In 2016, a handful of well-known UK-based open ended property funds invested in UK commercial real estate were forced to implement redemption gates after Brexit, as it became clear that their assets could not be realised quickly enough to satisfy the flurry of client redemption requests. In this instance, gating was necessary and effective, as it prevented further market turmoil, a point made by the UK’s Financial Conduct Authority (FCA) at the time. What unfolded in June 2019 at Woodford Investment Management’s Equity Income Fund has not elicited as sympathetic a response from the market, however.

UCITS: A trusted brand under fire

Having accumulated more than EUR 10 trillion in assets from investors globally, UCITS enjoys a reach and influence that few mutual fund wrappers – such as 40 Act funds in the US – can relate to or compete with. UCITS’ success is based primarily on its flexibility (i.e. the simplicity by which a third country manager can set one up inside the EU), regulatory oversight, solid  investor protections, and strict depositary liability provisions. For many retail and institutional investors, UCITS is a trusted brand. But recent events at the Equity Income Fund – which itself was a UCITS – could threaten this long-held perception.

For years, experts have warned that the UCITS brand would be forever tarnished if a fund was forced to gate because of a liquidity crisis. Yet last month, this is precisely what happened at the Woodford Equity Income Fund. The worrying issue for the industry is that Woodford did not technically breach the UCITS rules (which precludes managers from having more than 10% of their assets invested in unquoted securities), but he did list a number of companies on the Guernsey Stock Exchange – which were illiquid and incompatible with the UCITS risk framework. While no laws were technically violated, the entire episode should force regulators to consider whether structural changes need to be made to the UCITS regime. 

The possibilities for regulatory intervention

That the FCA has delayed the publication of its eagerly-awaited report on illiquid assets and open-ended funds has not gone unnoticed. It is possible the 10% cap on unlisted assets could be reviewed and potentially lowered, but this will be up to the EU, who are behind the UCITS framework. Even so, this threshold was not even broken anyway.  A more sensible option would be to ensure there are tighter governance checks on UCITS to ensure risk and investment mandates are not being flouted. Alternatively, EU regulators could change the redemption terms for UCITS, permitting only the most liquid strategies to offer daily liquidity, but of course that would severely restrict the opportunity set for retail investors.

A more radical approach might be to curtail the ability of UCITS managers to offer daily dealing funds moving to monthly or even quarterly dealing. This would extend the time horizons for investors and managers alike, helping the industry to deliver more patient capital. It has also been suggested that the UCITS rules could be changed to limit investments in unlisted or illiquid securities, but given liquidity can fluctuate hugely, and always reduces in points of crisis (when it is most needed), this does not necessarily solve the problem.  Strategies that flirt with illiquidity should operate as closed-ended vehicles, where there is always a price available for clients to get out, albeit it may be at a steep discount (so the customer makes a choice about how important it is to have liquidity).  

Depleting returns interlaced with excessively crowded trading conditions have forced asset managers to contemplate alternative approaches towards generating better performance for clients. By systematically integrating bottom-up, in-depth data – often supplied by external technology providers or bank counterparties – and then leveraging AI to conduct deeper analysis of securities, sectors or markets is one way fund managers could suppress the post-crisis downward return spiral, and revert to profitability. Or at least that is theory.

The reality is more ambiguous. Not only are genuine doubts being flagged about the actual reliability of data (i.e. its authenticity in the context of unchecked fake news and the superfluity of online misinformation) being used to furnish investment research, but firms are also being warned they risk inviting regulatory scrutiny if data is acquired improperly or used inappropriately. If managers are found to have inadequate controls or weak data governance, the consequences could be severe. A prudent data strategy is therefore key.

Know where the data comes from

Service provider (e.g. fund administrator, custodian,) selection requires asset managers to conduct intense vendor due diligence beforehand. A similar approach needs to be adopted by managers when engaging big data providers so as to validate that their service offering is robust and the information being supplied is accurate. Equally important is that managers corroborate that these providers are obtaining data responsibly through legitimate channels, and that they have full oversight over where the information is sourced from.

