of its original, more onerous proposals, namely the provisions on the reversal of proof rule, which would have required banks and PRA-regulated entities to demonstrate to regulators they had done all they could to prevent wrongdoing rather than obliging regulators to find evidence of such faults as had previously been precedent.
Despite this, the implications of the rules will be significant and asset managers will have to adjust their operations to take account of them. This may include added documentation requirements. It is crucial that fund managers up the ante and start implementing a working plan to demonstrate compliance with these rules. The time-frames are tight and firms are likely to be facing a number of other tasks around MiFID II compliance and Brexit contingency planning, so it is crucial SM&CR compliance is not put on the backburner.
The risk of breaching the rules could be significant and may result in investor withdrawals. A handful of individuals have said these rules could result in a talent drain due to the liability fears or firms moving to lesser regulated jurisdictions. Again, this is unlikely to materialise and a decision to relocate simply to avoid SM&CR will not be viewed positively by clients to whom managers have a fiduciary duty to protect.
SM&CR is going to require asset managers to document more carefully their internal procedures and this will obviously have costs. However, compared to other rules and regulations (Alternative Investment Fund Managers Directive, MiFID II, etc.), this should be manageable.
 Clifford Chance Briefing Note, May 2016 – Extension of the Senior Managers and Certification Regime: Impact on Asset ManagersRead more…
The European Market Infrastructure Regulation (EMIR) requires financial institutions such as fund managers to centrally clear their straightforward, vanilla over-the-counter (OTC) derivatives. Regulators have put enormous faith into central counterparty clearing houses (CCPs) to scale down the risk in the OTC market, turning these utilities into systemically important financial institutions (SIFIs). CCPs are certainly not invincible (there have been failures in Malaysia and Paris and a near-failure in Hong Kong), but they are a major improvement on the pre-crisis OTC environment. However, CCPs’ creditworthiness is dependent on the conservative nature of their margining policies and the quality of the collateral they take to cover anticipated market risk.
EMIR compliance obligations are being phased in. Clearing members – also known as category one clearers - (such as banks) have been centrally clearing their OTC contracts since June 2016. Category two clearers comprise of financial institutions such as alternative investment funds (AIFs) above a clearing threshold of EUR 8 billion. These organisations will start clearing in December 2016. Category three clearers will incorporate financial institutions and AIFs below the EUR 8 billion threshold. They will begin clearing in June 2017 although this could be delayed as the European Securities and Markets Authority (ESMA) is debating whether to extend the deadline for low volume OTC users. Nonetheless, fund managers need to be thinking about how to ready themselves.
The first priority is for impacted fund managers to appoint a clearing member. Very few managers have become direct members of CCPs due to the cost constraints and potential counterparty risks. Clearing banks act on behalf of buy-side clients and post the relevant margin to CCPs. Appointing a clearing member – certainly under Dodd-Frank – was originally quite straightforward. Banks originally jumped at the opportunity of clearing because they thought they would be allowed to re-hypothecate or re-use client collateral. Regulators quickly clamped down on this, rendering clearing less lucrative than many banks had hoped for.
The main issue for clearing banks now is a consequence of Basel III. Basel III requires banks to hold more capital. It also requires banks to hold capital for all on-balance sheet derivatives collateral. This includes client collateral posted to CCPs. In other words, clearing is now a cost rather than a commercial opportunity for banks. This has prompted a number of banks to exit the clearing business altogether and others are likely to follow. This presents a huge issue for the buy-side. If banks are unwilling or unable to clear their OTCs, fund managers may have to stop trading OTCs which could result in a decline in hedging. If this were to occur, firms and markets could face significant risks. The Bank of England is recommending a rethink on these capital requirements, although in the interim buy side firms are likely to see their clearing fees increase as the market consolidates and major banks/brokers decline to clear except on behalf of their largest clients.
