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.
Asset managers have long complained of the distribution challenges across EU member states. UCITS and the Alternative Investment Fund Managers Directive (AIFMD) theoretically negate additional, member state regulatory and administrative hurdles for managers marketing across the EU. There are standardised rules and EU-agreed principles governing distribution but divergences and gold-plating have occurred in many areas, which has hamstrung a number of firms’ cross-border marketing and distribution efforts. It is something the New City Initiative (NCI) has highlighted repeatedly in industry debates. An NCI white paper – published in conjunction with Open Europe in July 2015 – acknowledged these challenges.
Our survey was based on qualitative interviews conducted with lawyers across the EU, fund managers with cross-border marketing interests, and compliance consultants, coupled with publicly available information. The survey found that a typical UCITS manager would incur €1.5 million of additional initial costs, and on-going additional annual maintenance costs of €1.4 million if they market across all EU member states (plus Switzerland) due to extra regulatory and administrative requirements across individual countries. Asset managers are directly or indirectly affected by EU regulations costing around £2 billion a year, it added. Yet, they are still unable to market freely across EU member states. The announcement therefore on June 2, 2016 that a consultation on the Capital Markets Union (CMU) project would like to review and analyse the distribution challenges facing European fund managers is something the NCI strongly welcomes.
The consultation will seek industry comment on a number of perceived hindrances affecting asset managers including marketing restrictions; distribution costs and regulatory fees; administrative impediments; analysis on distribution networks such as online platforms which have grown in abundance yet are not referenced in UCITS or AIFMD; and taxation obligations in individual member states. The CMU seeks to bring about uniformity across capital markets, which the European Commission feels will help bring about greater non-bank financing and funding into the real economy, in what should help drive a Europe-wide recovery.
Streamlining all of these regulatory requirements would allow for quicker, easier and more cost effective distribution to occur at fund managers. It will also facilitate diversification and investor choice. Many small to mid-sized managers find navigating the multitude of individual requirements and obligations across the EU to be time-consuming and costly. Oftentimes, these costs must be borne prior to raising capital, putting the financial stability of the fund manager in jeopardy. Large asset managers can shoulder these costs by hiring more staff or external corporate counsel. This is not always possible at smaller managers due to cost constraints, often exacerbated by pre-existing regulations. By easing distribution barriers, the EC will enable more small to mid-sized managers to market and enable competition to flourish.
Fund managers have an excellent opportunity to contribute to this debate and the NCI strongly encourages manager participation in this consultation across all levels. The CMU is an example of thoughtful regulation, and by discussing with regulators the challenges faced in the EU’s cross-border fund distribution environment, managers have an excellent opportunity to shape regulation for the better. A withdrawal of gold-plating – be it additional reporting requirements or registration costs - would lead to cost savings and improve consumer choice.
For further information about the CMU project, or to participate in the consultation, please click here.
The passage of the Markets in Financial Instruments Directive II (MiFID II) Delegated Acts in April 2016 was meant to provide clarity on a number of outstanding issues affecting the asset management industry. The most pressing concern of course was the on-going uncertainty about paying for sell-side or broker research through equity trading commissions. The European Commission’s (EC) latest announcement on the status of commission sharing agreements (CSAs) has simply confused the market.
The provisions appear to require more transparency on how research is paid for. The rules state: “Investment firms providing both execution and research services should price and supply them separately in order to enable investment firms established in the Union to comply with the requirement to not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients."
Regulators and investors can also demand a summary of the research that has been provided to prove that it was not an inducement. Furthermore, research cannot be linked to transaction volume or the value of transactions executed by brokers on behalf of their clients. In effect, this makes CSAs operationally challenging albeit not impossible. There were high hopes the EC had softened its stance on CSAs in December 2015 when reports indicated that full unbundling was unlikely to happen provided managers were wholly transparent about the charges they paid their brokers.
Aside from the complexities around CSAs, there are two avenues managers can go down in regards to research. The first is to pay for it themselves. This will obviously eat into overall profit and loss (P&L) and could result in firms having to increase their management fees. Given the sensitivities around fees at the moment at active managers, this is hardly going to go down well among some investors. Most managers will conduct cost analysis to determine how much research is being used and how regularly. This is a sensible approach and will enable managers to be more selective about the research they purchase. After all, a lot of the research does not always get read.
However, small asset managers are often dependent on broker research. They do not have the scale to hire researchers internally, and these rules could make business even more cost prohibitive. It could also hinder performance as opportunities could go amiss if research has not been purchased. Again, this contravenes the very purpose of MiFID II which is investor protection as it undermines the managers’ fiduciary responsibility to deliver returns to stakeholders. This is all happening at a time when regulations and enhancements to internal operational infrastructure are disproportionately impacting smaller managers.
The second approach would be to create a separate research payment account. Again, this must be wholly transparent as managers are obliged to provide information on the nature and costings of research on an annual and ad hoc basis. Most importantly, the budget for the research payment accounts must be pre-agreed with investors and cannot be linked to transactional volumes and value.
If a fund manager has only a handful of institutional investors, this ought not to be too difficult. The problem will be for managers who have hundreds of accountholders. At present, there is no mechanism or viable solution to obtaining agreement with all of those investors. It also has the potential to increase legal costs as investor documentations and agreements will have to be rewritten to account for this new research budget. This could prove operationally burdensome, particularly if the research spend goes over limit.
The uncertainty around CSAs and the operational heavy-lifting required for maintaining a research payment account give managers few options but to pay for research themselves or to stop purchasing research altogether. The problem is likely to be compounded as individual regulators have scope to implement the rules how they see fit. This could result in widespread divergences in implementing MiFID II’s research provisions across the EU. This will only sow the seeds for confusion.
Asia-Pacific (APAC) investors have always been eager buyers of UCITS, accounting for approximately $200 billion of UCITS’ Assets under Management (AuM) or roughly 5% of the total €9 trillion. The buyers are broadly concentrated in Hong Kong and Singapore. However, there are concerns that the fund market could get saturated amid the launch of several regional fund passport schemes in APAC.
The ASEAN Collective Investment Scheme (CIS) was launched in August 2014 and simplifies the regulatory process of selling a vanilla fund vehicle to retail clients across Singapore, Thailand and Malaysia. The second initiative is the Asia Region Funds Passport (ARFP) which broadly mirrors the ASEAN CIS but incorporates Australia, New Zealand, Japan and Korea, although it is hoped it could be extended to Singapore, Hong Kong, Taiwan, Vietnam and Malaysia. ARFP will likely be implemented later this year or in 2017. Both fund passport schemes are modelled on UCITS.
The third initiative is the Mutual Recognition of Funds (MRF) programme between Hong Kong and China. This allows managers domiciled in Hong Kong to sell to Chinese investors and vice versa although it is contingent on firms obtaining regulatory authorisation first. It also scraps a longstanding requirement that Hong Kong managers enter a joint venture with a mainland financial institution if they want to sell to Chinese retail allocators. This requirement often presented a massive operational due diligence headache, and incurred potential reputational risk for Hong Kong managers. The volatility in China has slowed down MRF approvals by mainland Chinese regulators but this appears to be changing as markets have broadly stabilised. However, MRF is unlikely to be extended to other countries just yet.
The APAC market is certainly ripe for fund managers globally. Despite some challenges in emerging markets, the region has a growing and abundant middle class. Data from PricewaterhouseCoopers (PwC) suggests assets controlled by high net worth individuals (HNWIs) in APAC could reach $22.6 trillion in four years. APAC HNWIs are likely to become more populous than those in North America in 2016. The institutional investor base is certainly growing as sovereign wealth funds (SWFs), pension plans and cash-rich corporates look to allocate their capital beyond stocks and bonds.
At present, the capital managed by ASEAN CIS is minimal although few funds have been approved by regulators. In time, this will change but ultimately patience is required. These funds have parallels with UCITS insofar as they are subject to investment restrictions, limits on securities lending, repo activities and derivatives, the mandatory appointment of a global custodian and counterparty exposure limits. Those looking to launch an ASEAN CIS must have at least $500 million in AuM and a five year investment track record. However, these restrictions could be eased in time. Local representatives must be appointed in jurisdictions where the ASEAN CIS is marketing to liaise with regulators. Again, this has similarities with requirements in EU member states whereby UCITS must appoint local agents.
The key question UCITS managers should be asking is whether these regional fund brands could be a potential threat to their market dominance. APAC regulators are certainly keen to promote a regional funds passport. Equally, those same regulators are aggrieved with the European Securities and Markets Authority (ESMA) for failing to immediately confirm that Hong Kong and Singapore met regulatory equivalence under the Alternative Investment Fund Managers Directive (AIFMD). This has effectively shut out Hong Kong and Singapore based fund managers from the pan-EU AIFMD marketing passport. While ESMA’s position probably did not intend to cause deliberate upset in APAC, it could give impetus to regional regulators to encourage competition to UCITS.
Barring that, the overall threat by these fund passports to UCITS in APAC is unlikely to be significant in the short to medium term. There are a number of reasons for this. As with marketing into the EU, the distribution channels in Malaysia, Singapore and Thailand are varied with investors going through banks, independent financial advisers or even online platforms. Simply distributing a standalone fund to retail clients will not be straightforward, particularly if it is a new brand. Going via a bank or distributor will inevitably result in steep distribution fees for the manager. As such, it will take time for these new funds to obtain market traction.
The disparity of economic and regulatory development across APAC is far greater than in the EU. Whereas most countries in the EU share a single currency, this is not the case in APAC. This exposes managers and investors in the ASEAN CIS to FX risk. Attaining a degree of harmonisation around taxation is crucial to the success of the ASEAN CIS. Different countries will have different approaches towards taxation on dividends and capital gains, and this needs to be resolved before regional fund schemes can flourish. At present, this appears not be a priority for the countries involved. As and when this happens is unknown. But until it does, UCITS will dominate the mutual fund space in APAC.