Aside from the obvious risk of nursing steep losses by incorporating imprecise or inexact data into the investment decision-making process, firms could also find themselves in trouble for breaching GDPR (General Data Protection Regulation) rules if they acquire or use information illicitly. Regulators including the Financial Conduct Authority (FCA) have put the financial services industry on notice warning them that misuse of consumer data will not be accepted.[1] As the regulatory tide turns against big data, caution must be exerted by firms.  

Big data and a possible regulatory onslaught

Regulation is perhaps the biggest threat to the big data industry. With the increasing repudiation of technology companies unconstrained use of consumer data, the financial services industry needs to tread carefully. More alternative data firms are moving into the market offering fund managers everything from anonymised, aggregated reports on consumer credit card spending habits right through to cellular phone location information – all of which are designed to give investors additional insights into underlying market trends.

Firstly, it is crucial that data used by managers does not contain any personally identifiable information on the end consumer, although this is something institutions appear to be reasonably vigilant about. In addition to privacy protection, it is entirely possible regulators may start deliberating on whether some of the alternative data providers are bestowing investors with an unfair competitive advantage. While the US Securities and Exchange Commission (SEC) has not yet issued any enforcement action against users of alternative data, it is reportedly monitoring developments carefully.[2] Given the SEC’s takedown of expert networks in the early 2010s following a series of hedge fund insider trading scandals, alternative data providers could be a potential target for future regulatory investigations.

Big data as an operational enabler

On the investment side, firms need to be careful about where they source information from, and how they use it. Increasingly, however, fund managers are making more use of data as it applies to their operations. For instance, a number of custodians are scouring through clients’ trade settlement data to see whether they can prevent trade fails using predictive analytic tools thereby netting investors’ cost and risk benefits.  Elsewhere, big data from multiple sources and counterparties is being mapped with AI technology and used to help firms with their regulatory compliance requirements. This can expedite and improve the quality of regulatory filings, to the benefit of both managers and their market supervisors.  

In the aftermath of the financial crisis, many asset managers saw M&A with their competitors as a means to survival, principally a necessary evil by which to preserve their businesses amid the tumbling markets and as a counterweight to offset the sheer volume of client redemptions. Since then, M&A activity at asset managers has grown progressively year-on-year. According to data compiled by Sandler O’Neill, a US investment bank, there were 255 recorded deals in 2018, involving $3.71 trillion in AuM (assets under management), up from 210 and $2.88 trillion respectively in 2017.[1] This trend is not decelerating, and it is something that is likely to disproportionately impact boutiques firms.

A combination of challenging performance conditions, surplus regulation, rising internal costs (i.e. growing operational, technology and compliance spend) and the increasing ubiquity of ultra-low cost passive funds have helped create an environment that is ripe for consolidation to thrive. With excessive consolidation, however, comes a number of problems. Firstly, it means that the big shops have accumulated even greater, dominant market share. Analysis by Willis Towers Watson, for example, found the combined assets overseen by the 500 largest fund managers had reached $93.8 trillion, of which, the top 20 firms controlled an unprecedented 43% of assets, accounting for around $40.6 trillion. [2]

In addition to creating concentration risk in just a handful of large asset management providers, uncontrolled consolidation is depriving investors of much-needed choice. The decision also taken by some high-profile distributors to rationalise the number of fund products they sell has not helped matters either. For instance, Deloitte found five out of the eight leading US distributors have culled around 4,900 funds in the last two years alone.[3]  Boutique fund managers have been hit the hardest by this. As these managers are often the ones providing customers with access to niche or specialist markets, anything that threatens their collective existence could have adverse consequences on the investor community.

Even though rampant consolidation may result in fee compression across the industry, it could potentially preclude investors from acquiring diversification, potentially leading to a weakening of returns. Echoing these comments, the US Securities and Exchange Commission (SEC) has publicly confirmed that it is worried about the impact asset management consolidation is having on investor access to small and medium-sized funds. In fact, the SEC has since acknowledged it will review the barriers currently facing boutique managers as part of an industry outreach initiative over the course of 2019. NCI firmly welcomes this SEC stance, and would strongly advise the UK FCA to do something similar.

