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Today New City Initiative is comprised of 53 leading independent asset management firms from the UK and the Continent, managing approximately £400 billion and employing several thousand people.

GDPR

GDPR

2018 is likely to be a fairly difficult year from a regulatory perspective for asset managers. Sandwiched between Brexit planning and Markets in Financial Instruments Directive II (MiFID II) compliance lies the General Data Protection Regulation (GDPR). GDPR will become EU-wide law in May 2018 yet many in the asset management world have not given it due priority. This is ill-advised.

As the name would suggest, GDPR demands companies (of which asset managers are included) make material improvements around how they manage data on behalf of customers and employees within the EU. A failure to do this properly could result in a fine of up to 20 million euros or 4% of global turnover. GDPR should, however, not be viewed as a radical new change but rather a strengthening of already robust data protection laws.

So what does it mean? Firstly, asset managers need to ensure their customers consent fully to their data being used on a “purpose by purpose basis, using clear and plain language, in circumstances where, in order to be valid, the consent must be an unambiguous indication of the individual’s wishes, by a statement or clear and affirmative action, and individuals must be informed they may withdraw their consent at any time.”[1]

In short, consent must be obtained if customer data is used for purposes of analytics, distribution to third parties and marketing or anything else. Anyone who has attended a Fund Forum over last two years will attest that big data – has been high on the agenda as managers look for increasingly innovative means by which to sell the correct products to customers. Such analytics may involve managers scrutinising the economic wellbeing or buying trends of clients, among other factors.  

GDPR will not be the end of big data, but it will force organisations to be more circumspect about how they use it. Managers and their service providers will have to redouble efforts to ensure that personal data is not processed for any other reason than what it was intended for; and that it is not excessive. The situation could be quite complex as GDPR applies to data that has already been collected. Getting permission from clients to process this backdated information may be challenging.

GDPR also sets out a formalised framework for organisations to notify the authorities of any data breaches, while the rules stipulate firms should have robust security measures in place to prevent such violations from happening. Unfortunately, some breaches are completely unavoidable, but regulators will assess if firms have had lapses in their data protection processes and security measures, and fines may be issued as a result.

In addition, GDPR mandates organisations with a headcount of more than 250 people appoint a chief data officer, a threshold which exempts nearly all boutiques. Despite this, smaller managers should ensure an existing, qualified employee has a remit for data protection, a provision recommended in GDPR.

So what do asset managers need to do? To begin with, they need to identify where client data is held, before they start implementing processes around aggregation and collection. From here, gap analysis can be conducted, and subsequent documentation of processes and procedures drawn up. Any service providers hosting sensitive client data should be scrutinised by the manager to ensure their systems are sufficiently protected and compliant. Equally, any shortfalls in cyber-security needs to be remedied immediately.

The nxt twelve months are going to be a busy time for asset managers, and it is crucial they start taking GDPR preparations seriously.


[1] http://www.matheson.com/images/uploads/documents/GDPR_in_Context_-_Impacts_on_the_Asset_Management_Industry.pdf

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MiFID II - Five months to implementation

MiFID II - Five months to implementation

In less than five months, the Markets in Financial Instruments Directive II (MiFID II) will become UK law. The asset management industry – certainly in the UK – has faced a number of disruptions over the preceding 12 months including a hard-hitting Financial Conduct Authority (FCA) market study, and Brexit. 

Brexit remains an unknown, but it is an obvious priority for managers distributing UCITS or AIFMs into the EU. It is understandable that some managers may have been morepreoccupied with formalising or contemplating the best way to navigate Brexit than MiFID II

Analysis of 562 asset managers of all sizes in June 2017 by RSRCHXchange found 54% of firms said they did not have enough information about research unbundling. Fortunately, only 2% of managers said they were unaware of unbundling, although arguably this statistic is 2% higher than what it should have been.  

Most managers are seemingly leaving MiFID II compliance until the last quarter of 2017, although 60% told RSRCHXchange that they had already set or begun to set their research budgets, and decisions were in train about how they would pay for the research. Managers are now – after all – not allowed to use equity commissions to pay for research. 

