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Today New City Initiative is comprised of 46 leading independent asset management firms from the UK and the Continent, managing approximately £500 billion and employing several thousand people.

Displaying articles for 2015

Managers Get Relief on Bilateral Margining

Managers Get Relief on Bilateral Margining

Reform of the $595 trillion OTC derivatives market has been a regulatory priority ever since the financial crisis. While strong progress has been made towards transitioning vanilla OTC products into centralised clearing, a lot of contracts – either because their underlying properties do not align with CCPs’ exceptionally strict risk criterion or they are just too complicated – are still traded bilaterally between counterparties. Regulators concede these bilateral OTC trades are a systemic risk, but there are growing concerns – at least from the buy-side – about the regulatory treatment being levelled on some of these uncleared OTCs.

Six years ago, the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) created a set of global standards demarcating the margining requirements to be imposed on bilateral OTCs. Through tighter margining provisions, regulators hoped to avoid a scenario whereby OTC trades were at risk of being under-collateralised just as they had been during the 2008 crisis. Implementation of these wide-reaching BCBS/IOSCO guidelines has been ongoing for several years now, through legislation such as Dodd-Frank and the European Market infrastructure Regulation.

Right now, the bilateral margining rules only apply to financial institutions whose average aggregate notional amount (AANA) of uncleared OTC contracts exceeds USD/EUR 1.5 trillion. In September 2019, that threshold will drop to USD/EUR 750 billion. Most market observers say these current thresholds are perfectly acceptable. What riled the buy-side, however, were plans – scheduled to be enacted in 2020 – for the base sum to be lowered to USD/EUR 8 billion, a development which BNY Mellon estimated would ensnare more than 640 financial institutions. Predictably, industry associations have criticised the thresholds as being too low, as they capture a number of entities who are simply not systemically risky.

While several of these industry bodies advised regulators to raise the ceiling on the threshold for uncleared OTCs to circa USD/EUR 100 billion, it has so far fallen on deaf ears. However, IOSCO/BCBS did release a statement on July 23, 2019, stating it would delay the final implementation of the margining requirements for entities whose AANA of uncleared OTCs exceeds USD/EUR 8 billion by one year until September 2021. Nonetheless, IOSCO and BCBS pointed out that organisations with an AANA of uncleared OTCs greater than that of USD/EUR 50 billion will still be subject to the margining rules as planned in September 2020.  

The delay, however, was somewhat inevitable. Reports by a number of service providers had repeatedly indicated that many buy-side firms - who were due to post margin on their uncleared OTCs from September 2020 - were woefully underprepared and had yet to put in place the operational infrastructure necessary to facilitate effective collateral management.

While the delay should give buy-side firms a bit of manoeuvring room to enact operational changes, some industry groups are still hopeful the authorities could yet compromise on the USD/EUR 8 billion ceiling. Nonetheless, in-scope asset managers should use the one-year extension to better prepare their businesses for the incoming collateral requirements.

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Are Revisions To UCITS Necessary?

Are Revisions To UCITS Necessary?

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).  

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Is the Big Data Risk to Big to Bear?

Is the Big Data Risk to Big to Bear?

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.  

[1] Reuters (July 11, 2018) FCA warns financial firms over big data

[2] Financial News (December 6, 2018) Risks and opportunities in fund managers’ big data boom

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M&A: Too Much Activity?

M&A: Too Much Activity?

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.


[1] Pension & Investments (January 7, 2019) Alternatives firms fuel 2018’s increase in M&A

[2] Willis Towers Watson (November 16, 2018) The World’s Largest 500 funds managers – year ended 2017

[3] Deloitte – 2019 Investment Management Outlook: A Mix of Opportunity and Challenge

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Are We At The Technology Tipping Point?

Are We At The Technology Tipping Point?

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.


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.

[1] Financial Times (August 24, 2018) Robo advisers fail to beat market benchmark

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Some Regulatory Changes You May Have Missed

Some Regulatory Changes You May Have Missed

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]

[1] Loyens Loeff

[2] Loyens Loeff

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A Brexit Breather for U.K. Fund Managers

A Brexit Breather for U.K. Fund Managers

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. 

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The Move to Sustainability

The Move to Sustainability

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.

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Brexit: Nearly there, or are we?

Brexit: Nearly there, or are we?

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.

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SMCR: Not long to go now

SMCR: Not long to go now

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.  

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CMU's lack of ambition starts to show

CMU's lack of ambition starts to show

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.

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Managers Not Convinced By Digital Assets Yet...

Managers Not Convinced By Digital Assets Yet...

The temptation to invest in digital assets such as cryptocurrencies and initial coin offerings (not to be misconstrued with Blockchain, which is the technology that supports trading in those very same digital assets) is a growing one for some asset managers whose revenues from traditional equities and fixed income are becoming increasingly depleted. While some asset managers see crypto-investing as a tool to attract interest from younger clients, an investor pool which many providers have found difficult to onboard, others see it as a purely speculative tool with little or no value.  