Innovation is something asset managers should absolutely embrace. Simply disregarding change is a sure-fire catalyst for disintermediation, either from more forward-looking peers or new market entrants. At a time when active managers are losing assets and clients to cheap passive providers, it would be foolish for firms to ignore some of the technological advancements that are happening right now in financial services. Simultaneously, asset managers need full assurances that these technologies actually deliver value and are safe. As many of these technologies have been sensationalised, NCI takes an unbiased look at the progress made so far by disruptors, assessing how they may or may not benefit members.

Blockchain: Unfinished business

Blockchain is a product synonymous with unadulterated hype. Not only have most proof of concepts (POCs) at service providers led to nothing, but the Blockchain start-up market has undergone massive consolidation. Blockchain over-promised and under-delivered, although it is unfair to label the technology a failure. At only 10 years-old, Blockchain is still in its infancy and some trials – especially in post-trade equity markets, mutual fund distribution and trading of digital securities– have shown promise. In time, more tangible use cases will become visible, contingent on market-wide standardisation and interoperability being achieved. While Blockchain has lost its momentum lately, the technology should not be written off, as it may well play a meaningful role in asset management in the next few years.

Big data and AI

As returns receded, some institutional asset managers believed they could acquire a competitive and information advantage by using AI technology to disentangle big data, thereby energising performance. The reality has been somewhat different. Firstly, a lot of data  – it turns out - is fake (often generated by malicious chat-bots or through spurious social media channels), meaning firms need to be extra diligent about inputting information into algorithms, particularly if those AI tools are being used to identify key trends and potential investments. As fiduciaries to client money, making an investment decision off the back of badly constructed or misinterpreted data could be fatal for any asset manager.

The next big obstacle is that asset managers need to validate where the information came from insofar it has not been obtained from illicit sources (i.e. stolen records) or in breach of the EU’s GDPR (General Data Protection Regulation). Such data due diligence is not a small endeavour, and many firms – especially boutiques - may struggle to carry it out effectively. In the context of growing consumer opposition towards organisations profiteering from data, some asset managers may feel it is not worth the risk. For now, the asset managers using big data analytics – are doing so to complement their research, not replace it. In time, this may change as firms become more sophisticated in how they acquire and analyse data.

Robo-advisors

Like Blockchain, robo-advisors promised an awful lot but delivered an awful little. With retail customers deprived of advice as a result of MiFID II (Markets in Financial Instruments Directive II), experts were confident that cheap robo-advisory services would democratise the investment process. This has clearly not happened yet. The profitability of robo-advisors is linked to scale, and most providers have been unable to build large enough customer bases. Equally, research is beginning to show that robo-advisory platforms have not delivered adequate performance. For instance, a recent study showed that robo-advisory users with low-risk portfolios achieved a return of 0.8% in the 12 months leading to June 2018, versus the 1.17% they would have accumulated had they invested in a cash ISA.[1] At present, robo-advisors are not a threat to the wealth and asset management business.

What the future holds…

Even though some of the so-called disruptors have not uberised or dramatically reshaped the asset management industry yet, that is not to say they won’t. Technologies like Blockchain, big data and robo-advisory platforms will evolve and it is something NCI members should pay attention to. At present, the most significant challenge to asset managers lies with existing large technology companies.  Asset managers only need to look at China – where the Alibaba-owned Yu-e Bao fund – has become one of the world’s biggest money managers, having only launched in 2013. Agility and open-mindedness will be critical if boutiques are to flourish as disruptors mature and become increasingly ubiquitous.

The next few months are going to be challenging for NCI members. Firstly, the constantly interchangeable dynamics around Brexit are generating enormous regulatory and market uncertainty. In addition, asset managers are bracing themselves for a raft of regulatory changes including a tightening up of ESG (environment, social, governance) investment provisions; the possible introduction of amendments to the Alternative Investment Fund Managers Directive (AIFMD) and a roll-out of stricter margining obligations for bilateral, un-cleared OTC instruments under the European Market Infrastructure Regulation (EMIR). With so much activity underway, other equally pressing matters have received far less air time.