It is also crucial to note that UCITS has existed for over three decades now. It is a trusted, popular and well-developed mutual fund wrapper. However, UCITS managers with a focus on APAC should not rest on their laurels and they must be aware of the growing challenger brands that are emerging in APAC.
Liquidity and fund managers is now a pressing area of concern for regulators. Attempts by the Financial Stability Board (FSB), International Organisation of Securities Commissions (IOSCO) and the Financial Stability Oversight Council (FSOC) to designate certain asset managers as systemically important financial institutions (SIFIs) have so far failed to materialise. Instead, they are honing their sights on other potential risks posed by asset managers.
At present, the key focus is liquidity. One of the major fears among regulators is the impact mass withdrawals from mutual funds by investors could have on markets, particularly bonds. If a manager has a highly concentrated exposure to a specific market segment, would investor redemptions result in that manager being forced to sell underlying assets rapidly and at depressed prices to meet client withdrawals? If so, regulators are nervous about the impact this could have on capital markets.
Concerns around mutual fund liquidity were given a further impetus in December 2015 when Third Avenue, a US mutual fund, suspended redemptions to sell off its illiquid positions in the high-yield corporate debt market following withdrawal requests. Third Avenue offered clients daily liquidity despite having significant exposures to illiquid assets. One could argue that this is the exception rather than the rule, and most mutual funds will have diversified, liquid holdings and would not need to resort to such measures. Nonetheless, it represented the first mutual fund action of this kind since the Reserve Primary Fund broke the buck following its exposure to Lehman Brothers in 2008.
The Securities and Exchange Commission (SEC) is scrutinising events at Third Avenue and the mutual fund industry with a particular focus on so-called liquid alternatives. Provisions being considered by US regulators include limiting open-ended funds from having more than 15% of assets invested in illiquid instruments as well as the introduction of swing pricing. SEC Rule 18f-4 – proposed earlier in 2016 – could restrict the use of derivatives in leverage as well. This is aimed primarily at liquid alternatives. As such, the SEC recommended a hard exposure limit of 150% of fund net assets based on the notional amount of derivatives much to the chagrin of the industry.
UCITS are also under similar scrutiny. There have been a number of complaints, particularly from traditional UCITS, that alternative UCITS offered by some hedge funds, have been stretching the rules around investing into esoteric instruments. Many of these traditional managers are concerned the UCITS brand could be tainted in the event of a high-profile blow-up whereby investor redemption requests are not met. European UCITS are of course allowed to gate. However, any suspension of redemptions by a UCITS would tarnish the brand.
The European Securities and Markets Authority (ESMA) did clamp down on this by restricting the ability of UCITS to invest in commodities. Several UCITS commodity trading advisers (CTAs) shuttered subsequently although a number of managers do gain commodity exposures through exchange traded notes.
However, it is no secret that regulators are hoping to emphasise UCITS’ retail credentials and encourage institutional inflows into AIFMs following passage of the Alternative Investment Fund Managers Directive (AIFMD). Furthermore, the introduction – should it occur – of UCITS VI could result in regulators restricting the eligibility criteria of UCITS assets. In other words, UCITS could be prevented from investing into certain esoteric or higher risk assets. Nonetheless, UCITS VI remains a long way off.
In the immediate term, there are concerns around UCITS which have China exposures. The market volatility in China has prompted the regulator to delist shares. As such, those UCITS which are invested in delisted Chinese securities could struggle to accurately value their holdings, and sell their assets to meet redemptions. However, it is assumed that most UCITS with China exposure will have diversified portfolios enabling them to meet their liquidity obligations. Nonetheless, it does raise issues around valuation and liquidity among China-focused UCITS.
Regulatory scrutiny around liquid alternatives such as alternative mutual funds and UCITS is growing. The rules are likely to become stricter and managers need to keep abreast of these developments. Most importantly, managers must make sure they do everything they can to prevent any liquidity mismatches emerging, which could result in gating during market routs. Such a scenario would not only taint the UCITS and mutual fund brands but likely result in further, harsher regulations.
Loan origination funds are finally gaining traction within the European Union (EU). A host of countries have introduced legislation designed implicitly to boost lending to small to medium sized enterprises (SMEs) that have been cut off from conventional credit markets. France has witnessed the creation of Novo funds, private placement fund platforms that invest in mid-sized French companies although these vehicles are prohibited from industries associated with financial services, leveraged buy-outs and real estate. In Germany, BaFIN gave the green light to domestic funds being able to issue or restructure loans without needing to possess a credit license. The Central Bank of Ireland (CBI) authorised Qualifying Investor Alternative Investment Funds (QIAIFs), which too engage and participate in loan origination.
The reasons for the growth in such fund products is simple. Basel III capital requirements have applied serious pressure on the balance sheets of banks. Many banks are reluctant to provide financing to SMEs out of balance sheet considerations. Given the dependence of European SMEs on bank financing, this will have massive implications. It is hoped the renewed emphasis on non-bank financing will enable Europe to replicate corporate lending practises in the US, where 80% of corporate financing is conducted via the capital markets through issuances of equity and bonds. In Europe, about 80% of corporate lending is derived from banks. As such, the push towards loan origination is being driven by regulators’ recognition that European SMEs need to diversify their sources of financing.
Fund managers have taken note. Preqin, a data provider, estimates there is approximately $440 billion invested in private debt funds. The Alternative Investment Management Association (AIMA) is confident private debt funds could provide up to 20% of the funding to European SMEs in the next five years, compared with 6% at present. The AIMA study - “Financing the economy: The role of alternative asset managers in the non-bank lending environment” – said private debt funds were supporting a diverse range of sectors including shipbuilding, social housing, health and renewable energy. It added these funds rarely deploy leverage and have structured their businesses like private equity (i.e. longer lock-ins) so as to reduce maturity and liquidity transformation risks.
That a number of regulatory authorities have endorsed loan origination funds raises the question as to whether there needs to be some sort of EU framework governing it. The rules in Germany, France and Ireland are not necessarily consistent despite broadly having the same objective. The argument against regulation is that it could stifle and hamstring loan origination funds at an embryonic stage of their development. Conversely, arguments for regulation suggest it may result in the emergence of harmonised rules and a credit fund passport similar to what is available to managers regulated under UCITS and the Alternative Investment Fund Managers Directive (AIFMD). As with UCITS and AIFMD, the big fear is that national regulators could introduce their own barriers to marketing and restrictions through gold-plating which could make pan-EU distribution of credit funds challenging.
The mood, however, is reasonably optimistic in the context of the Capital Markets Union (CMU). Many believe regulators will introduce some sort of harmonisation which ought to facilitate the growth of loan origination funds. The European Commission – through the creation of the European Long Term Investment Funds (ELTIFs) last year – has sought to reduce the role of bank financing in the real economy. ELTIFs are allowed to invest in loans alongside infrastructure and real estate, while Solvency II capital requirements for ELTIFs have been eased to encourage greater investment into the asset class by insurers. Such sensible policies should bode well for any potential regulation of loan origination funds.
Loan origination funds could be an exciting opportunity for investors, while the creation of pan-EU standards governing them must be done in a sensible way that does not impede their development, either in lending to SMEs or soliciting capital from EU investors.
The Securities Financing Transaction Regulation (SFTR) has not solicited a huge amount of attention from fund managers. This is understandable given most firms have been busy implementing the Alternative Investment Fund Managers Directive (AIFMD) and the European Market Infrastructure Regulation (EMIR) or getting up to speed with the requirements laid down by the soon to be enacted Markets in Financial Instruments Directive II (MIFID II). SFTR is a regulation though that fund managers should take note of.
SFTR was published in the Official Journal of the European Union (EU) in December 2015 and came into effect on January 12, 2016. Compliance, however, is being phased in as the European Securities and Markets Authority (ESMA) is presently debating the Level 2 technical standards. The precise deadlines for the phase in for fund managers is not yet known although it is expected to occur at some point in 2016 or early 2017. The implications of SFTR should not be underestimated.
SFTR is in part a replication of EMIR, which was introduced in February 2014 and forced financial institutions to report details about their over-the-counter (OTC) and exchange-traded (ETD) derivative transactions to ESMA approved trade repositories (CME Trade Repository, Depository Trust & Clearing Corporation [DTCC], ICE Trade Vault Europe, KDPW, Regis-TR, UnaVista). The difference being is that SFTR forces firms to report details of their securities financing transactions (SFTs). This is all part of European regulators’ clampdown on potential risks in the shadow banking system.
What are SFTs under SFTR?
Repurchase transactions for securities, commodities and guaranteed rights; Lending and borrowing transactions on securities and commodities; Buy-sell backs and sell-buy backs of securities, commodities and guaranteed rights; Margin lending transactions – extending credit in connection with the purchase, sale, carrying or trading of securities – but not other loans secured by collateral in the form of securities; liquidity swaps; collateral swaps
That SFTR is modelled on EMIR raises a number of questions. Derivative trade reporting under EMIR has been in train for two years now yet trade repositories are still struggling to reconcile reported derivative transactions. This is because ESMA demanded there be dual-sided reporting under EMIR – I.E. both counterparties to a derivative transaction must report details of that trade to the relevant trade repository.
As part of the reporting process, a counterparty must generate what is known as a Unique Trade Identifier (UTI), a bespoke alphanumeric code that helps trade repositories reconcile reported trades. The flaw in this process was that ESMA did not elaborate on which counterparty to the trade creates the UTI. Inevitably, both counterparties to derivative transactions developed UTIs, which frequently were not harmonised but completely different. This made it challenging for trade repositories to reconcile trades. As such, regulators are still unable to glean from the trade repositories whether there have been major build-ups of systemic risk in the derivatives markets.