The second challenge for fund managers is identifying the correct collateral to post as initial margin and variation margin at CCPs. CCPs cannot accept low quality collateral due to their systemic nature. Many managers – particularly equity fund managers – will have assets that are considered low quality by CCPs due to their marketability and volatility. Attempts by some CCPs to lower their margin requirements or adjust their collateral policies have been slapped down by regulators and some clearing members who accused them of trying to “race to the bottom” in an effort to gain market share. Margin comes in two forms. Initial margin is typically high-grade government bonds or cash. Variation margin – something which can be called intra-daily in turbulent markets – is usually cash. Some CCPs do permit quality equities to be posted as initial margin but subject them to severe haircuts.
Given investors’ over-subscription to bonds and the immobilisation of high-quality liquid assets (HQLAs) by insurers and banks due to Solvency II and Basel III respectively, fund managers need to find quality collateral from somewhere or someone. Industry experts have predicted that a collateral squeeze – whereby available eligible collateral simply gets stuck in CCPs – could occur, although market analysis does suggest there are sufficient high-grade assets for organisations to source. Nonetheless, a shortage could occur in a market stress event, and this could exacerbate instability.
Collateral transformation upgrades – a process whereby a bank will swap illiquid or risky assets into safer instruments which fund managers can then post as margin – is one option. The repo market has shrunk as Basel III subjects these activities to heightened capital requirements. There is a possibility that cash-heavy managers such as private equity or firms which are long high-grade government bonds could lend out these assets to collateral hungry firms on a collateralised basis in exchange for a fee. Some firms are looking at this, although it could increase counterparty risk, and many potential lenders do not have suitable treasury operations to make it workable. At a basic level, fund managers need to manage collateral efficiently, and to build systems in place and work closely with service providers to ensure they do not miss margin calls.
The move towards mandatory clearing is inevitable and it is going cause challenges for fund managers. Firms need to ensure they are ready for these requirements by initiating early discussions with their service providers.
The latest advice from the European Securities and Markets Authority (ESMA) on which third countries meet the conditions and criteria to enable their domestic fund managers to passport freely under the Alternative Investment Fund Managers Directive (AIFMD) has experienced a mixed reception from the industry. Firstly, the advice is not legally binding, and it still needs sign off from the European Commission, the European Parliament and the European Council before it can be rolled out in force. Attaining agreement could also take a while, particularly given other pressing priorities facing European policymakers at present, namely Brexit negotiations and the solvency challenges facing Italian banks.
ESMA has repeatedly said it will conduct equivalence assessments of third countries in batches, and this is likely to take around 18 months. This longevity is in part due to the fact ESMA is conducting analysis on countries individually. The July 2016 announcement by ESMA did not yield huge surprises. The regulator affirmed that Canada, Guernsey, Japan, Jersey and Switzerland all met its equivalence criteria meaning it saw no issue or objection as to why managers based in those countries cannot market freely across the EU using the AIFMD passport without the obligation to rely on national private placement regimes (NPPR) across the 28 (at present) member state bloc. NPPR is frustrating for managers and it is plagued by regulatory arbitrage and legal differences across member states, which can make compliance challenging.
Guernsey, Jersey and Switzerland were told in 2015 that they met equivalence by ESMA so the latest advice was hardly news. All three countries had made excellent efforts to bring their regulatory regimes up to speed with AIFMD. The ESMA advice to the US, Hong Kong, Singapore and Australia is less clear cut, although equivalence is likely to be granted. ESMA confirmed that potential impediments were minor and ought to be easily remedied. For example, Hong Kong and Singapore were advised to let UCITS from more EU member states sell into their respective jurisdictions. Australia was informed that EU member states required “class order relief” from its regulations.
Perhaps the biggest challenge lies with the US. While ESMA acknowledged there were no major impediments for US money managers attaining the passport, it said it “considers that in the case of funds marketed by managers to professional investors which do involve a public offering, a potential extension of the AIFMD passport to the US risks an un-level playing field between EU and non-EU AIFMs.” Resolving this issue could take time. Nonetheless, many US managers seem agnostic to ESMA’s advice and very few will likely embrace the passport. The majority of US firms manage North American assets only. Those that do market into the EU do so only in a handful of countries or regions, such as the UK, Holland or Scandinavia. These managers will probably rely on NPPR rather than the AIFMD passport for the foreseeable future.