Most managers are either choosing one of; a transactional research payment account (RPA); an RPA funded by a direct charge to investors; incorporating research into overall profit & loss; or a hybrid model. Managers in different markets have their own preferences for how they will pay for research going forward. It appears managers in the UK, Benelux and Germany are happy to incur the cost of research into the P&L, while client funded RPAs are more popular in Scandinavia and Spain. 

The debate about research is highly sensitive. It is true that some managers may find themselves deciding not to acquire research, which could undermine their ability to trade. Others warn it creates operational problems, particularly if research is sourced by a foreign subsidiary of an EU firm from a bank which operates in an ex-EU market.  Lawyers have warned those subsidiaries could be prevented from passing on research to their EU colleagues. 

The extraterritorial nature of MiFID II also presents issues for EU managers obtaining research from US brokers. Under Securities and Exchange Commission (SEC) rules, only US-based entities registered as investment advisers can receive payments for research. In other words, MiFID II will complicate the lives of many US broker-dealers as they are not allowed – because of US securities laws – to be remunerated for providing research to the buy-side in the EU. The SEC is aware of this issue, and it is expected to give an opinion in the fourth quarter of 2017 outlining its stance. 

Firms which have yet to clarify their research budgets generally blame a lack of information on how research will be priced. Around 23% of respondents to RSRCHXchange said that research providers had not given them any pricing information, and some have complained there are significant disparities in terms of the costings being provided to big and small managers.  

However, a number of NCI members have acknowledged a lot of research they receive is of limited value, and being deprived of it would not be a problem. Most firms – if they feel the research is of sufficiently high quality – will pay for it. Even so, research charges at some organisations could be quite high. 

An article in the Financial Times said major investment banks were proposing charges of up to $1 million and more for annual subscriptions to their research platforms. It added smaller banks in Europe, or those with a fixed income as opposed to an equities bias – were charging less, quoting sums between $100,000 and $500,000. Others expect research to be priced in a fairly bespoke fashion depending on how frequently managers use it. Despite this, those research costs are not trivial and some boutiques may struggle with the overheads. 

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The FCA's plan for Asset Managers

The FCA's plan for Asset Managers

Many in asset management were bracing themselves for an uncomfortable summer period ahead of the UK Financial Conduct Authority’s (FCA) final report on the industry. Having been caught off guard somewhat by the extent of the criticism in the AMMS Interim Report in November 2016, the spectre of the FCA referring asset managers to the Competition and Markets Authority (CMA) could not be discounted. 

While the report does make for uncomfortable reading at times, the bulk of the recommendations can be accommodated and are broadly fair. Active managers reading the report certainly had their nerves calmed when they arrived at Section 1.7. Here the FCA confirmed that it never intended for its interim findings to be construed as arguing the case for passive funds over active. 

The debate over passive versus active has somewhat consumed the industry since the AMMS interim findings were first released. The big issue for the FCA is not so much if people invest into passive or active – both obviously have their respective merits and are key to a balanced investment portfolio, but whether clients are paying active fees for closet tracker products. NCI has always taken a firm line that investors should only pay for performance, and we believe that boutique providers are very well placed to deliver this. 

Governance 

Governance is central to the FCA’s report. The FCA said it would use the Senior Managers & Certification Regime (SMCR) as a tool to ensure fund managers are adhering to their duty of acting in accordance with the interests of the end investors. 

The FCA also recommended enhanced board independence, advising managers appoint at least two independent directors, or have such individuals comprise 25% of the board’s membership. A handful of asset managers have expressed concern that qualified, independent directors are not in abundant supply, and those that are tend to be expensive. 

NCI believes in robust governance, as we feel that having a strong board can ensure business interests are aligned strongly with investors’ needs.  Institutional investors are increasingly scrutinising manager boards in due diligence, and many operations’ teams do veto investments if they feel corporate governance is subpar. As such, we feel a more independent and strengthened governance set-up can only be an advantage for the fund management industry. 