ESMA has confirmed SFTR reporting must be dual-sided and carried out on a T+1 basis. European regulators have been advised to follow the example set by the Commodity Futures Trading Commission (CFTC), which under the Dodd-Frank Act, permits single-sided reporting of derivatives to swap data repositories (SDRs). European officials, however, have repeatedly said that it is the responsibility of market participants to resolve the on-going issue around UTI generation around EMIR. Nonetheless, European regulators have confirmed they will revisit the issue of whether to introduce single-sided reporting for SFTR after two years of the rules being implemented.
As with EMIR, fund managers can delegate SFTR reporting to third parties such as fund administrators or technology vendors although this cannot obviate the fund manager from responsibility for inaccurate reporting and records of SFTs must be maintained for five years after the contract has terminated. The Clifford Chance paper adds that SFTs with non-EU counterparties which are not subject to SFTR will still have to be reported. This obviously raises issues around extraterritoriality. The only exemptions to SFTR reporting have so far been granted to European Central Banks, the Bank for International Settlements (BIS) and EU public bodies managing public debt.
SFTR also introduces enhanced transparency for managers of UCITS and Alternative Investment Funds (AIFs). SFTs and total return swaps must be disclosed in their bi-annual and annual investor reports as mandated under UCITS IV and the Alternative Investment Fund Managers Directive (AIFMD) as regulators feel these transactions can increase the risk-profile of the fund vehicle. Investors must also be notified about SFTs and total return swap usage in any prospectuses. ESMA has yet to announce the exact details, but a legal brief by Freshfields believes the following will likely need to be disclosed to investors at the minimum.
Information likely to be reported to AIFM and UCITS investors
Amount of securities and commodities on loan as a proportion of total lendable assets
Amount of assets engaged in each type of SFT and total return swap expressed as an absolute amount and as a % of the fund’s total Assets under Management (AuM)
Other transparency obligations surround the re-use of collateral. Firms must notify clients about the risks associated with collateral re-use and solicit written consent and agreement from investors explicitly allowing the re-use of collateral. This again could be an operational headache for fund managers, and some believe it could be a precursor to a further regulatory clampdown on re-hypothecation practices. In the US, collateral re-use is capped at 140% of client liabilities by the Securities and Exchange Commission (SEC). European regulators have discussed the possibility of a hard and fast cap on re-hypothecation in the past, and such action should not be ruled out.
The consequences of infringements to SFTR are tough. A legal update by Dechert in December 2015 said firms could be fined up to €5 million or 10 per-cent of their total annual turnover for SFTR reporting requirement infringements. In the event of transgressions around the re-use of collateral, the sanctions could be up to €15 million or 10% of total annual turnover. As such, firms need to make sure that they fully comprehend the rules and have adequate systems and processes to deal with SFTR and its requirements.
 Clifford Chance –“The SFTR: New Rules for Securities Financing Transactions and Collateral” – January 2016
 Freshfields – The Securities Financing Transaction Regulation - November 2015
 Dechert – New EU Regulation on Securities Financing Transactions and Reuse of Collateral – December 2015
One of the biggest challenges facing asset managers, be it those regulated under UCITS or the Alternative Investment Fund Managers Directive (AIFMD) surrounds EU cross-border marketing.
It is a point repeatedly made by The New City Initiative (NCI). In our paper – “Asset Management in Europe: The Case for Reform” – produced in conjunction with Open Europe, we estimated a UK manager distributing and marketing its fund in all other 27 EU member states plus Switzerland would incur initial set-up costs of over €1.5 million. Total on-going maintenance costs – allowing for the continuation of cross-border marketing – could be near €1.4 million per year. If a firm has yet to raise meaningful capital, such costs are a huge hindrance.
But there is reason for hope. A senior regulator at the European Commission (EC), speaking at a private equity conference on AIFMD, confirmed regulators were cognizant of this issue. The policymaker said a review at an EC-level of the impediments and restrictions around cross-border marketing would happen in 2018. This is all part of the reformist agenda laid out in the Capital Markets Union (CMU), an initiative designed to facilitate harmonisation in the EU’s capital markets and bolster non-bank lending in the real economy.
UCITS IV was designed to remove barriers that had emerged in some member states preventing cross-border distribution of UCITS. UCITS IV did have a positive effect but national gold plating does continue. Tax transparency rules in Germany and Austria are onerous. Furthermore, different regulators have different registration requirements and fees. Others force asset managers to appoint local agents. And this is just for UCITS. AIFMs report similar issues despite the presence of the pan-EU distribution passport. The costs of appointing lawyers, auditors and local consultants in multiple jurisdictions is not insignificant and adds to the cost of running a viable asset management business.
These costs ultimately add yet another barrier to entry for mid-sized and smaller managers thereby reducing competition. The UK’s Financial Conduct Authority (FCA) is conducting a market study, due out in 2017. In its announcement of the study, the FCA acknowledged that regulation was introducing barriers to entry - potentially hindering competition and reinforcing the dominance of large asset management players. As such, the UK FCA should work closely with other European regulators in formulating the CMU to make it more straightforward for mid-sized and smaller asset managers to market across the EU. This will boost competition and ensure investors get good value for money, which is a core component of the FCA’s market study.
Part of the EU’s regulatory agenda to review the barriers to marketing derive from the ascendency of digitisation. UCITS and AIFMD did not really envisage the role disruptive technology would have on distribution. As such, the EC recognises that it needs to promulgate regulation where funds are being distributed across borders through online platforms.
The ambition of the CMU should not be underestimated, and neither should the divergences in opinion across the EU. Overcoming these challenges will not be straightforward, and will likely take some time. This has been evidenced in a number of regulatory discussions over the years. Nonetheless, it is a step in the right direction should it come into fruition. Easing the cross-border marketing restrictions and harmonising the rules will make distribution of funds a more straightforward process.
The proposed one year delay by the European Commission (EC) to the Markets in Financial Instruments Directive II (MiFID II) is a welcome relief at asset managers. The European Securities and Markets Authority (ESMA) had reportedly written to the EC recommending a delay amid widespread concerns that financial institutions would be unable to undertake the necessary IT infrastructure reforms to implement MiFID II.
The UK’s Financial Conduct Authority (FCA) had hinted there could be delays amid uncertainty over the final proposals while industry associations and market participants had all called for a postponement. However, recent reports suggest that senior Members of European Parliament (MEPs) have said they will not renegotiate any aspects of MiFID II.
The original implementation date of January 3, 2017 was ambitious. While Regulatory Technical Standards (RTS) were published in September 2015 outlining proposals surrounding commodity derivative position limits, algorithmic trading and pre and post-trade transparency, any definitive announcement on the proposed ban on utilising equity commissions to pay for sell-side research had yet to be forthcoming. The ban on using equity commissions to pay for research is an emotive topic among policymakers and regulators, although an announcement is expected before year-end.
The challenges for fund managers around prohibiting the use of equity commissions to pay for sell-side research are well-documented. However, some of the pre and post-trade transparency obligations are going to require huge investment by fund managers too, either through building the technology infrastructure internally, or by outsourcing some of the reporting in a manner not too dissimilar to how they managed their derivative reporting under the European Market Infrastructure Regulation (EMIR).
Pre and post-trade transparency will require firms to report details of any orders or transactions conducted on a trading venue such as a regulated market (RM), multilateral trading facility (MTF) or organised trading facility (OTF). Post-trade data, including information on positions in commodity derivatives, must be supplied to regulators as well. This will include data points such as pricing, timing of transactions and volumes. This will require significant changes to fund managers’ and other MiFID regulated firms’ operations.
Transaction reporting will also apply to any financial instrument traded on a trading venue. It will include any financial instrument where the underlying is a financial instrument traded on a trading venue, or where the underlying is an index or basket of financial instruments traded on a trading venue.
Again, highly forensic information about the client, trader or algorithmic formula responsible for the trade is to be included in transaction reports which must be made through the trading venue where the transaction occurred or via an Approved Reporting Mechanism (ARM). While there were concerns that there could be overlap with EMIR derivative reporting, regulators have said if derivative reports supplied to a trade repository contain the same data, there is no obligation to report again.
There is no doubt that regulators in the run-up to 2008 lacked the pre-requisite information to properly identify build-ups in systemic risk. While there is an obvious merit to reporting much of this information, the risk regulators now face is that they are receiving far too much data to properly digest it all. Should another crisis or major fraud occur, regulators could face a torrent of criticism for failing to prevent such an event from occurring despite possessing all of the information.
The delay has fortunately given fund managers time to organise their systems and service provider relationships to ensure they can report in good time. A delay will also mean there is a reduced risk of a last minute panic to build reporting systems, something which would undoubtedly lead to errors and mistakes creeping in.
However, this delay should not be viewed by asset managers as an excuse for complacency. The implications of MiFID II are enormous, and its impact is going to be far more significant than previous rules such as the Alternative Investment Fund Managers Directive (AIFMD). As such, firms should focus on MiFID II implementation and work to attain compliance as soon as possible.
UCITS has evolved markedly since its inception in the 1980s, and continues to do so. It remains a truly global brand with particular interest from Latin American and Asia-Pacific allocators. UCITS V, which must be transposed into national law by EU member states by March 18, 2016, is going to bring about a number of changes around remuneration, depositary appointments and harmonisation of sanctions – i.e. fines for administrative breaches. The first two provisions are likely to have the biggest impact on managers.