The LIBOR bugbear facing boutiques

From 2021, LIBOR, which benchmarks interest rates for a whole stream of financial products (securitisations, loans, derivatives, etc.) will not exist. Admittedly, some asset managers have spent a lot of time readying themselves for the move to overnight risk free rates, but a lot of firms are still unprepared.  So why does it matter? Any boutique firm trading bonds or using derivatives could find the behaviour, valuations and risk modelling underpinning those instruments changes markedly as a consequence of this shift to alternative rates. Asset managers therefore need to begin inserting fall-back provisions into their contracts, or repapering them altogether, in what could be a very costly and time-consuming exercise.

Why the buy side should start caring about settlements

For many boutiques, the responsibility for ensuring their trades settle on time lies with their custodians or brokers. Under CSDR (Central Securities Depository Regulation), this could change. CSDR, having introduced a t+2 settlement regime inside the EU, is now fixated on imposing better settlement discipline in the market. The CSDR rules give CSDs the authority to fine guilty counterparties in instances when settlements do not complete on the contracted settlement date. As such, boutiques could find themselves incurring large fines if they do not deliver securities in good time to their brokers.  If NCI members are to avoid these penalties, they need to start delivering securities to their brokers much faster.

More to the EU than just Brexit

While Brexit has dominated discussions in Europe, much less has been said about the EU’s increasingly fractious relationship with Switzerland. The root of the EU-Swiss dispute lies with MiFIR (Markets in Financial Instruments Regulation) Article 23, a clause which states that any trading of shares by EU investment firms must take place on a recognised trading venue. While Switzerland’s trading venues currently have EU equivalence, that designation is up for review in June 2019, which is causing widespread uncertainty. If equivalence is refused, EU investment firms could be prevented from trading equities at Swiss venues.

Somewhat irked by this prospect, the authorities in Switzerland have announced countermeasures which will bar foreign trading venues from listing or admitting to trade any Swiss companies [1] unless that venue is recognised by FINMA, the national regulator. For third country venues to qualify for FINMA recognition, a precondition is that the venue must be operating out of a market which does not prevent its local investment firms from trading Swiss shares in Switzerland. Again, not only does this create challenges for investment firms but it risks leading to companies listing outside of Switzerland or holding off their IPOs. [2]

The risk of a no-deal Brexit has now become unacceptably high for financial market regulators. Conscious that the uncertainty was fuelling instability, European and UK regulators signed two significant MOUs (memorandum of understanding) at the beginning of February 2019 in what should help ease industry concerns about the risk of a Hard Brexit. Both MOUs will only take effect if there is no deal in place ahead of March 29, 2019.

The first MOU, which was announced on February 1, 2019, applies to fund management. In short, it is a multilateral MOU between European market regulators and the UK’s Financial Conduct Authority (FCA) covering exchange of information and delegation of portfolio management to UK authorised firms. This comes more than six months after the FCA announced its temporary permissions regime (TPR) for EEA funds passporting into the UK.

The fact that European securities market regulators have reciprocated on the FCA’s TPR is a positive development, as it confirms that existing delegation frameworks can be retained should there be no deal. Not only does this give UK managers a degree of continuity in the event of a Hard Brexit, it also safeguards fund hubs such as Luxembourg and Ireland. These MOUs will therefore help insulate asset managers in the EU and UK from significant disruption, and it is something which is strongly supported by New City Initiative (NCI) and its constituents.

In its statement, the European Securities and Markets Authority (ESMA) also confirmed an MOU concerning information exchanges about the supervision of credit rating agencies and trade repositories had also been signed too and would cover a no-deal Brexit. Given the EMIR (European Market Infrastructure Regulation)-mandated oversight role that trade repositories play in monitoring the on-exchange and over-the-counter (OTC) derivative markets, this MOU will help regulators in their efforts to prevent build-up of systemic risk.