The volatile returns available through digital assets are well-documented, as are its violent price swings, whose erratic daily movements often exceed the basic risk thresholds put in place at most regulated fund managers. Ripple’s price, for example, rose by 1200% at the end of 2017, while Bitcoin grew by 200%, only to fall precipitously since. Unlike conventional securities, digital assets remain something of a black box financial instrument, whose gyrating prices are dictated by broadly inexplicable variables.   

For pension funds and insurers seeking out regular, predictable income streams, digital assets do not strike a chord. This, however, has not prevented a small band of pioneering, unconstrained fund houses – overwhelmingly hedge funds - from investing in digital assets with mixed results.  Most regulated institutional managers are naturally less enamoured, preferring to stick with their tried and tested investment formulas, and for good reason.

The global regulatory response to the growth of these unconventional instruments has been haphazard, and arguably quite random.  Unlike OTCs where global regulation is broadly synchronised, the market response to crypto-assets has been fragmented and confused. Some markets have decided to ban or heavily curtail digital assets, whereas others are not passing any legislation until they know more about the instruments’ modus operandi. 

This absence of regulation and oversight from Central Banks and market authorities means there is extremely little in the way of protection for managers insuring them against losses and fraudulent behaviour.  As these assets are not securities, there is no legal requirement for beneficial owners to be reimbursed for any loss of private keys held in custody as they are not covered by regulations such as AIFMD or UCITS V.

Ensuring that assets are kept safely with credit-worthy, well-regulated financial institutions and protected against external threats is an elementary requirement for anyone managing money. While the traditional custody market is well-developed, the existing safekeeping arrangements for digital assets’ private keys – at least at crypto-exchanges - can best be described as primitive and amateur.

Crypto-exchanges have repeatedly been hacked or compromised by cyber-criminals, with billions of dollars recorded stolen from such infrastructures over the last few years. While a handful of technologists are launching crypto-custody products for the institutional market, their solutions are untested, and none of these companies will have the balance sheet security and protections offered by a conventional banking provider.

Some bank custodians – conscious that their own business model is under cost-pressures – are in the early stages of developing crypto-custody products. They do – however – remain a minority, as client demand for such solutions has not yet reached critical mass. Unless the AUM of crypto-funds ramps up dramatically, the number of traditional custodians willing to provide the necessary services and infrastructure supporting digital assets will be limited.

Another hindrance is that digital asset transactions are conducted anonymously, meaning managers may find it difficult to ascertain if they are breaching sanctions or violating money-laundering or terror financing provisions. Given the chastening fines levied on banks recently for breaking sanctions or abetting money laundering, fund managers would be well- advised to avoid partaking in any transactions which put them at heightened regulatory risk. 

It is possible – in the short-term – that some investors will ask their managers about whether they intend to diversify into digital assets given all of the recent hype and excitement. Until there is a more sizeable range of mature custody solutions and greater clarity and oversight from regulators about their treatment of digital assets, fund managers should exert patience and avoid rushing into these new instruments.

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China: The next frontier for asset managers

China: The next frontier for asset managers

A country once assumed to be impenetrable for investing and fundraising, China is now turning course. The last five years have seen a number of positive reforms being implemented making it easier for foreign institutions to invest into China’s sizeable equity and bond market through initiatives such as the Hong Kong-Shanghai/Shenzhen Stock Connect, China Interbank Bond Market (CIBM) Direct and Bond Connect, all of which have helped result in the country’s A Shares being added to the MSCI EM Index.

That the market has been so under-tapped by foreign institutions presents an excellent opportunity for fund managers looking to generate returns or identify niche investments. The depth of the country’s equity and fixed income markets is not the only draw for foreign managers though. As a growing emerging market, China has undergone an unprecedented middle-class boom, but many ordinary people are growing impatient with the desultory interest being paid on retail deposits and are searching for new places to put their capital. This underserved retail market could be a lucrative avenue for asset managers.  

In addition to its prospering middle class, China also has a large high-net-worth-investor (HNWI) community, with Boston Consulting Group estimating their investable assets could reach $16 trillion by 2021. However, only 4% of this demographic actually puts money into foreign financial institutions to invest compared to 87% who leave their cash in private banks owned by domestic commercial banks. The country’s institutional market – comprised of major sovereign wealth funds such as CIC – is already sophisticated and well-versed in the mechanics of traditional and alternative asset management.

Opening up slowly

China’s market regulators – as part of their broader reform effort – have attempted to make it easier for foreign asset managers to launch onshore products through a handful of market entry channels. Beginning in 2013, a small number of established foreign private funds including hedge funds were allowed to raise a limited amount of capital (quotas were initially set at $100m/fund) in onshore vehicles from mainland HNWIs to invest overseas through a scheme known as the Qualified Domestic Limited Partnership (QDLP) programme.