The remuneration provisions contained within UCITS V broadly mirror those imposed on managers under the Alternative Investment Fund Managers Directive (AIFMD), and it is part of the regulatory effort to ensure that investor/manager interests are aligned. The rules will apply to individuals within UCITS funds whose roles have a material impact on the risk profiles of their firms.
Approximately 40% to 60% of variable remuneration must be deferred over at least three years, while at least 50% must be paid in non-cash instruments such as units in the UCITS fund itself or other approved financial instruments. This is designed to dis-incentivise excessive risk-taking. As with AIFMD, proportionality principles will apply to any restrictions around remuneration. In other words, firms below a certain Assets under Management (AuM) threshold will be excused from implementing restrictions around employee pay.
The UK’s Financial Conduct Authority (FCA) confirmed in 2014 that Alternative Investment Fund Managers (AIFMs) would be exempted from AIFMD remuneration rules if they managed less than £1 billion leveraged or £5 billion unleveraged. As such, this will therefore exempt a number of smaller UCITS managers from the provisions.
A more pressing challenge for UCITS managers surrounds the new rules around depositaries. UCITS V will broadly align depositary rules with those of AIFMD. However, there are differences around the principles towards discharging liability for lost financial instruments under UCITS V versus AIFMD.
AIFMD permits depositaries to discharge liability for loss of financial instruments to sub-custodians (agent banks, central securities depositories [CSDs]) in extreme circumstances which are beyond the control of the depositary. UCITS V explicitly prohibits depositaries from discharging any liability for lost financial instruments to sub-custodian entities.
There are reports that some UCITS managers are facing fee hikes from their depositary banks because of the increased risk they are now underwriting. This is particularly true for UCITS managers if they invest in slightly esoteric markets or instruments. One expert at a depositary bank acknowledged fee increases would be inevitable but said they were likely to be in the low single digit basis points.
The big fear is whether this ban on depositaries discharging liability under UCITS V is rewritten into AIFMD or introduced via an AIFMD II. Regulators have said there are no plans for this. Industry experts argue extending the prohibition on discharging liability to AIFMs would be unlikely given the risk profile of AIFMs and the institutional nature of their underlying investors. However, AIFMD is broad and applies to nearly any manager that is not a UCITS. It is therefore possible that non-UCITS retail AIFMs could be impacted by any extension of the ban on depositaries discharging liability.
While national competent authorities talk of a regulatory hiatus or temporary reprieve for fund managers, there is already speculation as to what UCITS VI may look like. Some hypothesise a pan-EU depositary passport could be introduced. This would allow managers to appoint a depositary located anywhere within the 28 EU member states, instead of having to appoint a provider in their fund’s jurisdiction. This would certainly increase competition and provide an opportunity for emerging EU fund domiciles such as Malta. Simultaneously, it would also imply the rules and regulations governing depositaries would need to be harmonised. Again, this could facilitate a pan-EU prohibition on the discharge of liability.
The most probable outcome of UCITS VI is likely to be a clampdown on the eligibility of assets permitted within a UCITS wrapper. There has been intense criticism that some UCITS managers are shoehorning illiquid or esoteric products into UCITS, raising concerns that there could be a liquidity shortfall in the event of mass redemptions. Such fears have already prompted the European Securities and Markets Authority (ESMA) to restrict UCITS’ exposure to commodity products in 2012. As such, regulators could further restrict UCITS from investing into certain asset classes or derivative products.
Regulators have made it abundantly clear that talk of UCITS VI is premature. While a consultation was issued in 2012, very little has been heard since. As such, regulators are probably focusing their attention on other areas such as the Capital Markets Union (CMU) with UCITS VI likely to be put on the backburner.
Regulators have made it no secret they want alignment of UCITS and AIFMD. Regulators are keen to push more esoteric products into AIFMD from UCITS, thereby making UCITS a strictly retail orientated product and AIFMD a purely institutional one. While the obligations under UCITS V could add to the costs of running a UCITS product, the asset class shows no sign of losing its appeal to investors globally.
Base Erosion and Profit Shifting (BEPS) is the latest tax initiative to impact the financial services industry following the US Foreign Account Tax Compliance Act (FATCA), its UK variant – “The Son of FATCA” and the Organisation of Economic Co-operation and Development’s (OECD) Common Reporting Standard (CRS).
Like CRS, BEPS is an OECD-led initiative first unveiled in 2014 and it is designed to clamp down on cross-border double non taxation and treaty shopping by multinational corporations. While the OECD cannot introduce legislation per say, it does carry political clout and a number of countries will take note of it.
BEPS will affect fund managers despite this not being the original objective of the OECD. Given its scope and ambition, many market participants assumed BEPS would be put on the backburner, unlikely to have a major impact on financial services for quite a few years. These market participants have been proven wrong.
BEPS has come into fruition remarkably quickly and it is going to be presented to the G20 finance ministers in October 2015. The initiative has a lot of political backing behind it, so a change of heart about implementing BEPS by national tax authorities looks unrealistic. An action plan is likely to be published at the end of the year meaning implementation could occur as early as 2016 or 2017. This is not long for financial institutions to prepare for BEPS.
Of the 15 action point plan being proposed by BEPS, several stand to impact fund managers. Action 6 is designed to prohibit treaty shopping or treaty abuse where a financial institution will structure their business to take advantage of tax treaties as a mechanism to reduce their tax bill. BEPS introduces a Limitation of Benefits (LOB) rule, which is likely to restrict treaty shopping. Another action point in BEPS is its stricter interpretation of permanent establishment, which would force financial institutions to have a substantive presence in the jurisdictions in which they are structured.
This matters to fund managers. A number of hedge funds or private equity funds will domicile their funds in tax efficient, offshore jurisdictions such as the Cayman Islands, British Virgin Islands (BVI), Bermuda, Jersey or Guernsey. Others will structure businesses in onshore jurisdictions such as Ireland, Luxembourg or The Netherlands as these countries also offer tax efficiencies. Any funds or special purpose vehicles domiciled in tax efficient jurisdictions benefiting from reduced tax on income or dividends should be concerned.
If a manager does not have investors or little/if any investments in these tax efficient jurisdictions, they could face scrutiny from tax authorities. Fund managers will now need to demonstrate meaningful substance in those countries to mitigate this risk.
While a number of firms will argue they manage capital on behalf of geographically diverse investors – and need to pool this capital into funds based in “tax neutral” jurisdictions, this is unlikely to convince national regulators to change course, particularly given the political backdrop. Some jurisdictions – notably Guernsey and Jersey – both of whom are home to sizeable private equity communities highlight senior personnel do reside there. They argue this should satisfy the authorities should they question managers’ substance in these jurisdictions.
BEPS does, however, distinguish between Collective Investment Vehicles (CIVs) and non-CIVs. The former are regulated fund vehicles such as UCITS, while non-CIVs are comprised of alternative investments such as hedge funds and private equity. CIVs will attain better treatment under BEPS than non-CIVs.
However, the OECD has made no reference as to whether alternative investment fund managers (AIFMs) regulated under the Alternative Investment Fund Managers Directive (AIFMD) are classified as CIVs or non-CIVs. Critics point out AIFMD is regulation and AIFMs are regulated, and as such should be afforded the same benefits as CIVs. Again, whether this request is granted is a big unknown. The OECD has yet to make public its stance.
The implication of BEPS should not be underestimated. As with previous tax initiatives, it is likely to prove extremely complicated and expensive. Some countries have already introduced their own variants of BEPS. The UK’s Diverted Profits Tax (DPT), which is part of the 2015 Finance Bill, requires firms to pay 25 per-cent on any profits that have been diverted to lower tax jurisdictions. The UK rules are extraterritorial and impact US parent companies with UK subsidiaries. Australia has said it could push for a DPT initiative as well. It is inevitable other countries will follow suit. If an un-harmonised approach to DPT is adopted, this could lead to widespread uncertainty for fund managers.
Cyber-crime is an issue that is rapidly gaining traction in financial services – among managers, investors and regulators. A survey of clients conducted by the Depository Trust & Clearing Corporation (DTCC) on their attitudes to systemic risk in May 2015 found 46 per-cent of respondents cited cyber-crime as the biggest risk to the world economy, while 80 per-cent identified it as one of their top five risks. This is more than double the number who identified cyber-crime as the biggest systemic risk in DTCC’s 2014 survey.
This should not be surprising. In 2013, the then Committee on Payment and Settlement Systems (CPSS), the International Organisation for Securities Commissions (IOSCO) and the World Federation of Exchanges (WFE) said 53 per-cent of 46 exchanges surveyed had been victim to cyber-crime over the preceding 12 months. Banks are not immune either. J.P. Morgan, for example, was revealed to have suffered a massive hack with accounts of approximately 75 million households being compromised.
The costs of cyber-breaches can be staggering. In 2014, the Director General of MI5 said one business in London had incurred £800 million in losses because of a single cyber-attack. Banks and market infrastructures such as exchanges, central security depositories (CSDs) and central counterparty clearing houses (CCPs) invest millions into cyber-protection and insurance. The same cannot be said for asset managers, many of whom believe they are too small or below the radar to warrant attention from cyber-criminals. Such complacency is dangerous. Some argue that smaller to mid-sized firms are actually more vulnerable to cyber-breaches as cyber-criminals are cognizant these organisations often lack the infrastructure and personnel to adequately deal with such threats.
Falling victim to a cyber-breach can result in substantial reputational damage. A KPMG study of institutional investors managing more than $3 trillion in assets found 79 per-cent would be discouraged from investing their capital into a business that had been victim to a cyber-crime.