It should not come as a surprise that offshore jurisdictions such as Bermuda, the Cayman Islands and the Isle of Man have been told by ESMA that they do not yet meet AIFMD equivalence to enjoy the passport. To its credit, Cayman Islands has been working hard to create a dual funds regime similar to that of the Channel Islands in what could convince ESMA to extend the passport in due course. However, the Cayman Islands was late to introduce this dual funds regime meaning ESMA did not have sufficient time to assess it properly. The Cayman Islands’ constitutional links to the UK, and the Panama Papers’ expose may have also made it politically unacceptable for ESMA to grant equivalence.
That offshore jurisdictions such as the Cayman Islands have not been granted equivalence does raise issues for managers in the hedge fund and private equity world. Many of these managers will have UK or US offices, but their funds will be domiciled in offshore centres. A manager cannot make use of the AIFMD passport if their fund is domiciled in a non-equivalent third country irrespective of whether the manager is based in an equivalent third country. In other words, the majority of the world’s hedge funds and private equity firms will not be able to take advantage of the AIFMD passport but will continue to rely on NPPR, or at least until offshore centres receive confirmation of equivalence. Relying on NPPR is not a foregone conclusion for managers as it is likely to expire once ESMA grants equivalence to more third countries. As and when this happens is unclear, but it could take a few years, with some estimating 2020 at the earliest.
The constitutional earthquake following Brexit cannot be ignored either. Depending on the negotiations and how they proceed (i.e. whether the UK maintains single market access or becomes a European Economic Area [EEA] country), it is possible that the UK will retain the passport. The UK has implemented AIFMD into local law and it is fully compliant with the rules so it should be fairly assured of its fund passporting rights. That being said, if the UK exits the single market, it will be designated a third country and would be required to reapply for the passport in what could be a time-consuming and potentially politically charged process. Furthermore, the UK’s role in EU policymaking decisions is going to be much reduced, and this could result in some of the more protectionist member states exercising greater clout, and restricting third country access despite ESMA’s advice.
The drama and uncertainty of the UK’s referendum result to leave the European Union (EU) has inevitably distracted numerous financial institutions, and rightly so. Fund managers should be in the early throes of analysing their contingency plans for Brexit and reassuring their investors, particularly those in the EU, that they are doing so.
But it is also important to remember that the UK will remain a member of the EU for at least two years, and probably longer while exit negotiations unfold. One of the first acts of the UK Financial Conduct Authority (FCA) following Brexit was to remind financial institutions that their compliance obligations with EU rules still stood irrespective of the vote’s outcome. Nowhere is this more important than the Packaged Retail and Insurance-based Investment Products (PRIIPs) rules, which take effect from December 31, 2016.
The deadline for PRIIPs implementation – coupled with the fall-out from Brexit – will be challenging for affected fund managers. PRIIPs will apply to retail-orientated entities such as structured products; insurance linked products and investment funds including UCITS, although the latter has been granted a five-year transition period. The rules require impacted organisations to supply on a timely basis a Key Information Document (KID), an investor reporting document of no more than three pages which must be straightforward and easy-to-understand that has been mandatory for UCITS managers since the passage of UCITS IV.
This is all part of the regulatory agenda to enhance investor transparency. Retail-orientated alternative investment funds (AIFs) have never been obliged to file a KID, and this could prove challenging initially. However, as with all regulatory reports such as Annex IV or Form PF, firms will eventually get used to the obligations and build streamlined processes or outsource to the relevant service providers to enable compliance. UCITS managers reading this are most likely scratching their heads asking why this is relevant to them. If they are already providing KIDs, why would PRIIPs have a meaningful impact?