Some well-known private funds did register under QDLP, raising $1.23 billion in the process but its wider adoption was stonewalled when the scheme was suspended following the imposition of capital controls in 2015 amid the equity market volatility. QDLP has since resumed though, while its overall quota tally has increased to $5 billion.  However, the quotas being allocated to individual managers are still quite small, making it difficult for organisations to fully justify the costs of setting up operations on the mainland.

QDLP was subsequently followed up with the Mutual Recognition of Funds (MRF) initiative, a passporting scheme unveiled in 2015 between Hong Kong and China which streamlined the distribution process for fund managers looking to sell to retail investors in each other’s jurisdiction. Flows to date have been fairly limited, as China’s regulators slowed down authorisations of Hong Kong managers during the equity market volatility in 2015 and 2016. Nonetheless, this is expected to pick up over the next few years as the country continues on its liberalisation path. 

Another factor behind the disappointing MRF uptake was the requirement that foreign asset managers enter into a 49/51 joint venture (JV) with Chinese financial institutions, a compromise many organisations were reluctant to make, mainly because of the operational risk it incurred. The China Securities Regulatory Commission (CSRC) has since confirmed that foreign asset managers can now obtain a 51% stake in mainland financial institutions, adding this threshold will be removed in the next three years, eventually rising to 100%.

The most recent entry route for asset managers looking to distribute into China is WFOE (wholly foreign-owned enterprise), a scheme which excuses foreign firms from having to purchase a minority stake in a local provider, allowing them to operate under their own brand name. Unlike MRF, firms authorised under WFOE can only raise funds from institutional clients and not retail and must invest in the local market. While the WFOE is not available to retail at present, this may change, a development which could result in the scheme cannibalising the MRF.

The opportunity for boutiques

China is opening up, and it is a market boutiques ought to be considering, at least on the institutional side where they are free to market directly to professional investors that have the ability to allocate capital outside of China.  

At present, most foreign asset managers lack the brand recognition among Chinese retail investors, a hindrance which will force them to partner with local banks and platforms for distribution purposes, potentially at significant cost. However, two-way distribution relationships may be possible.  Boutiques should certainly not rush into China, but it ought to be a market on their radar as it could offer enormous fundraising opportunities in the next five to ten years. 

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Brexit: An Update

Brexit: An Update

Another week, another Brexit drama. The release of the eagerly awaited Brexit white paper by the UK government was welcomed in some quarters for bringing clarity around the country’s impending departure from the EU, something which a number of sectors including financial services have been urging for since the June 2016 referendum aftermath. Nonetheless, not everybody is happy with what has been published.

The financial services industry has been left disgruntled by the paper’s contents, mainly because the government confirmed it will not pursue a mutual recognition policy, an approach which in theory would have reduced some of the frictional headwinds of Brexit. Instead, the government is pushing through with an association agreement, comprising of a free trade area for goods, but pointedly excluding financial services, a decision that is poised to limit UK (and EU) firms’ unimpeded access into each other’s respective markets.

A number of industry bodies had implored the UK government to adopt mutual recognition, instead of equivalence, citing the latter was notoriously capricious and could be removed at less than 30 days’ notice, an unacceptable risk for many financial services firms in the UK to stomach. While UK regulatory bodies such as the FCA had said that mutual recognition with the EU was eminently achievable, policymakers in Brussels thought otherwise.

The government’s position on financial services – while not in tune with the City’s thinking – is relatively pragmatic and supports an expanded version of the existing equivalence regime.  Recognising the current framework for withdrawing equivalence is a risk to UK financial services, the government has asked EU negotiators to consider creating what it has termed a “structured withdrawal process”, whereby equivalence cannot be arbitrarily taken away unless a consultation is launched to discuss possible resolutions to maintain it.

In addition, the paper said cross-border data flows will continue, as will the free movement of skilled persons post-Brexit. Reassuringly, the paper confirmed it will support the mutual recognition of qualifications, something which had been asked for repeatedly by financial services professionals. While the latest proposals are likely to find more traction inside the EU, policymakers on both sides are simultaneously stepping up their efforts to implement contingency plans for a no-deal Brexit.

The likelihood of a deal may have increased but fund managers should not lose focus on Brexit. EU regulators have repeatedly warned UK fund managers that they need to start submitting their applications for authorisation by mid-year (i.e. now) to member state regulators if they want to continue marketing into the EU27. The regulators added national competent authorities (NCAs) in the EU could become overwhelmed if applications all arrived simultaneously, so firms should make their submissions in good time.  If fund managers fail to obtain NCA approval on time, they risk being excluded from the Single Market.