Last week, ESMA also announced a further MOU had been agreed with the Bank of England (BOE) whereby it confirmed it would recognise UK CCPs (central counterparty clearing houses) and CSDs (central securities depositories). This MOU was expected, particularly as ESMA had repeatedly acknowledged at the end of 2018 that it supported continued access to UK CCPs and CSDs in order to limit any possible disruption post-Brexit. Ensuring the continuation of clearing and settlement activities post-Brexit was critical to market stability.

While some European leaders insisted that certain derivative transactions be cleared inside the EU post-Brexit, the practicalities of forced relocation never made much sense. Firstly, repatriation of euro-denominated clearing risked sparking a protectionist battle between major economies (i.e. US and Japan) whose currencies are overwhelmingly cleared outside of their home markets. Secondly, the policy would have caused fragmentation at CCPs inflating margin costs, a point made by a number of EU derivative users themselves.

Even though the EU has some CCP infrastructure of its own, it does not come close to rivalling London in terms of product solutions and talent depth. This was – again – an argument made by some pragmatists within the EU. The final issue impeding repatriation of clearing was politics (of course) whereby some markets insisted euro-denominated clearing take place in Eurozone economies only, a demand that was met with fierce opposition from non-Eurozone countries such as those in Scandinavia and Poland.

The MOU covering CSD recognition was also urgently required, mainly because only CSDs regulated under CSDR (Central Securities Depository Regulation) could settle EU trades, an issue that was likely to prove awkward for the Irish. Ireland is something of an oddity within the EU insofar as it does not have its own national CSD, because its securities’ market is so small. Instead, Irish securities are settled on Euroclear UK’s CREST platform. The MOU assuages Ireland’s securities market and precludes the country from setting up its own CSD. 

If an asset manager – five years ago – slightly exaggerated or over-inflated their adherence to ESG (environment, social, governance) values, they would likely have fielded some mild criticism for nothing other than operating a cynical marketing tactic or PR campaign in order to win mandates. Times have, however, changed. Nowadays, such behaviour – also called greenwashing – could in extremis prompt existing clients to issue redemption requests or result in a blacklisting among prospective investors as institutional and retail allocators increasingly embrace the ESG model. 

Regulatory concern about the extent of greenwashing – along with a broader commitment to meet various policy objectives set out in international agreements such as Paris COP21 and the UN’s Sustainable Development Goals (SDGs) – have prompted the European Commission (EC) to act decisively. Among the EC’s proposals – announced in March 2018 – were recommendations that asset managers and asset owners integrate sustainability risk into investment decisions and report on their activities to end clients. In order to enable investors to assess the sustainability of managers across the board, the EC also advocated the establishment of an ESG taxonomy or basic standard.

While an increasing number of NCI members – according to a soon to be published survey – integrate ESG into their investment processes as a means to better manage long-term risks, drive performance or widen their investor appeal, there was scepticism among our constituents about the need for regulatory intervention particularly as the ESG market has been developing organically. With more investors asking for exposure to ESG linked assets, it was natural that managers would provide products to satisfy their demands. While the EC’s initial proposals were open to interpretation, ESMA has struck a more moderate tone, clarifying many of the issues which NCI had. 

One of NCI’s concerns with the initial proposals was that managers might be forced to divest from certain sectors or companies which did not meet the EC’s sustainability criteria. As long-term investors, asset managers play a large role in changing corporate behaviour and ensuring businesses are sustainable. Forced divestments would constrain the ability of managers to drive reforms at corporates, thereby resulting in the continuation of unsustainable practices. In its consultation, ESMA assuaged those fears, stating integration of sustainability risks into the investment approaches at AIFMs and UCITS should be done on a high-level principles-based-approach.

Rather than demanding managers explicitly apply ESG into their investment strategies, ESMA is proposing firms incorporate sustainability risks into their due diligence and risk analysis just as they would assess an underlying securities’ credit risk or interest rate risk. “To this end, sustainability risks need to be captured by the due diligence process and risk management systems in a way and to the extent that is appropriate to the size, nature, scope and complexity of their activities and the relevant investment strategies pursued,” reads the consultation.