An All in one Fee

Fee transparency has long been an area of interest for the FCA, and it was expected that an all-in-one fee charge inclusive of transaction costs would be proposed. Such a charge, argued the FCA, would help investors understand better what they are paying, but also help them compare different prices across asset managers more effectively. NCI believes strongly in fee transparency, and we are looking forward to engaging with the FCA on the matter.

However, there are some challenges, which were cited by the FCA itself. “Some warned against investors becoming too focused on charges or not understanding the charges. A number of respondents argued that while charges are important they are not the only thing that investors should consider,” it read. The paper cited other respondents who complained that incorporating transaction charges into the headline fee would be practically complex, mainly because such costs can be difficult to predict ahead of time. 

Another risk of an all in one fee could be that it inappropriately incentivises asset managers to not trade even if it was in the clients’ best interests. This would immediately result in the manager being in a conflict of interest situation, and could put them in non-compliance with their new obligations. Again, this is obviously a scenario that nobody wants to see emerge. 

One of the bigger challenges of the FCA’s proposal is that a single figure fee could make it difficult for clients to compare funds accurately, unless a breakdown of the component charges is provided. An all in one fee could also dent the competitiveness of the UK asset management industry, as charges may appear higher than their peers in other markets. The UK financial services industry – including fund management – is facing huge challenges and threats to its eminence over Brexit, and now is a difficult time to introduce rules which could undermine its ability to compete internationally. 

Switching Share Classes

In the FCA’s AMMS interim report, the regulator criticised the asset management community for making it difficult for retail investors to switch share classes. It identified managers often levied charges on investors looking to switch, and said the process could be an administrative headache. This meant investors – predominantly retail - simply stayed in fund share classes which may not necessarily be in their best interests. 

NCI members acknowledged in response to the AMMS that switching share classes was operationally straightforward, and could be done “at a push of a button.” However, permission must be given by the investor for switching, and this can be surprisingly difficult to obtain and creates administration, which the clients rarely want anyway. The FCA agreed that switching share classes needed to be simplified, and that it would support removing the obligation of the manager to explicitly seek investor approval to do so. 

“Several respondents suggested removing the opt-in requirement to seek consent from investors before moving them into a different share class where they would be better off. Respondents also suggested replacing the opt-in requirement with an opt-out style requirement. Respondents felt that this should be considered especially in cases where the investors are not paying trail commissions. Respondents argue that this would be more straightforward for investors, from whom consent is often difficult to obtain, and make it cheaper for asset managers to implement bulk switching,” read the paper. 

NCI also pointed out in its AMMS response that switching could have associated tax implications, and can result in investors being subject to capital gains tax. As a result, many investors simply are reluctant to switch. The FCA recognised this issue in the final report, and we look forward to working with them more closely on this matter. 

Future FCA Areas of Scrutiny

➢ The FCA said it would consult further on whether to refer investment consultants to the CMA. The FCA believes there are high levels of concentration in the consultancy market, a lack of transparency over fees, and potential conflicts of interest particularly where providers offer fiduciary management services. This could precipitate further regulation of consultants. 
➢ Further scrutiny is to be undertaken on investment platforms, in terms of their competitiveness and cost efficiencies.
➢ Managers of private equity and hedge funds should expect similar FCA scrutiny in due course.  
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Back to the Drawing Board

Back to the Drawing Board

In June 2016, nearly all reputable media outlets and indeed some financial institutions agreed that Brexit posed a risk tothe City of London’s influence in the world economy. The UK’s financial services industry provides a gateway for the rest of the world into Europe, and for Europe into the rest of the world. Many felt this USP would be chronically imperilled by Brexit. 

Since the referendum, attitudes have moderated. Organisations realised they could create a separately capitalised entity in an EU country, while maintaining their UK presence. It was also rumoured that UK government officials warned relocating financial institutions not to congregate in any one EU market, so as not to jeopardise or threaten the UK’s influence. 

Many financial institutions – at least those with EU client interests – reluctantly accepted Brexit and were willing to work around it. The actual outcome of Brexit was difficult to predict even when the Conservatives had a working majority but people knew the core facts – i.e. the UK would leave the Single Market and Customs Union.  Today, the end result of the negotiations is more difficult to forecast.  