Asset managers with large European distribution footprints are in something of a bind over Brexit as they do not want to incur large legal costs preparing for hypothetical risks, while at the same time they cannot afford to lose their EU business or passporting rights. Most firms with investors in Europe are playing it safe and readying themselves for EU authorisation irrespective of the costs involved.

Industry fears, however, that delegation would be abandoned have largely disappeared. While the European Securities and Markets Authority (ESMA) has confirmed it wants more involvement during the authorisation of delegation arrangements, it acknowledged the existing model works perfectly well and the agency did not want to undermine it, not least because it would antagonise non-EU users/buyers of UCITS and AIFMD products.

Furthermore, the AMF (Autorité des marchés financiers) publicly said it had no intentions of restricting delegation although that decision will ultimately be determined by ESMA, and not the French regulator. While UK firms should be assessing their options about appointing management companies or establishing subsidiaries inside the EU, most experts believe the current delegation framework will not be dramatically altered post-Brexit.

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The Next Reporting Challenge for Asset Managers

The Next Reporting Challenge for Asset Managers

ESG having once been an outlier issue for most asset managers, is becoming increasingly important, and it is a metric which more organisations are utilising in their portfolio construction processes. The primary motivations for applying ESG measurables in stock selection are the purported performance benefits it brings, investor pressure and growing regulatory intervention. As such, ESG is something which investment managers must understand and have a clear position on.

The regulatory drivers

While governments are actively pursuing green policies, regulators are not far behind. The EU recently announced that it would implement rules to help enable asset managers and institutional investors to incorporate ESG consistently into their decision making, adding their policies would need to be fully disclosed.  Similar provisions are already in play in France, where asset managers and investors over a certain size now have to document and publish how they apply ESG into their day to day operations, and disclose their carbon footprints

Simultaneously, the FSB launched its own voluntary climate financial risk reporting template - the Task Force on Climate Related Disclosures (TCFD) – which is being increasingly adopted by market participants. Disclosure obligations like the TCFD are not currently mandatory but a minority of institutional investors are beginning to request managers provide it. Meanwhile, the UN PRI has upped its game and threatened to de-list signatories which they do not believe are living by the PRI guidelines.

Performance benefits

Admittedly, the data evidencing that companies which score highly on ESG deliver better shareholder returns versus those that do not apply ESG, is mixed but the initial results do look promising, and should not be disregarded entirely. After all, a company which is not sustainable can hardly be described as being a solid long-term investment play in a political backdrop increasingly dominated by ESG concerns, and where agreements like UN SDG and COP21 are radically altering corporate behaviour.

Take plastics. An asset manager with exposure to a company heavily dependent on single-use plastics, must carefully consider that holding given the EU’s recent announcement that it intends to outlaw single use plastic utensils such as straws and cutlery. The same is true for managers with investments in heavy carbon emitting industries, as governments globally implement gradual bans on diesel vehicles. If companies do not have transition plans in place to deal with these challenges, then institutional investment will dry up.

Investors are also becoming more conscientious about where their returns are sourced from. Charities and religious endowments have long demanded that managers root out so called sin stocks from their portfolios such as companies linked to alcohol, firearms or tobacco, but such requests are now becoming far more mainstream. A lot of this is down to demographic change as younger investors appear to be more attuned with sustainable investing than previous generations, prompting reform at a number of institutions.

Asset management initiatives like documenting and monitoring internal carbon footprints are a potential starting point, whereas other firms – resources permitting – might even begin filling in the TCFD. Not only would this demonstrate resolve to ESG aware clients, but it could make it easier for firms to adhere to climate risk regulations and disclosure obligations as and when they are eventually introduced. 

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EU Cross-Border Marketing Proposals Fall Short

EU Cross-Border Marketing Proposals Fall Short

In 2015, New City Initiative (NCI) partnered with Open Europe and produced a paper – Asset Management in Europe: The Case for Reform – which acknowledged that despite the availability of passporting under the UCITS and AIFMD regimes, various impediments levied at a national level stifled the seamless cross-border distribution of EU-regulated fund products across member states.

These restrictions, NCI calculated, created 1.5 million euros of initial costs to a UK-based fund manager distributing across the EU-27 (plus Switzerland), and a further 1.4 million euros in on-going Annual maintenance costs. NCI notified EU and UK regulators about this anomaly and the detrimental impact it was having on boutiques raising EU funds at a time when Growing regulatory and operational requirements were eating into margins.

Shortly thereafter, it was announced the Capital Markets Union (CMU), an initiative welcomed by NCI at the time, contained among some of its policy objectives a commitment to make cross-border distribution of EU fund structures (AIFs, UCITS, ELTIFs, EUVECAs, EUSEFs) more efficient, by removing some of these national barriers and obstacles flagged by NCI among other industry bodies and associations.  