Regulators are honing their sights on cyber-risks too. The US has been the most active with the Securities and Exchange Commission’s (SEC) Division of Investment Management publishing guidance in April 2015 following examinations of asset managers by the SEC’s Office of Compliance Inspections and Examinations. The SEC advised firms routinely assess threats and vulnerabilities, initiate a strategy to mitigate and respond to a cyber-threat, document policies and procedures and ensure staff are properly trained.
The overwhelming majority of cyber-threats can be mitigated through basic initiatives and procedures. The SEC highlighted firms should ensure they have password-protected access to sensitive files, data encryption, firewalls, restrictions on the use of USBs and technology systems to prevent cyber-breaches. Cyber-policies should be rigorously tested and any data or information must be backed up, ideally in a wholly separate data centre. It is also advised that fund managers which have outsourced huge swathes of their technology operations review the measures and procedures to guard against cyber-crime at their external vendors. Adhering to these best practices will help prevent most cyber-attacks.
Nonetheless, any cyber-breaches or attempted hackings must be reported to national authorities immediately. This comes as John Carlin, assistant attorney general for national security at the US Department of Justice, told hedge fund managers in May 2015 at the annual SALT Conference in Las Vegas that they should notify authorities if there is an attempted or successful cyber-breach at their organisations.
Regulators in the UK are also scrutinising cyber-crime. In 2014, the Bank of England announced at a summit held by the British Bankers Association a new initiative – CBEST – which would stress test financial institutions’ security systems utilising real-threat intelligence obtained from Internet monitoring. The Central Bank of Ireland (CBI) was reported to be scrutinising cyber-security policies and procedures at asset managers in May 2015 amid concerns that they have been found wanting.
But what are the threats facing managers? The most common cyber-attack normally involves a Distributed Denial of Service (DDOS), something which British Telecom (BT) estimates has impacted 41 per-cent of businesses globally. Increasingly firms have found sensitive, non-public material information being leaked. For fund managers, one of the biggest risks would be to have trading strategies disseminated into the public domain. A sophisticated hacker could even gain control of a firm’s portfolio management systems and start entering erroneous trades. One cyber-expert said fake websites had proliferated, prompting unsophisticated investors to allocate capital into entities that were not the manager. It is suspected that some of these funds have gone into the pockets of terrorists.
As such, fund managers do need to invest more time and effort into mitigating the risks of falling victim to cyber-criminals by ensuring their management teams are educated about the dangers, and adopt best practices. Managers are also strongly advised to purchase insurance against cyber-crime (a growing market), and check the coverage is sufficient against liability for any data breaches, damage to technology, losses and regulatory sanctions. It is also recommended the insurance policy provides coverage across all countries. Different US states, for example, have different rules and some coverage may not protect firms against losses in certain states.
Regulators and enforcement agencies must also adopt a harmonised approach to helping industries safeguard against cyber-crime. An article published by Slaughter & May in April 2014 said different jurisdictions apply different rules towards security techniques by which corporates can protect themselves against cyber-breaches. The Slaughter & May article highlighted some jurisdictions, for example, prohibit data encryption unless the encryption codes and keys are supplied to the national competent authorities. Such conflicting rules hinder the ability of firms with global footprints to deal with cyber-threats. As such, a more consistent approach needs to be taken by national authorities towards cyber-protection.
Aside from following best practices and educating their staff, asset managers should look to work closer with their peers on how to mitigate the risks of cyber-crime. The WFE created a cyber-security committee in 2013 with the sole objective of enabling industry participants to share information on cyber-breaches. In 2014, the DTCC urged regulators and financial institutions to work more closely to mitigate the risks of cyber-crime, and to help develop sensible regulations. Fund managers should certainly be a part of this collaborative effort as they are not immune from cyber-crime.
The European Securities and Markets Authority (ESMA) advice followings its review of the implementation of the Alternative Investment Fund Managers Directive (AIFMD) did not yield many unwelcome surprises. In fact, numerous market participants had anticipated a delay to any announcement as to which non-EU countries will be able to avail themselves to the pan-EU distribution and marketing passport. While the news is not to everyone’s liking, there are some grounds for optimism.
ESMA confirmed it had reviewed the regulatory regimes in six jurisdictions –Jersey, Guernsey, Switzerland, US, Hong Kong and Singapore. Of those six jurisdictions, ESMA said it saw no obstacle to Switzerland, Guernsey and Jersey being granted access to the pan-EU passport. This news will be welcomed by a number of private equity and real estate managers, many of whom are domiciled in Guernsey and Jersey.
The Channel Islands had made enormous strides in seeking to obtain AIFMD equivalence by introducing dual-sided funds’ regulation in a timely fashion, permitting managers to simultaneously attain AIFMD compliance and utilise national private placement regimes (NPPR), while allowing others to bypass EU investors altogether and focus only on soliciting investment from non-EU allocators. This pragmatic, forward-thinking approach has certainly paid dividends for fund managers domiciled in Guernsey and Jersey.
ESMA has yet to take a definitive view on whether the passport be extended to managers operating out of the US, Singapore or Hong Kong citing concerns relating to competition, regulatory issues and a lack of sufficient evidence to properly assess the relevant criteria. There are concerns among EU regulators that US fund managers might receive preferential treatment when marketing into the EU were the passport extended compared to the treatment afforded to EU managers marketing into the US. Furthermore, the ESMA consultation appears to refer to the difficulties of EU AIFMs marketing to US retail investors when AIFMD is aimed strictly at professional investors. This is an issue that needs to be clarified.
Other areas where equivalence in the US is found wanting with the EU is around manager remuneration, professional investor accreditation and capital requirements. There are hopes that ESMA will come to a decision quickly on whether the passport will be extended to the US given its dominance in the alternative investment fund management industry.
The notable absence of certain offshore jurisdictions, namely the Cayman Islands, British Virgin Islands (BVI) and Bermuda has caused some concern. Again, this should not be a surprise. Some feel it would have been politically impossible to extend the passport to these jurisdictions in the first wave of approvals. Others argue these offshore territories simply do not meet equivalence.
Nonetheless, some did attempt to introduce equivalent regulation albeit quite late in the day. In mid-July, the Cayman Islands announced it would establish two opt-in regimes which it said were consistent with the AIFMD. This would allow fund managers to tap EU institutional money via the existing NPPR or through the passport as and when it became available. It would also allow managers without EU investors to maintain the status quo.
While there is nothing to prevent ESMA extending the passport to the Cayman Islands in the future, it certainly would not have had time to evaluate the proposed regulatory framework that had just been announced. Nonetheless, ESMA has made it clear it will review other countries including the Cayman Islands, Australia and Canada in later passport assessments. Quite how long this will take is uncertain.
There are a number of implications of this. Firstly, many expect that NPPR will remain in place for a few more years, and with it the depositary-lite model, possibly even beyond 2018. ESMA even said that the delayed transposition of AIFMD in some member states made a meaningful analysis and assessment on the functioning of NPPR difficult. ESMA said it would like to have more time to assess its impact before issuing another opinion on NPPR.
Another consequence could be that non-EU managers, particularly those in the US, may simply elect to establish onshore investment vehicles. Many managers had hoped the ESMA advice would be more definitive, which obviously has not materialised. As such, some firms may give up on waiting for regulatory certainty and just look to attain AIFMD compliance in the near-term by launching onshore vehicles if the cost economics make sense – for example, if they have investors across a number of EU countries. Those managers marketing into a handful of EU member states will continue to use NPPR. The uncertainty, limitations and risks associated with reverse solicitation will also make this approach more attractive to fund managers.
Going forward, ESMA approvals of third countries will undoubtedly take time. Some experts even warn the European Commission could reject the ESMA findings, a scenario which would lead to more delays.
The aftermath of the financial crisis has precipitated a number of changes in financial services, none more so than the fact that governments have identified some financial institutions as being simply “too big to fail.” In 2011, the US Congress stated that any foreign or domestic bank holding company with more than $50 billion in assets constituted a Systemically Important Financial Institution (SIFI), a financial entity whose collapse or failure would have severe ramifications on capital markets.
It was inevitable global regulators would move their remit beyond banks into what has been dubbed the shadow banking market. The $182 billion US government bail-out of American International Group (AIG) demonstrated a non-bank financial had the potential to pose a systemic risk. The intervention of the US Treasury to guarantee deposits held in money market mutual funds under the Temporary Guarantee Programme in 2008 when the Reserve Primary Fund “broke the buck” following its Lehman Brothers exposure was another incident which undoubtedly meant regulators would be lining their sights towards other market participants.
A publication produced by PricewaterhouseCoopers (PwC) identifies farm credit unions, stock exchanges, central counterparty clearing houses, swap execution facilities, trade repositories, broker-dealers, futures commissions merchants, fund managers and hedge fund managers as entities that regulators might designate as SIFIs. Such a label would subject these financial institutions to an onslaught of bank-style rules and regulations, which could render their businesses uneconomic.
Unhelpfully, it appears that multiple regulatory agencies in the US, EU and on a global level are pursuing the same agenda with what some believe to be minimal coordination. The Financial Stability Oversight Council (FSOC) was created under Dodd-Frank with the sole objective of monitoring systemic risk. The FSOC had originally envisaged designating the largest asset managers as SIFIs although appeared to retreat from this stance, and instead refocused its sights on products being offered by asset managers, as well as their practices such as securities lending and leverage.
Large asset managers including BlackRock, PIMCO and Fidelity have lobbied against the FSOC’s proposals. BlackRock, which manages approximately $4.6 trillion in Assets under Management (AuM) argued to US regulators that asset managers are not SIFIs and that major events at these financial institutions do not pose a risk to broader markets. BlackRock cited the limited market reaction to outflows from PIMCO following the shock departure of Bill Gross as evidence that large fund managers do not pose a systemic risk. Other non-banks are taking a more aggressive approach. Insurance giant MetLife has taken legal action against the US government in response to its SIFI designation. General Electric is offloading its asset management and financial products business, to avert the risks and costs of being deemed a SIFI.