A number of managers will already have such mechanisms in place although ESMA has conceded that some changes (i.e. increased allocation of resources to monitoring sustainability risks and structural changes to oversee those sustainability risks) may be required at some firms. This will come at a cost to asset managers who have yet to factor sustainability into their businesses, although given the evolving investor environment, it is arguable that such changes would have happened irrespective of EU intervention. It is possible that those forward-thinking managers which implement policies on sustainability risk could find themselves in a strong capital raising position.

NCI will be releasing a paper, based on a series of interviews and a survey of its membership, in the coming weeks looking at how boutique asset managers apply ESG into their investment strategies, along with analysis of the proposed EC regulations on sustainability.

Despite 30 months lapsing since the referendum, the status of Brexit is constantly shifting and interchangeable, making it very challenging for UK asset managers to implement contingency plans ahead of March 2019. A growing number of domestic managers – conscious of the complete breakdown in political consensus inside the UK – are resigned to the fact that either a no deal or bad deal is pending, prompting some firms to increase their substance onshore within the EU, in order to keep AIFMD and UCITS passporting rights.

Efforts by the Financial Conduct Authority (FCA) – through its Temporary Permissions Regime (TPR) to cushion the blow of a no deal Brexit on EEA (European Economic Area) managers selling into the UK will help maintain a semblance of stability, but NCI is frustrated that no such reciprocity has been provided by European regulators. A failure to provide equivalent assurances risks depriving European investors of choice if the UK crashes out of the EU, and will undoubtedly deter UK managers from distributing their products in the EU.

The Death of CMU

In November 2018, NCI published an article stating the EU’s Capital Markets Union (CMU) was not living up to industry expectations, predominantly because the scheme’s proposals simply lacked ambition. While CMU introduces some regulatory harmonisation for funds looking to register their products on a cross-border basis, the proposals fell well short of what NCI and other industry associations had been lobbying for. As such, NCI doubts CMU will encourage more managers to distribute their products on a cross-border basis.   

Simultaneously, the EC’s decision to heavily restrict pre-marketing has frustrated fund managers as it makes it harder for them to engage with investors prior to launch without becoming AIFMD registered. Boutiques feel disenfranchised as it will impede them from meeting with prospective investors in European markets as they simply do not have the resources to become AIFMD registered in jurisdictions when there are no assurances investors will commit. This pre-marketing proposal totally undermines CMU’s objective.

SMCR: Get ready

The Senior Managers & Certification Regime (SMCR) will apply to fund managers from December 2019, and it is something NCI members should be paying attention to. The rules are not too burdensome though and they simply oblige senior persons at asset managers to be FCA approved and sign a Statement of Responsibility, a document that outlines their prescribed responsibilities. SMCR also insists senior managers and staff members who carry out activities which could pose a risk to clients or the firm be certified as fit and proper.

Nonetheless, the rules could pose some problems for firms. Assessing whether a person should be certified as fit and proper ought to be fairly routine, although in some cases, incidents of misconduct can arise for reasons other than poor character and judgement, such as a lack of training. Irrespective, it is imperative managers begin mapping out people’s responsibilities across their businesses, and create an action plan on compliance. A failure to adequately prepare for the SMCR could have major ramifications for asset managers.

ESG moves onto the statute books

The growing focus on ESG (environmental, social, governance) investing has been a positive development for the funds’ industry, and one that has been encouraged by clients, especially millennials. Some experts argue ESG investing correlates with better performance although this hypothesis is still open to debate. In response to these global trends, the EC is proposing that fund managers integrate ESG into their investment processes and produce detailed reports for clients clarifying their ESG approach.