In March 2018, the European Commission (EC) came up with a set of proposals designed to expedite cross-border distribution of EU regulated fund products. To summarise, the proposals do not exactly tally with what NCI or other industry associations had in mind, mainly because they introduce even more obligations and complexities for firms marketing into the EU to deal with. Arguably, this is the exact opposite of what was being called for by the industry.

Nonetheless, there are some small wins for asset managers to take home, primarily around local regulatory costs and charges. A persistent irritation – and one that was outlined in NCI’s paperback in 2015 – was that home and host state regulators levied fees on AIFMs and UCITS during the authorisation and registration process, which were not homogenised, thereby discouraging EU funds from distributing beyond just a handful of markets.

A report on the CMU proposals by law firm William Fry said that while local regulators can still levy charges on AIFMs and UCITS during authorisations and registrations, these must be proportionate to the regulator’s own costs, and they must publish all fees and charges on their websites, and notify ESMA accordingly. The same report said that while this change was modest, it was welcome, a view shared by NCI.

Less welcome, however, is the EC’s stance on pre-marketing, a vaguely defined concept that allows firms to avoid notifying EU regulators and complying with AIFMD and UCITS while they make preliminary contact with investors provided they adhere to some very strict conditions. The lack of EU-wide standardisation has always meant that pre-marketing in one jurisdiction (i.e. the UK) may contradict the marketing rules in another country.

Having not previously demarcated where the boundaries for pre-marketing actually were, the EC has sought to instil some clarity under CMU for the benefit of its member states and fund managers. The EC said that pre-marketing was the “direct or indirect provision of information on investment strategies or investment ideas by an AIFM or on its behalf to professional investors domiciled or registered in the Union to test their interest in an AIF that is not yet established.”

In addition, pre-marketing does not allow managers to share draft prospectuses or offering documents with investors. This latter proposal is certainly more constraining than the existing approach taken in the UK where it is permissible under pre-marketing rules to share draft documentation with investors – provided prospects are not obliged to enter into a binding agreement afterwards.

In the short-term, the rules are likely to rile the UK, which takes a fairly tolerant attitude towards pre-marketing versus other constituents in the EU27, but its lasting impact may be felt elsewhere, especially among third country managers. Many non-EU firms (including UK managers post-Brexit) have expressed alarm that legitimate practices under reverse solicitation could well be outlawed under the new pre-marketing rules.

This leaves few options for third country managers looking to run EU money after Brexit. Firms can either comply with AIFMD and then build the appropriate infrastructure around it, or just assiduously study the pre-marketing rules being put forward by the EU and ensure they do not break them (i.e. do not market inside the EU period).

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Enabling Technology Change at Boutiques

Enabling Technology Change at Boutiques

Advancements in technology bring benefits, but boutique asset managers need to embrace change in a way that is considered and not impetuous. While fin-tech is an exciting premise, fund managers must ensure they do not get overwhelmed by the hype that some of these innovations have generated. This will require asset managers to be engaged on fin-tech matters, but equally pragmatic so as to reduce the risk of wasting money on products that deliver limited or zero value to their businesses and clients.

Finding the right use cases

Fin-tech innovations like Blockchain and AI offer a number of advantages, but asset managers need to be selective about how and where they integrate this technology into their organisations. Firstly, a lot of fin-techs have been established, some of whom are marketing products which are unsuited to the industry’s needs, or that solve a non-existent problem. Such providers need to be avoided.

Furthermore, not all inefficiencies within a business warrant a fin-tech intervention. Existing software providing automation can solve many of the current operational inefficiencies which are present across the industry. Spending money on fin-tech when it is untested and expensive is not a sound business judgement, so boutiques may want to wait until the technology becomes more commoditised and homogenised before adopting it.

Managing risk

The risks posed by innovative technologies to businesses are only now beginning to be understood. As such, human intervention is still necessitated when managing these new technologies. While a lot has been written about robotics removing jobs in the middle and back office, there will still need to be human oversight to check that the data being inserted into these AI programmes is accurate, alongside the trends that are identified by the software in order to spare fund houses from serious losses.

Ensuring technology is future-proofed against embryonic risks is also key. Take Blockchain, for example. Blockchain theoretically protects the data it holds through encryption and cryptography, but concerns are growing about how effective these defences will be as and when quantum computing enters the mainstream.[1] Highly-powerful quantum computers – if exploited by cyber-criminals – could unlock Blockchain’s encryptions thereby

undermining one of the technology’s chief selling points. 

Service provider risk is a serious issue for managers when working with fin-tech firms. While banks are cushioned by balance sheet capital, many fin-techs are reliant on VC or private investor funding, with a limited runway to achieve success. With fin-techs aggressively burning through these cash reserves, many are anticipating a consolidation of providers. As such, managers need to make sure they work with fin-techs which have a long-term strategy and strong balance sheets.