The European Banking Authority (EBA),a regulatory body whose name suggests was thought to have limited if any remit over fund managers, has waded into the argument too. The EBA announced that it wanted to curb credit institutions’ exposures to shadow banks, and ensure banks have sufficient capital to withstand a failure of a shadow bank. It has been suggested banks should not have more than 25 per-cent of their total capital buffers exposed to shadow banks. There are concerns the EBA’s definition of what constitutes a shadow bank could include UCITS managers and managers of Alternative Investment Funds (AIFs) regulated under the Alternative Investment Fund Managers Directive (AIFMD). Reports suggest the EBA wants to push these reforms through in 2016. As such, this could be yet another hindrance for asset managers.
The third front being opened up against asset managers is a global one waged by the Financial Stability Board (FSB) in conjunction with the International Organisation for Securities Commissions (IOSCO). The FSB and IOSCO recently published a second consultation advocating a SIFI designation materiality threshold of $100 billion in net assets for asset managers, and $400 billion gross notional exposure for hedge funds, which would include the gross notional value of any outstanding derivatives and leverage in the calculation. As such, some large hedge funds could be affected.
Furthermore, the calculations proposed by the FSB and IOSCO do not take into account for netting or the posting of collateral. Some argue hedge funds do pose a systemic risk, evidenced by the market panic following the failure of Long Term Capital Management (LTCM). However, LTCM was leveraged at 25 times its Net Asset Value (NAV), a ratio that is a rarity today. Even the UK’s Financial Conduct Authority (FCA) said the overwhelming majority of hedge funds used low levels of leverage in its latest hedge fund survey published in June 2015. Martin Wheatley, chief executive officer at the FCA, recently gave his backing to asset managers more broadly saying that they should not be deemed as SIFIs. Whether US, EU or international regulatory agencies heed this advice is difficult to gauge.
But managers could unwittingly find themselves ensnared. One unintended consequence of the Annex IV regulatory report mandated under AIFMD is that the regulatory reports actually inflate AuM beyond what most managers would have put down in their investor reports. Regulatory Assets under Management (RAUM) calculations as demanded under Annex IV incorporate the notional value of derivatives and fail to account for hedging or netting arrangements, and also includes leverage. As such, a fund manager’s assets being reported under Annex IV could be far higher than what they assumed was the case. One New City Initiative (NCI) member with $350 million said his Annex IV RAUM figure was substantially higher and appeared at $1 billion. As such, regulators could assume the asset management industry is bigger and more systemically important than it actually is. At a bare minimum, some asset managers could find themselves subject to more frequent regulatory reporting obligations if their RAUM is above certain thresholds.
The consequences of SIFI designation for asset managers could be serious. The added reporting and regulatory obligations, namely liquidity risk management standards, capital requirements, stress-testing, curbs on remuneration and even the introduction of “living wills” will add to fund managers’ costs at a time when operational and regulatory overheads are already significant.
Client suitability is an issue at the forefront of the UK Financial Conduct Authority’s (FCA) agenda. The introduction of the Retail Distribution Review (RDR) in 2012 required investment firms to assess whether their portfolios and advice was aligned with their clients’ suitability. In other words, were clients being sold or advised on the correct financial products, and were these in line with their risk parameters and understanding? It is not just the FCA. The Markets in Financial Instruments Directive II (MiFID II) requires firms giving investment advice to supply periodic reports to clients outlining an assessment of their suitability for the product.
The EU is simply playing catch-up as FCA requirements already oblige firms to provide suitability reports to retail clients to whom they make recommendations. Suitability reports identify the requirements and risk profiles of clients, and explain in plain English the rationale including the pros and cons as well as the associated costs of any recommendations. These reports have to be kept on record for several years. They must also be periodically updated so as to take into account material changes in the clients’ risk profile or net worth. This can be an incredibly time-consuming exercise for wealth managers with market participants stating it can take several hours to simply produce one report. For firms with thousands of retail client accounts, producing suitability reports is a significant undertaking and massive distraction. The regulator has told managers these reports do not need to be overly complex, although this does not negate the challenges facing institutions tasked with producing the reports.
The Financial Services Authority (FSA) – the precursor to the FCA – has conducted a number of thematic reviews into wealth managers’ practices and has taken regulatory action against a handful of firms. Many wealth managers have made significant operational improvements to how they assess clients’ suitability. In the FCA’s latest thematic review, the regulator is yet again assessing the suitability standards provided to clients. It has asked a handful of wealth managers to provide it with information on client portfolios, processes for gathering customer information and assessing attitudes to risk. The FCA has demanded a substantial amount of data from the affected wealth managers, and the time-frame allotted to supply this information to the regulator is not generous – again, something that is frustrating wealth managers.
The regulator has said it will assess whether an on-site review of wealth managers’ practices in this area will be required. One wealth manager highlights the industry is highly reputable, and says there are very few documented cases of respectable wealth management firms being sued by a client, or being sanctioned by a regulator for offering clients unsuitable investments. Irrespective, the FCA’s thematic review could potentially herald further regulatory clampdowns. Quite what these will be is the big unknown and it will be contingent on the FCA’s findings. Should the thematic review show major improvements and high standards of compliance, the likelihood of intrusive regulation is lower and vice versa.
It is perfectly understandable and reasonable that wealth managers conduct suitability assessments on clients. But it is important these assessments are proportionate. Wealth managers should be allowed to use their own judgement to determine how they work with their clients, instead of filling out copious amounts of forms and data, much of which add little to investor protection. The burden of proof required to demonstrate suitability is onerous and at times excessive. Regulators should enable wealth managers to streamline the process.
But the biggest challenge, according to one wealth manager, is that suitability tests will make it prohibitively costly to take on smaller accounts. Smaller accounts – broadly speaking- tend to pose a higher risk to the manager in terms of suitability, and this could discourage managers from on-boarding those accounts. Managers already err on the side of caution when determining equity weightings for small clients as the burden of proof on the manager to demonstrate the client has sufficient risk appetite, capacity for loss, experience and understanding is so high. As such, these clients often find themselves with high exposure to bonds – a number of which have negative yields – instead of equities as regulators tend to view bonds as low risk and equities as high risk. This deprives those retail clients from a steady source of investment returns and reduces choice.
It is entirely justifiable wealth managers demonstrate that they are acting in the best interests of their clients, but the level of proof required by the FCA is disproportionately high.
The implications of the Foreign Account Tax Compliance Act (FATCA) are well-documented. The legislation, which has been strongly criticised for its extraterritorial nature, has been in train for several years now and obligates financial institutions and foreign financial institutions (which includes fund management houses) to disclose US accountholders’ details or at least prove that there are no US accountholders to the Internal Revenue Service (IRS). The rationale behind FATCA is straightforward. It is part of the US government’s clampdown on wealthy Americans who have failed to pay their income tax. The settlement by UBS to the tune of $780 million with US authorities for helping to abet tax evasion provided the impetus for the US government to act against tax evasion.
Non-compliance is not an option. Failure to adhere to the rules will result in a 30 per-cent withholding tax on all US derived payments. In addition, the reputational risk associated with non-compliance would certainly scare off any prospective investors from allocating into a fund. As such fund managers must identify all of their US clients. This can be achieved by demanding clients supply either a W-8 form or their passports.
Nonetheless, the definition of what constitutes a US person is not clear-cut. US indicia goes beyond having a US passport. Under FATCA, any individual with a US mailing address, power of attorney in the US or who has been a long-term resident in the US could be classified as a US person. If an investor has not properly revoked their Green Card, they too could be ensnared. Perhaps more troubling is that individuals born and resident in a third country but with US parentage could be caught under US indicia. In short, fund managers have to up the ante on their know-your-customer (KYC) checks. While most investors recognise the quagmire fund managers are in, there are risks that some might be reluctant to provide this information. As such, managers will have no other option but to kick out recalcitrant or non-cooperative clients from their funds.
A further complication is the proliferation of Intergovernmental Agreements (IGAs) that the US has hammered out with third countries. IGAs were intended to make FATCA more palatable to third countries by requiring the US to hand over reciprocal data on third countries’ recalcitrant taxpayers with US accounts. Ironically, some political figures in the US lamented IGAs for breaching the privacy of US financial institutions. There are two models of IGAs circulating, and there are variances even within the same model of IGA. Fund managers therefore operating out of multiple jurisdictions will have to be compliant with each IGA in each of the jurisdictions in which they have offices. Firms will therefore have different reporting obligations in different countries.
But FATCA is only the beginning. Rules on tax information exchange are proliferating globally and these are going to present operational challenges for fund managers. The recent woes to affect HSBC’s private banking operations in Switzerland have certainly provided politicians globally with more firepower to pursue this agenda. Furthermore, a governmental clampdown on wealthy citizens failing to pay tax is hardly a vote loser in this political environment. In other words, it is a near certainty that these rules are going to come into force.
But what exactly do these tax information exchange proposals look like? The UK has introduced its own version of FATCA with its Crown Dependencies and Overseas Territories, which comprise Jersey, Guernsey, Isle of Man, Anguilla, Bermuda, the British Virgin Islands (BVI), Cayman Islands, Gibraltar, Montserrat and the Turks and Caicos Islands. The rules effectively mirror US FATCA and obligate financial institutions in these territories to supply data on UK accountholders to the Inland Revenue and vice versa. China – as part of its clampdown on high-level corruption – passed the Foreign Asset Reporting Requirements which forces wealthy citizens to publish details of any offshore accounts they may hold.