Underpinning these reports will be an EC-created taxonomy for ESG, a provision which is proving quite contentious at NCI members. A number of NCI members feel the development of ESG should be a market and not regulatory-led initiative, while there is equal opprobrium among the ranks about the added reporting requirements which may come with these EC rules. NCI recognises that some firms have been greenwashing their credentials in order to win mandates, but the EC must ensure the taxonomy it produces is not excessively prescriptive, nor are its reporting requirements duplicative or overly disproportionate. 

Good luck in 2019

2019 is shaping up to be a difficult year for asset managers from a regulatory perspective. Brexit is undoubtedly going to cause challenges for the industry, while other political risks in the UK lie lurking and cannot be ignored either, namely the possibility of a new government which is hostile to financial services and free markets. On an EU-wide basis, some of the regulations being proposed could be quite testing for boutique asset managers, potentially eroding margins even further if they are implemented badly.

When the Senior Managers and Certification Regime (SMCR) was first made public by the UK’s Financial Conduct Authority (FCA), market participants were shocked at the regulator’s proposals to reverse the burden of proof, in effect presuming senior managers at financial institutions would be guilty until proven innocent in the event of wrongdoing. Admittedly, this contentious element of SMCR is no longer in the rules, but the requirements do pose some challenges, which NCI members should be alert to. NCI held a seminar on SMCR led by Dechert in London on November 8, 2018, which was attended by a number of its members.

What businesses are in scope?

Banks have been compliant with SMCR since 2016, although asset managers are going to come into scope in December 2019.  While “enhanced SMCR” provisions will apply to any asset management group looking after more than £50 billion, firms under that threshold – which is nearly all NCI members – will be subject to the less intrusive obligations set out in the SMCR’s “Core Regime”. Despite this set of rules not being as onerous as those in the “enhanced” category, asset managers do need to build an SMCR compliance programme for their organisations, a process which may not be as easy as many companies first assumed.

SMCR’s genesis lies with a number of the post-crisis scandals that blighted several leading banks. In response to these governance failings at large institutions, SMCR was designed to embed a structure of accountability across organisations. Put simply, the FCA wants to know who the appropriate point person is within any regulated entity to apportion blame to should a problem materialise. To enable this, the FCA will need to approve all senior managers at impacted firms, and those persons must sign a Statement of Responsibility, a document that affirms and outlines their prescribed responsibilities.  

Firms can help themselves with SMCR by ensuring the current control functions are apportioned correctly, in what will allow for automatic mapping and identification of people with Senior Manager Functions (SMF).  The FCA also requires asset managers certify that staff members without an SMF designation who carry out activities, which could pose a risk to clients or the firm, are certified as being fit and proper. All SMF and certified person will be subject to the SMCR’s Conduct Rules, which outline the basic behavioural standards expected of staff, broadly mirroring the APR’s Statements of Principle. Asset managers have been advised to begin implementing staff training in advance of the Conduct Rules.

The Big Risks

While SMCR compliance is not as exhaustive an undertaking as MiFID II (Markets in Financial Instruments Directive II), it does throw up some awkward challenges. While determining whether an individual is fit and proper should be fairly routine under most circumstances, there are certainly some grey areas. A brief by Allen & Overy said employee misconduct incidents may occasionally arise because of a lack of training, in which case labelling someone as being no longer fit and proper might be construed as rather unfair.

References will need to be periodically updated as the rules require firms to retain information related to staff misconduct, a provision which also extends to former employees who have left the organisation in the last six years. Companies providing references on behalf of ex/current employees could potentially become more vulnerable to legal risk under SMCR if the contents of those references cause career harm to people. Freshfields highlights employers will need to balance their SMCR regulatory responsibilities against a common law duty to exercise due skill and care when preparing references.

Getting SMCR ready

SMCR has been a long-time coming, and firms are being advised to start identifying employees’ responsibilities and building up training programmes to ensure firm-wide compliance. It is also advisable that companies think carefully about their policies on regulatory references to ensure they adopt a homogenised approach. While SMCR compliance is not as challenging as previous post-crisis regulations, it could create some potential problems, in sensitive areas such as employment law.  