Not disregarding the rules

Regulators have been highly supportive of disruptive technology and are encouraging financial services to innovate, but abuses will not be tolerated. The big tech industry has been left rattled after data mismanagement was exposed at Facebook, and some financial services firms are understandably nervous about whether some of their own big data strategies could incur scrutiny.

As the General Data Protection Regulation (GDPR) becomes law later this year, innovations in big data need to be counterbalanced carefully with clients’ privacy rights, otherwise firms could be on the receiving end of some severe regulatory reproaches.  Adopting a strategy which puts client data at risk of being misused would be a very dangerous approach for any manager to take in the current political environment.

Don’t be afraid of the new competition

While boutiques should not prematurely implement innovative technology without a clear-cut strategy, they cannot afford to ignore the lurking competition which could potentially challenge the industry. The big tech companies are moving into financial services courtesy of open banking rules. Apple and Amazon already facilitate payments, while Facebook has obtained an electronic money license in Ireland.

Many of these big tech providers will also be monitoring developments at Yu’e Bao in China, a subsidiary of Alibaba which now operates one of the biggest money market funds in the world. These firms are undoubtedly identifying ways to tap into asset management to complement their existing services.

For boutiques to succeed in the future, they must be willing to face this new competition head on, and not bury their heads in the sand.  History has shown in many industries that large incumbents can struggle to deal with disruption if they move too slowly and focus on protecting their existing business.  Boutiques are smaller, nimbler and more innovative, giving them an excellent advantage.


[1] Global Custodian – Quantum computing threatens Blockchain security

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Reflections on NCI’s Blockchain Event of 28 March 2018

Reflections on NCI’s Blockchain Event of 28 March 2018

On 28 March 2018, New City Initiative (NCI) held a discussion and panel event on the topic of how Distributed Ledger Technology (DLT) and other technologies would likely affect the boutique asset management industry. In some of NCI’s recent policy papers we have explored the unique culture within small and medium-sized boutique asset managers: that culture promotes innovation and use of DLT is likely a trend that will advance rapidly in the industry.

The evening was structured as follows. Firstly, I gave a brief introductory presentation on DLT, including some usage cases across industries such as banking, insurance, music and public services. The common perception of DLT is its usage in Bitcoin, yet that is merely one usage case and moreover presupposes that public blockchains will dominate. The transformative effect runs more deeply and is likely not yet fully perceived, just as early use-cases of the internet in the late 1990s were not necessarily those that thrived: companies such as Amazon have used the internet as an enabler to drive changes in real-world businesses and, in my opinion, that is how the effect of DLT will ultimately be seen. This was followed by a panel discussion featuring three expert panellists: Liliana Reasor, who is CEO of SupraFin; Richard Maton, Partner at Aperio Strategy and Founder of the Financial Institution Innovation Network, and; Nick Bone, Founder and CEO of EquiChain.

Liliana talked about how the traditional IPO market can be disrupted by the processes used in Initial Coin Offerings (ICOs), transforming the operation of capital markets and empowering individual investors: SupraFin is a leader in this space. Nick commented on how DLT can be used to automate middle and back-office functions, but how there should be an awareness of vested interest in resisting change. Rather, investors may ultimately access securities and the custody chain directly, a usage case that EquiChain is developing. Richard commented on the need for changes in organizational culture and collaboration models to create and develop solutions that incorporate DLT and other technologies such as Artificial Intelligence (AI) and the capacity to be self-critical: by way of example, Kodak, Xerox and the like could not adapt, and perhaps actively avoided change; the result is self-evident.

Another interesting topic discussed was how DLT, and the security it can give, could allow emerging economies to leapfrog legacy economies, a process assisted by demographic change and a modern dependence on the state in Western countries. I walked away feeling excited about the future yet thinking that the asset management space, and financial services generally, will change rapidly in the face of technology: DLT intersects with AI and the increased data processing capabilities often called Big Data.

Panels such as these are a good opportunity to consider major changes in our industry and make us rethink certain assumptions. For instance, it may not be Brexit or regulation that turns out to be the biggest threat and opportunity to asset managers, but instead the adoption of disruptive technologies such as DLT and AI, amongst others.

Furthermore, the insightful questions from the industry audience put paid to the view that asset management is conservative and resistant to change; instead they demonstrated an appetite for innovation.

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Brexit - Still far from settled

Brexit - Still far from settled

To say the timing of AIMA’s (Alternative Investment Management Association) Global and Regulatory Policy Conference in Dublin was fortuitous is an understatement, happening less than one day after the UK and EU announced a conditional agreement for a transition or implementation period, potentially giving businesses an additional 21 months to finalise their Brexit planning. The word conditional here is very important because the transitional arrangement will only be formalised if the withdrawal treaty is fully agreed.