Perhaps the biggest initiative is the Common Reporting Standard (CRS) being pushed by the Organisation for Economic Co-operation and Development (OECD). CRS is due to come into force next year. This proposal looks set to provide a multinational framework for tax information exchange with 90 countries reportedly involved in the project albeit at different stages of progress. CRS has been dubbed a Global FATCA or GATCA.
The reporting obligations for these multiple tax information exchange agreements could be an operational headache. The best mechanism by which to prepare is to ensure systems and processes for gathering all of the required data are holistic and coordinated. Furthermore, many financial institutions are likely to leverage some of the expertise and skill-sets acquired through compliance with US FATCA. In addition, service providers such as fund administrators and technology vendors have unveiled products that can help managers meet these reporting requirements. Most managers acknowledge that dealing with FATCA itself has not been that onerous, although they concede that understanding the myriad rules and obligations has been difficult and far from straightforward. Given the multitude of tax information exchange rules coming into force, and their multifarious nature, fund managers will have a lot of work to do going forward.
As part of the EU’s efforts to increase the amount of non-bank funding available to the real economy, policymakers are heavily pushing the European Long Term Investment Fund Regulation (ELTIF), which will enable both institutional and retail investors to allocate to managers with heavy exposure towards illiquid asset classes such as infrastructure, real estate, or private loans. ELTIFs are in effect something of a halfway house between a traditional UCITS structure and an alternative investment fund manager (AIFM) subject to the Alternative Investment Fund Management Directive (AIFMD). Experts believe that smaller to mid-sized pension funds and insurers, some of whom will not have the expertise or operational infrastructure, to invest in alternatives, will be keen buyers of these products. The minimum subscription amount of €10,000 is certainly low enough to enable a number of retail investors to allocate. The ELTIF is projected to be adopted by the middle of 2015 and implemented by year-end 2015 or early 2016, although some hypothesise this regulatory timeline is too ambitious.
To become approved as an ELTIF, a manager must already be subject to AIFMD, although there are additional requirements which are more akin to UCITS. Namely, an ELTIF must appoint a UCITS V full-scope depositary bank and supply a Key Information Document (KID) to investors, a prerequisite of the UCITS IV Directive. As such, the ELTIF can then be passported across the EU. ELTIFs are by their nature required to invest 70 per-cent of their capital into long-term investments, although the fund cannot have more than 10 per-cent exposure to any one particular asset. This will enable diversification although this is already common practice in a number of infrastructure funds marketed to institutional investors. 30 per-cent of assets must be held in highly liquid securities that meet UCITS eligibility criteria. ELTIFs – given their nature – will lock all investors in for the shelf-life of the fund, and regulators have actively discouraged managers from offering redemptions, although they have not prohibited it. For those ELTIFs that do permit redemptions, it cannot be before the half-life of the fund. This is to encourage sticky capital. Nonetheless, for those few managers that permit redemptions, their 30 per-cent holdings in liquid assets should enable them to meet any redemption requests in a timely fashion.
In terms of investor protection, there are obvious concerns but these can be overcome. Real assets can depreciate in value, and oftentimes it can take a long time for these assets to recover. Retail investors tend to have short term investment horizons, and must be kept well informed that their assets are in fact locked in for the life cycle of the fund, and cannot be redeemed. In other words, retail allocators have to be clearly notified that their capital is actually invested in long-term investments, and is not subject to mutual fund style redemption terms. The rules do afford other investor protections. For example, an individual with a “portfolio” of less than €500,000 cannot have more than 10 per-cent of their net worth invested in ELTIFs. Quite what constitutes portfolio is at present unclear. If it applies to investable assets only, the sum is reasonably substantial, but if that €500,000 includes the value of an individual’s primary residence and net worth, the threshold is very low.
There are other restrictions although these are to be expected given retail money is at risk. ELTIFs are explicitly prohibited from using derivatives as a form of speculative activity, confining it instead to the hedging of risk. A Clifford Chance paper adds ELTIFs are curbed from short-selling; taking on excessive leverage; having direct or indirect commodity exposures; and securities lending or repurchase transactions if it affects more than 10 per-cent of the ELTIFs’ assets. ELTIFs are, however, permitted to invest in other ELTIFs, which could precipitate an ELTIF funds of funds industry. Whether or not these will succeed is open to debate given an ELTIF fund of funds would be yet another layer of fees that investors are required to pay. ELTIFs can also allocate into European Social Entrepreneurship Funds (EUSEF) and European Venture Capital Funds (EUVECA) although these products have not enjoyed resounding success and have struggled to attract meaningful capital.
The big question is whether ELTIFs will be a success. The initiative certainly will not hurt the asset management industry although ELTIFs will most likely be the preserve of only the larger AIFMs. At present, the proposal is in its embryonic stages, and marketing has yet to begin so it is difficult to assess whether they will be successful. Previous efforts such as EUVECA and EUSEF have notably struggled to attract interest. Others point out it would make more sense to launch an infrastructure fund wrapped as an AIFM because there will be fewer investment restrictions.
The implications of the Markets in Financial Instruments Directive (MiFID II) should not be underestimated by the fund management industry. Given its sheer volume and depth of content, this ought not to come as a surprise. However, its implementation date – January 3, 2017 – is rapidly approaching and fund managers are going to have to make substantial changes to their operating model if they are to attain compliance. One of the most contentious aspects of MiFID II surrounds managers’ use of dealing commissions to pay for equity research.
What does MiFID II mean for research?
In summer 2014, the European Securities and Markets Authority (ESMA) proposed an outright ban on the use of dealing commissions to pay for research. This was reaffirmed in the publication by ESMA of the second consultation on MiFID II on December 19, 2014. Quite what constitutes research is open to debate. Cautious lawyers advise that access to research analysts, bespoke reports, corporate access and market data services [Bloomberg, Thomson Reuters] could all be affected. The train was set in motion more than two years ago when Martin Wheatley, chief executive officer at the Financial Conduct Authority (FCA) publicly criticised asset managers for charging what he termed erroneous expenses to the end investor and masking it as research. Despite these forceful words, the FCA adopted a pragmatic approach towards the issue. In May 2014, the FCA announced in policy statement 14/7 that fund managers could only use equity commissions to pay for “substantive” research. The precise definition of “substantive” was not elaborated on but it was made clear this did not extend to corporate access. In a follow-up paper in July 2014, the FCA warned asset managers that not enough was being done about equity commissions being used to purchase research, and added there was a strong possibility MiFID II would impose similar restrictions on research.
MiFID II does indeed go further than that of the FCA. If firms are going to have to pay for research through their management fees, the most obvious knock-on effects will be that managers incur a drag on returns, or simply buy less research. Research by German bank Berenberg estimated UK asset managers could see 20 per-cent to 30 per-cent wiped off their profits if research costs were absorbed into the P&L. This will do nothing but a disservice to end investors. The pain will be felt most by smaller fund managers, who do not have the economies of scale to pay for it out of their management fee. Such additional charges could make the barrier to entry into the asset management space even higher at a time of already mounting regulatory and operational costs. Another challenge could be if a culling of research facilitates negative performance. That the Securities and Exchange Commission (SEC) has shown little enthusiasm towards tinkering with its policy on soft-dollars indicates the UK and EU could be put at a competitive disadvantage should MiFID II get fully implemented. There are dissenting voices. Some believe the bulk of research is ignored the vast majority of the time, and that it adds limited value to firms’ investment decisions. These same individuals point out firms could actually make cost savings if they culled chunks of research.
Whether or not MiFID II prompts a wholesale decline of research is uncertain. The FCA has confirmed it is supportive of ESMA’s plans around research, which recommend investment managers pay for research through their own resources or through a research payment account, which can be charged to clients separately. However, all of the costs associated with this account must be agreed upon with clients, and expenses must be disclosed to the end investors. The biggest risk (and unintended conflict of interest) that could arise would be if managers provide business to brokerage houses in exchange for free or heavily discounted research. Others prophesise independent research houses could be adversely impacted as they tend to charge higher prices. Nonetheless, these specialist institutions could potentially thrive assuming their research is genuinely bespoke. Furthermore, cost advantages do remain to hiring specialist researchers. After all – commissioning an independent research firm to undertake an evaluation of Uzbekistan’s infrastructure – for example – would certainly be cheaper for an asset manager than appointing a full-time staffer in house to do the job. The industry can indeed help itself, particularly those selling this research. Asset managers routinely complain about the spurious lack of transparency around brokerage research insofar as how it is priced within a bundled service offering. Brokers should be required to clearly identify the costs of research into the overall charges they pass onto asset managers, so managers can determine whether they want to pay for it, while enabling them also to be transparent to their own end investors. Whether or not this becomes a regulatory requirement is unknown.
MiFID II’s raison d’etre is all around transparency, and the ban of equity commissions paying for research is just one part of it. It is not just regulators that are clamping down on research but investors too. Asset managers report that sovereign wealth funds and public sector pension plans are sensitive to these costs, and this has prompted a number of firms to phase out or begin to phase out soft-dollars for research. These allocators comprise the bulk of institutions investing in the asset management industry today, so their opinions cannot be ignored. The imminence of these rules should not be underestimated. Managers should therefore explore other mechanisms by which they pay for their research.