At the point at which the Capital Markets Union (CMU) was formally announced, there was an outpouring of support from financial services, a sector which until then had faced a barrage of regulations and added costs. CMU was welcomed by financial institutions and industry bodies representing them because its end goals stood to benefit the entire European financial ecosystem and the real economy - if implemented correctly.

Almost three years after its launch, there are some very serious questions about what – if anything CMU – has actually achieved. Jaws recently dropped at an Association of the Luxembourg Fund Industry (ALFI) Conference, which took place in the Grand Duchy when David Wright, a 34-year veteran of the European Commission and former secretary general of IOSCO, stated that the CMU had failed and needed to be completely overhauled.

This is a stark analysis but there is some truth in it. Very few participants in the funds’ industry can list many tangible benefits that CMU has brought them. A number of experts believe CMU’s failings are directly correlated to Brexit as it is no longer the priority it once was. Others concede the departure of the biggest financial services market in the EU was always going to wound CMU in terms of both its scope and ambition.

ELTIFs: Good in theory, bad in practice

Many of the initiatives outlined in the CMU were not defective ideas, but they have been implemented badly. The ELTIF (European Long Term Investment Fund) is a prime example. The framers behind the ELTIF saw it as a fund structure regulated under AIFMD which would give retail investors and smaller institutions exposure to illiquid assets like infrastructure, real estate and loans, enabling them to generate consistent, long-term returns.

It is here where regulators misread the market, which is why the AUM at ELTIFs has remained so stubbornly low since the brand’s creation. Most retail investors do not want to be trapped in an investment vehicle for a decade, not least one like infrastructure which is vulnerable to political risk. The absence of liquidity is therefore a massive problem for retail investors, who prefer products offering daily or weekly redemption terms. 

Furthermore, ELTIFs are subject to onerous investment restrictions, deterring some institutions from putting money into them, particularly when they can allocate directly or indirectly through their consultants to unconstrained infrastructure, real estate or private credit managers. Even the CMU’s commendable attempt to lower the Solvency II capital requirements for insurers to tempt them into ELTIFs has not had its intended impact.

Harmonising distribution does not go far enough

NCI lobbied EU regulators and educated them extensively about the benefits of streamlining the existing cross-border fund distribution process, an activity which is rife with localised charges, registration requirements and arbitrages across member states. NCI estimated the total initial costs of marketing  a fund throughout the EU (plus Switzerland) for a typical manager was in the region of EUR 1.5 million, which is why so few firms actually passport across all EU markets.

The EC’s proposal to align regulatory fees and excuse managers from having to appoint local agents in countries where their funds are being marketed was a positive step but many believe the reforms simply do not go far enough. Furthermore, the decision by the EC to heavily restrict pre-marketing has frustrated fund managers as it makes it harder for them to engage with investors prior to launch without being AIFMD registered.

Boutiques feel particularly disenfranchised as it will impede them from meeting with prospective investors in European markets as they simply do not have the resources to become AIFMD registered in jurisdictions where there is no firm assurance that investors will commit capital. Ironically, the EC’s proposals on marketing – while attempting to iron out arbitrages – will actually deter managers from selling into certain European countries.

Fixing a broken CMU

These are just a handful of instances where CMU has struggled. Other areas of financial services report similar frustrations with CMU. The Simple, Transparent and Standardised Securitisation Regulation (STS), for example, has not resurrected the European securitisation market, mainly because the rules are too complex and not bold enough, according to multiple industry practitioners. 

Nonetheless, there are some CMU reforms, which could prove to be successful. The establishment of the PEPP (Pan-European Personal Pension) product is gathering momentum and attendants at the ALFI Conference seem to be genuinely excited by its development. Providers – including asset managers – see it as a useful tool by which to enter the European personal pension market, although it is still early days. 

CMU is very expansive and it would be unfair to presume that all of its programmes and initiatives will be hugely successful. However, there is a growing realisation that too many schemes are succumbing to failure, mainly because they are not ambitious enough, applying only token or piecemeal changes to remedy engrained problems. Unless regulators step up a gear, the CMU is likely to turn into a very damp – albeit well-intentioned - squib.