To summarise one AIMA attendee, "it is an agreement conditional on an agreement." Any number of issues could wreck UK-EU negotiations over the next 12 months including the future status of the Northern Ireland border; Spanish disagreement over Gibraltar; or even insistence from nationalistic Greeks that a Brexit transition be somehow linked to the immediate return of the Elgin Marbles (sadly not a joke).

If no withdrawal agreement is ratified, a Hard Brexit in March 2019 beckons. Despite all of the vainglorious media reports over the last 48 hours, it is very difficult to see what has actually changed. EU regulators – conscious of this misplaced optimism - have been at pains to stress that the risk of a no-deal is not a remote possibility, but something which organisations should still be actively provisioning for.

As such, fund managers must not over-analyse this relative thawing of Brexit negotiations, but should continue making preparations to ensure EU access – assuming they still want it – is still available to them following the UK’s departure. With delegation and reverse solicitation’s future both looking increasingly precarious in the AIFMD review, now is the time for firms to consider whether they create subsidiaries in the EU-27.

On the basis that there is unlikely to be any certainty around Brexit until early next year, the decision to relocate will have to be made blindly.  However, regulators at the AIMA event warned UK fund managers and banks that establishing shell companies inside the EU to game market access will not be tolerated post-Brexit. A number of EU regulators have also told managers that authorisations could take time if submissions all occur concurrently, and are recommending that firms send over their applications by mid-2018.

The other big risk for asset managers is fragmentation. Recent statements from EU regulators have been revealing. While fragmentation is not ideal, many EU regulators seem resigned to the fact it will happen, and have urged firms to plan for it.  For boutiques, this risks adding more costs to their operations if they are marketing into the UK and EU. Managers should start factoring these potential costs into their businesses, and build buffers accordingly.

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liquidity - avoiding a mismatch

liquidity - avoiding a mismatch

Liquidity – when markets are volatile – is a priceless commodity for fund managers to have, which is why UCITS’ products – for example - have seen strong, regularised inflows from investors globally.

However, some NCI members are warning that certain daily dealing products are at risk of facing a liquidity mismatch, causing significant damage to their reputations. UCITS’ brand strength is attributable to several factors, not least of which is the daily liquidity these funds provide clients. Nonetheless, there have been warnings that macroeconomic conditions – most notably in the fixed income market – could present liquidity challenges for UCITS managers running bond funds.

In 2016, Fitch issued a statement warning that 90% of UCITS running fixed income strategies were at risk of suffering a liquidity mismatch amid volatility in bond prices. While not a UCITS, a high-yield mutual fund in the US shuttered in 2016 after it failed to satisfy client redemption requests during the bond market volatility. Similar outcomes for UCITS cannot be ruled out if fixed income trading conditions take a turn for the worst.

The growth of alternative UCITS operated by hedge fund managers typically replicating their flagship products albeit under more regulated conditions is also a worry for some NCI members, mainly because they believe unsuitable or illiquid strategies are at risk of being distributed under the UCITS banner. If markets were to seize up, and redemptions grounded by one of these firms, the UCITS brand could be seriously undermined.

However, it is important to note that most hedge funds running UCITS will do so within the confines of the rules, while regulators are very proactive at flagging strategies down which they believe are unsuitable for the brand. Equally, esoteric or complex strategies should not be misinterpreted as being illiquid in nature. 

NCI members also expressed misgivings about the proliferation of daily dealing open-ended property funds. It was well documented that a handful of such funds were forced to temporarily suspend redemptions following the shock Brexit vote, and its immediate hit on UK property prices. Despite these funds having large cash reserves to satisfy redemptions in ordinary market conditions, these holdings are not always sufficient during periods of high volatility.

In extremis, firms could be forced to unwind property in fire-sales at uneconomic prices causing widespread losses for end clients. Even if a property fund was able to sell its underlying investments, it would be very difficult not to suspend redemptions as it is physically impossible to offload a building in a single day to a buyer. In response, some NCI members feel regulators should scrutinise the liquidity terms offered by daily dealing property funds.

NCI will produce a white paper exploring whether or not some fund types including alternative UCITS, daily dealing open-ended property funds and certain ETFs are at risk of facing a liquidity mismatch, a scenario which if played out would undoubtedly result in serious damage to the industry and its standing among investors. NCI will be consulting with its membership on this paper shortly.

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Blockchain and Boutiques

Blockchain and Boutiques

Having begun its life as a fairly unimposing piece of technological infrastructure supporting the then peripheral and arguably mysterious world of cryptocurrencies, Blockchain is now seen as being one of the biggest potential enablers of cost reduction and efficiency in financial services, including fund management.  

Blockchain or shared, immutable distributed ledger technology (DLT) is forecast to save the financial services industry approximately $110 billion in costs over the next three years, according to McKinsey, with cross-border B2B payments, trade finance, P2P payments, repo transactions, derivatives settlement, AML and KYC likely to be the areas targeted for streamlining and disintermediation.