First proposed in 2009, the EU’s Solvency II Directive’s core objective is to prevent a taxpayer bail-out of an insurer should its investments turn sour rendering it unable to meet its policyholders’ obligations or enter into a major credit event. After several years of delay, the Directive will be implemented in January 2016 although it will be transposed into national EU member state law as of January 2015. The logic behind the Directive is fairly reasonable. AIG – having sold credit default swaps (CDSs) on collateralised loan obligations (CLOs), many of which were structured securities backed by sub-prime loans that were effectively junk – found itself having to be rescued by the US government with a bail-out to the tune of $182 billion. The events surrounding AIG have prompted global and national regulators to designate a number of insurers to be systemically important financial institutions (SIFIs) - therefore subjecting them to greater regulation and risk oversight. Solvency II is part of this clampdown. The Directive – put briefly – comprises three pillars. Pillar 1 imposes a capital adequacy regime on insurers not too dissimilar to what has been implemented at banks insofar as it requires insurers to hold varying levels capital on their investments corresponding to the perceived risk profile of those investments. Pillar 2 outlines the governance and risk management standards insurers must adhere to, while Pillar 3 requires insurers to supply information about their investments and assets to national competent authorities on a timely basis.
Why does this matter to asset managers?
Capital raising for asset managers in both the long-only and alternative world has been challenging. Insurers are awash with a wealth of available capital. Analysis by PricewaterhouseCoopers (PwC) forecasts insurers will have approximately $35.1 trillion in investable assets by 2020, compared to $24.1 trillion in 2012. This should make them ripe targets for prospective asset raising. Solvency II is not directed immediately at asset managers but its impact will be felt by them nonetheless courtesy of Pillar 1 and Pillar 3. Pillar 1 stipulates insurers must hold more capital if they invest into what regulators perceive to be higher volatility and riskier products [See table below].
Hedge funds, ‘other equity’
Private equity, OECD listed equities
European Economic Area (EEA) sovereign debt
The capital weightings have predictably incurred much scorn. That a hedge fund providing a risk-adjusted return incurs a 49% capital charge versus a 0% charge on European Economic Area (EEA) sovereign debt despite Portugal, Ireland, Greece, Spain and Cyprus all receiving bail-outs during the Eurozone crisis has prompted some frustration. Commentators point out that capital requirements could force insurers to shift their portfolio exposures from alternatives. A move away from diversification could have negative ramifications for insurers during another (all too possible) market downturn. There has been a steady stream of industry and academic papers advocating alternatives be subject to a lower capital charge, and regulators did acquiesce for private equity, which originally had a capital charge of 49% bracketing it alongside hedge funds. Lxyor Asset Management in conjunction with EDHEC advocated hedge funds be allowed a capital charge of approximately 25%. Such a climb-down is wishful thinking, mainly because it would be politically impossible for EU officials to justify irrespective of the merits.
But there are mechanisms by which fund managers can help insurer clients lower their capital charges. This can be done through enhanced transparency on a regular basis to insurers by fund managers. If a fund manager provides position level data enabling the insurer to look-thru the portfolio and identify assets which have a lower risk weighting, then the insurer can lower its capital adequacy charge if it sufficiently demonstrates to regulators that its investments are at the lower end of the risk spectrum. Some have warned this “preferential transparency” by fund managers to insurers could precipitate awkward questions from regulatory bodies such as the US Securities and Exchange Commission (SEC) who might be mindful that a handful of investors are receiving better treatment in a pooled fund vehicle. This has been countered by industry experts who argue the establishment of a managed account vehicle at a fund for individual insurance clients should mitigate the risk of regulatory sanction. Another method by which insurers could lower their capital charges – particularly those with exposure to alternatives – is by encouraging managers to provide them with the Open Protocol Enabling Risk Aggregation (Open Protocol) risk reporting toolkit developed by Albourne Partners. There are similarities between the Open Protocol and the data Solvency II obligates insurers to collect from managers, and this too could help alleviate the pain around capital charges.
But this is not without its challenges. Managers will be obligated to provide proprietary data to clients, which could intentionally or unintentionally find itself in the public domain. Such leakage could precipitate copycat trading, or short squeezes. The sheer volume of data that must be supplied by fund managers is substantial, and must be provided in a timely manner. The operational challenges this presents should not be underestimated. It is therefore advised that fund managers that count insurers as clients should give this data collection exercise some serious thought.
Whether or not Solvency II will lead to insurers having a diminished risk appetite is a bit of an unknown. Surveys by different banks reach different conclusions, often polar opposite. Perhaps the best way for fund managers to deal with the challenge is to start gearing their operational set-up to cope with these transparency requirements. Another potential issue could arise if the Solvency II capital adequacy regime was extended to pension funds via the Institutions for Occupational Retirement Provision (IORP) Directive. In 2013, pension fund associations, trade unions, plan sponsors and fund managers successfully persuaded the European Commission to shelve such a requirement highlighting it would exacerbate the already sky-high liabilities at pension schemes across Europe. There is a strong possibility the European Commission could yet resurrect this provision in what could have serious ramifications for the European fund management industry.
EMIR, which took effect on February 12, 2014, obligates financial institutions including fund managers and pension funds, and non-financial institutions such as corporates, to report details of their over-the-counter (OTC) and exchange traded derivatives (ETDs) to the six trade repositories (Depository Trust & Clearing Corporation, Regis-TR, UnaVista, CME Trade Repository, ICE Trade Vault Europe, KDPW) approved by the European Securities and Markets Authority (ESMA).
EMIR in effect is part of the G20 agenda to clampdown on OTC derivatives, widely held to be responsible for contributing to the 2008 financial crisis. EMIR is part of the effort to enable regulators to spot build-ups of systemic risk in the derivatives markets. EMIR is all-encapsulating. It applies to equity, interest rate, currency, commodity, credit and “other” OTC products as well as ETDs. There are few exemptions - even index or basket-linked products are ensnared. The only exemption so far in Europe is exchange traded warrants. Unlike Dodd-Frank, where the Commodity Futures Trading Commission (CFTC) permits for single-sided reporting (IE one counterparty – nearly always the central counterparty clearing house [CCP] or swap dealer) of swaps instruments to swaps data repositories (SDRs), EMIR requires both counterparties to a derivatives transaction to report. This policy in Europe has caused severe problems.
What are the problems?
In order for trade repositories to identify counterparties to a derivatives trade, firms need to obtain what is known as a Legal Entity Identifier (LEI), a unique alphanumeric code. Obtaining an LEI was certainly not top of the agenda for the bulk of buy-side institutions although the early teething problems appear to have been resolved on this matter. The core challenge today surrounds the Unique Transaction Identifier (UTI) or Unique Product Identifier (UPI), which are required to tag specific transactions between two counterparties thereby avoiding duplication at the trade repository. That ESMA did not provide technical guidance on how trade repositories should actually work until the day before EMIR’s implementation did not alleviate the inevitable difficulties. That guidance, particularly around the development of UTIs certainly threw the industry off-balance. ESMA devised multiple methodologies by which financial institutions could develop UTIs and never clarified which counterparty to a trade should actually create the UTI. In the guidance, it said either the trading platform or CCP assign the UTI for any ETD transactions. For OTCs, it said counterparties to the trade develop the UTI leaving it open as to whether the fund manager or its counterparty is responsible.
This has prompted enormous confusion. Both buy-side firms and their counterparties are developing UTIs concurrently, and oftentimes these alphanumeric codes are wildly different. With no common methodology or process for generating a UTI, trade repositories are finding it nigh on impossible to match trades enabling regulators to identify build-ups of systemic risk in the derivatives markets. In other words, this data is simply being reported for the sake of being reported. This was evident in the summer of 2014 – four months into EMIR’s implementation. Speaking at the International Derivatives Expo in London, an executive from the DTCC said that just roughly 30 per-cent of OTC derivatives and three per-cent of ETDs that were being reported had been paired successfully. The supply of inaccurate and incomplete data is unlikely to go down well with regulators. Having initially adopted a pragmatic approach to errors and mistakes in trade reports following EMIR’s implementation, patience appears to be wearing thin with speculation that regulators will begin to impose fines and sanctions on market participants who continue to submit inaccurate reports to trade repositories. To rub further salt into the wounds of asset managers, regulators in Brussels have made it no secret that resolving the issues around UTI generation is a problem for the industry and not for regulators.
Challenges going forward
Fortunately, EMIR permitted managers to delegate derivatives reporting to third party service providers albeit not the responsibility. A handful of technology vendors and reporting platforms – many of whom already had access to details of managers’ OTC transactions – began offering delegated reporting. The majority of custodian banks, despite having a comprehensive list of their fund managers’ transactions – were loath to assist. While there were a few notable exceptions, many custodians argued that reporting under EMIR on behalf of clients would require enormous investments in internal operational infrastructure, adding the risk-reward and liability was simply too high for reporting to be commercial. A handful of fund administrators provide reporting but the lateness of ESMA’s guidance meant many were reluctant to take the commercial risk of investing in infrastructure that may not actually work or adhere to the regulatory standards. Finally, clearing brokers did offer the service to larger clients although following EMIR’s implementation, many started to offer delegated reporting to their broader client base. This has predominantly been a goodwill service, and anecdotal evidence suggests some clearing brokers are considering a retreat from delegated reporting. If such a scenario becomes more mainstream, fund managers will be obligated to port business to another provider in good time. Whether or not regulators in Europe simplify EMIR reporting is open to debate. The European Commission is set to review EMIR in 2015, and regulators have suggested single sided reporting could be introduced. Such an outcome would alleviate the challenges facing fund managers.
Despite all of the travails surrounding EMIR’s implementation, the regulators show no sign of abating. In fact, regulation of the shadow banking space seems only to grow. In January 2014, the European Commission confirmed it was looking to introduce Securities Financing Transaction Regulation (SFT), which would require financial and non-financial institutions engaging in securities financing transactions such as repos, reverse repos, securities lending and borrowing transactions, buy-sell backs, sell-buy backs, total return swaps, liquidity swaps and collateral swaps, to report these transactions to repositories. While the rules are unlikely to be imposed for a few years, regulators have confirmed they intend to model SFT on EMIR. Fund managers might want to brace themselves for EMIR part two.