PRIIPs’ KIDs must contain details on performance, product complexity and information on the product, costs and risk. A Summary Risk Indicator (SRI) must also be incorporated into the KID on a one to seven scale with seven being the highest risk. Calculating the SRI can be quite complicated. The PRIIPs’ KID and UCITS’ KID are similar in many areas, but there are subtle differences hence why KID reporting for UCITS has been grandfathered. The methodologies and calculations behind some of the data supplied by PRIIPs’ KIDs are not necessarily in complete tandem with that of UCITS’ KIDs. This obviously has recipe for misunderstanding. For example, this could result in investors with exposures to the same UCITS receiving KIDs that do not necessarily possess identical risk calculations.
Perhaps the most controversial aspect of the PRIIPs’ KID has been the insistence by regulators that managers disclose anticipated future returns across three market scenarios. Anticipated returns in unfavourable, favourable and moderate market conditions must be supplied to investors. This obviously exposes managers to legal risk, if they supply information on anticipated returns that fail to materialise, particularly in volatile markets. This is an area of notable concern which needs to be rectified.
Furthermore, many UCITS have devoted scant attention to their PRIIPs’ KID obligations due to the five-year grandfathering clause. This needs to be reviewed as any UCITS managing insurance assets will have to provide those investors with data. This is to allow insurers to create KIDs by the end of the year. Lawyers acknowledge they have not heard of any UCITS supplying PRIIPs in their entirety to insurance clients, but they are building up procedures and processes to supply the relevant data. Affected firms should be liaising with their service providers and general counsel about this.
Critics point out that PRIIPs’ KIDs will bring complexity and additional workloads for fund managers although some point out the added transparency will help enable competition to flourish. Nonetheless, it is crucial firms start executing their PRIIPs’ strategy as soon as possible, while UCITS managers must assess whether or not they are excused from immediate reporting.
On June 23, 2016, the UK voted to end its historic political and economic union with the EU. At present, different governments across what the EU are formulating or attempting to formulate a credible exit plan for the UK. A fine line will likely be maintained among EU leaders between those who actively want to punish the UK and deter other members from following suit, and those who recognise that having a strong UK is in the EU’s and global interests. Compromises will have to be made on both sides.
Invoking Article 50 of the Treaty of Lisbon will set off the starting gun for negotiations, which in theory cannot exceed two years. The two-year negotiation time-frame is unrealistic. In fact, one could argue that the time-frame is not only unrealistic but impossible given the degree of interconnectedness between the UK and EU political and economic systems. As such, there is likely to prolonged uncertainty in regards to the UK’s status within the EU for around a decade, and that is assuming talks make decent progress. In extremis, the negotiations could last up to 20 years.
Uncertainty in capital markets will last for a long time, and it is highly probable the UK will lose considerable standing in the world economy during this process. A handful of banks have already confirmed they are moving euro-denominated trading activities to the continent and others will follow suit as they seek a home within the EU rather than a third country which will have no direct influence on EU developments and institutions.
The relationship the UK will have with the EU is unknown now. Some feel the UK should join the European Economic Area (EEA), which would give the country access to the single market but would subject it to full compliance with EU law and regulations, including potentially the freedom of movement of people, as well as a contribution to the EU budget.
Optimists speak of the UK retaining an associate membership of the EU with full access to the single market albeit with enhanced flexibility to implement EU rules and requirements such as free movement of people. However, free movement underpins the single market, and it is mission critical, especially for the countries in Eastern Europe, and any meaningful climb-down by the EU on this fundamental lynchpin is highly unlikely. Free movement of people is a huge benefit to the EU, the City and its financial institutions, as it broadens the talent pool available. Lord Jonathan Hill, the former EC Commissioner, expressed doubt that the single market alongside its requirement for free movement could be sold to the British people.
A failure to enable British banks and funds to have passporting rights across the EU would reduce the UK’s standing immeasurably with Frankfurt, Paris, Luxembourg and Dublin becoming the main beneficiaries of financial institutions’ exodus. The UK’s influence within the EU would be non-existent. In theory, the UK could go at it alone and work with third countries beyond the EU. However, one of the UK’s strengths is due to its ability to provide a gateway into the EU for the rest of the world.