Compromises will probably have to be made by the minority government, an argument could be made that Brexit may be softer than what had been expected, given that consensus and allegiances will have to be built across some of the political parties. On the fringes, it has been suggested Brexit may be called off. The latter is not particularly realistic but cannot be ruled out. Ultimately, we will have to wait and see. 

Brexit negotiators have less than two years to strike a deal. Even with a majority government leading the way, this was ambitious. But with a government beholden to smaller parties’ support, the hope for agreement by 2019 is even less assured.If another election is called yielding a different set of political leaders, Brexit talks will further stutter, and become even more fragmented.  

In the grand scheme of things, none of this really matters. Uncertainty is the real danger to financial institutions and economies, and the UK’s position is anything but clear. Those organisations hesitating about exiting the UK may become less so if it becomes apparent that Brexit is being poorly handled.  

The NCI has no political leanings and its position is clear. Negotiations on Brexit need to be dealt with competently and capably if the UK and EU are to reach a mutually acceptable agreement. Transparency about the progress of the negotiations is needed and a two-way dialogue between the government and financial services – not just fund management – is critical if the UK is to remain a leading financial centre.  NCI aims to be at the heart of that dialogue.

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ManCos

ManCos

The Management Company (or “ManCo”) was a proposition that seemed almost too good to be true for a number of firms who were assessing how they should approach the EU’s Alternative Investment Fund Managers Directive (AIFMD) back in 2013 and early 2014.

These EU structures allowed managers to delegate risk management to the ManCo; retain control over their portfolios; and distribute products across the EU without having to go through the aggravation and cost of setting up an EU branch or subsidiary.

It was a model that had come to prominence earlier in the decade when UCITS IV was implemented permitting managers to use cross-border ManCos. The ManCo was an ideal set-up for US or APAC managers, who wanted to test the investor waters in the EU, in a cost-effective manner and without over-committing resources.

The ManCo (along with lawyers and consultants) was given yet another boost by Brexit as providers warned UK managers they risked being shut-off from EU investors.  Exiting the Single Market means that UK-based UCITS and AIFMs are at a risk of becoming designated third country fund managers, and will no longer benefit from pan-EU cross-border distribution available through the passport. This obviously matters more to some managers than to others.

Firms are therefore conducting analysis on ManCos and whether it will be sensible to appoint one. It is certainly wise managers be considering the case for hiring a ManCo, but they need to be mindful of unexpected challenges and regulatory developments. Time and again, EU regulators have warned against UK firms setting up letterbox entities – that is branches with barebones or no substance – within the EU as a contemptuous attempt to keep their passporting rights.

There is no clear or definitive indication that ManCos are implicitly being accused by regulators of not providing sufficient substance, but it is certainly something managers should acknowledge as a potential business risk, particularly given the EU-focus on delegation right now. ManCos would beg to differ and argue that they do provide substance to non-EU managers and that any regulatory stance suggesting otherwise is unfair.

There is a possibility protectionism could revert in the EU, and if this occurred, it is highly probable fund managers selling into the EU may be forced to up their presence on the continent, particularly if restrictions were imposed on the ManCo operating model.  Such a requirement would dramatically increase costs for managers with UK and EU client interests.

As the EU continues to make a push for substance, managers need to be careful about how they approach their Brexit strategy. The cost of appointing a ManCo is not insignificant, and on-boarding can take some time. It is better for managers to wait until there is further regulatory clarity on the status of ManCos before rushing into appointing one.

The danger for fund managers seemingly at the moment is not the final outcome or net result of Brexit, but rather the uncertainty leading up to it.  Market timing is absolutely everything in trading, and managers on both sides of the Channel need to adopt a similar approach to their Brexit planning.

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...And so begins Brexit

...And so begins Brexit

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. 

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The FCA’s scrutiny continues…

The FCA’s scrutiny continues…

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. 

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Clearing and Brexit

Clearing and Brexit

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.

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FCA Asset Management Study

FCA Asset Management Study

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.

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AIFMD

AIFMD

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-EU firms 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 it carries 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

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