So what does this mean for Fund Managers
Fund outflows preceding the vote were already considerable and withdrawals will likely continue over the next few months until greater clarity on the UK’s status emerges. Part of this is because the status of UCITS and AIFMs is unknown. If a German pension fund is required to invest in onshore fund vehicles, would they really invest in a UK manager who might in a few years be designated as non-EU and possibly non-eligible for investment pending the outcome of protracted negotiations?
However, firms can reorganise their businesses to arrest this issue. Some fund managers are exploring whether to move parts of their businesses to Dublin or Luxembourg, two jurisdictions with excellent service providers and experience in the fund management industry. Firms could simply delegate portfolio activities back to a London manager. Others may relocate key persons into the EU or partner with an EU AIFM or UCITS to maintain the cross-border distribution benefits. All of this will come at a cost, but it may be the only option available for managers if they wish to retain favourable access to EU institutions and retail allocators. However, exit is still several years away so firms should not rush this decision. Restructuring out of Dublin or Luxembourg only to have fund passporting benefits retained in the UK would be an expensive mistake for managers to make. Nonetheless, firms should be reviewing all of their options.
Equally, exit does not mean non-compliance with EU Directives or regulations. Rules including the Markets in Financial Instruments Directive II (MIFID II) will be enacted before any Brexit materialises. The Financial Conduct Authority (FCA) has confirmed all EU regulations and Directives must be complied with during the period in which the UK is a member of the EU. Many fund managers will probably be reticent about backtracking on their compliance processes anyway given the time and money spent on complying with these rules in the first place.
Whether the UK scraps or amends EU laws is an unknown. If the UK goes at it alone following a withdrawal, it must ensure the rules governing financial services are aligned with the EU. For example, UK deviation around centralised clearing of over-the-counter (OTC) derivatives with the European Market Infrastructure Regulation (EMIR) will only frustrate market participants who will inevitably complain of arbitrage. Dual regulations will add costs. Financial institutions have spent years trying to achieve harmonisation globally as well as within the EU, and this must continue to be a priority for any UK government irrespective of any negotiation outcomes with the EU.
The UK must fight tooth and nail to attain equivalence status with the rest of the EU to preserve its single market access. A failure to implement EU rules will not be viewed kindly by EU policymakers in such a sensitive time. An inability to attain equivalence will mean that funds that choose to remain domiciled in the UK will not be able to passport across the EU, but would need to rely on private placement regimes. As private placement is likely to expire in the next few years, equivalence is a must for the UK. Simultaneously, EU AIFMs and UCITS may struggle to access the UK market through the passport scheme.
In theory, the UK could create a dual funds regime. Guernsey, Jersey and the Cayman Islands allow managers to establish AIFMD compliant fund vehicles but permits others to retain the status quo. Again, this would be contingent on the EU granting equivalence to the UK’s fund regulatory regime.
The Capital Markets Union (CMU) initiative is up in question. There have been soundings from MEP Markus Ferber that market regulations will continue to be implemented as planned. However, the status of CMU is uncertain. CMU’s cheerleader – Lord Hill- has stepped down, and most resources within the Brussels machine will now be devoted to Brexit. CMU projects, which have been initiated – such as eased capital requirements for investors (insurers etc.) into European Long Term Investment Funds (ELTIFs) and amendments to the Prospectus Directive – will probably march on albeit at reduced pace. Rules including the Simple, Transparent, Standardised (STS) Securitisations Directive could be held up as renewed political resistance may emerge. Efforts to harmonise fund distribution rules across the EU will also be hampered by the uncertainty, and it is probable that the UK will be marginalised in any future discussions. As such, the CMU may not go down the path that many UK managers and financial institutions had hoped for.
There are going to be tough and uncertain times ahead for the UK financial services industry and it needs to ensure that it minimises any negative fall-out from the referendum by close involvement in the negotiations, both in respect to the single market but also in other negotiations for trade deals with third party countries.