Fund managers – at least in the short term – are likely to find Blockchain technology being increasingly used in client and regulatory reporting, corporate actions, proxy voting and automation of transactional processes in the distribution cycle. Over time, the use cases will expand with the technology – which can process transactions in real-time -  potentially disrupting clearing and settlement. The elimination of intermediary costs – certainly in the custody chain – will bring cost savings for managers which can be passed on to customers.

Boutique asset managers will not be omitted from the Blockchain revolution. Admittedly, most boutiques will not develop proprietary Blockchain solutions, mainly due to the initial costs of the R&D being too high, but also because service providers should do it for them, providing industry-wide solutions and infrastructure. As fiduciaries, however, fund managers have a responsibility to investors to mitigate operational risk, and this applies to how they use Blockchain.  

Interoperability: Getting it Right

System upgrades and transformations rarely go ahead without some form of inconvenience or impediment to the end client. The legacy technology supporting the fund management industry and their service providers can be antiquated, making it very difficult to introduce new systems without causing massive disruption. If Blockchain is to work, it must be able to operate with legacy infrastructure, which can be decades old.

This may require service providers to maintain their existing technology simultaneously to rolling out a Blockchain solution in parallel. A dual infrastructure should help avoid IT meltdowns as and when Blockchain becomes more customary in financial services, but the cost of running two systems may result in the industry and its customers being saddled with higher fees during that interim or transition period.  

Making a Complex Ecosystem More Unnavigable

Given the gravity around unwanted disclosure of confidential information and cyber-crime, most fund managers do not support the idea of a public Blockchain despite the efficiencies it will bring. As such, most service providers are developing private Blockchain solutions.

This has scope to exacerbate complexity in an already convoluted and crowded financial ecosystem, particularly if different Blockchain solutions cannot interoperate, or were fund managers to find themselves working across dozens of distinctive and arbitraging DLT interfaces. Rather than saving costs, this could potentially add to them. 

No Standards

Market-wide standards are essential as they help create uniformity across capital markets. SWIFT, for example, has played a vital role in setting the standards for payments and securities transactions across multiple geographies. Nothing of this sort exists for Blockchain although this is symptomatic of any technology’s early stage development and a reluctance among industry participants to impose prescriptive requirements at the expense of innovation.

Regulation of Blockchain is limited for similar reasons. Without some standardisation or regulation, Blockchain’s development is likely to be slightly staggered and uneven across markets, something which will make it harder for the fund management industry to fully embrace.

Secure or Not?

Cyber-security was found wanting in 2017 as a number of multinational organisations fell victim to sophisticated hacks. Information contained on a Blockchain is protected through encryption and cryptography, barriers which make it materially harder for hackers to breach, or so the theory goes.

Advances in technology have cast doubt as to whether Blockchain encryption is sufficiently capable of protecting client information against future threats such as those posed by quantum computers.  Quantum computing is an extraordinarily powerful, theoretical form of computational strength which could decipher or crack even the most sophisticated Blockchain encryptions and cryptography.  

If Blockchain providers do not take note of this potential risk, the technology may only be usable for a decade or less. It is critical for managers to pause before they consider Blockchain, and ensure the technology is future-proofed, otherwise they could end up spending significant sums on a short-lived concept vulnerable to new, unexplored risks.

Blockchain Bubble?

The highly speculative Bitcoin and Initial Coin Offering (ICO) mania which has swept the world over has alarmed some Blockchain providers. For several years, they have worked assiduously to disassociate themselves from Bitcoin, and the big fear now is that any sudden price rationalisation in cryptocurrencies could hurt a number of investors which in turn may sour (unfairly) the reputation of DLT.

Conversely, there is a Blockchain bubble in itself, namely an oversupply of providers, many of whom are hoping to capitalise on the technology’s popularity in financial services. Most Blockchain providers will fail and it is important managers work with established or credible organisations when implementing a DLT strategy to avoid any business disruption.  

The Best Approach

Blockchain will have a positive impact on asset management, but firms still have time to make a decision on how to apply it to their businesses. It is probable the larger asset managers that will embrace the technology initially, before it trickles down to the boutiques unless they collaborate. NCI is hosting a Blockchain seminar later this year for its members. Venue and details will be published shortly.  


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2018: Key Considerations for NCI Members

2018: Key Considerations for NCI Members

Mathematical economist Irving Fisher once confidently assured his followers that prosperity would be in a perpetual state, arguing that the stock market had reached “what looks like a permanently high plateau.” The only issue was that he made those comments in 1929 and three days later the stock market nosedived leading to the Great Depression. In short, making predictions is not for the faint-hearted, but New City Initiative (NCI) will have a go, looking at some of the key regulatory trends likely to impact asset management in 2018.


MiFID II will be EU-wide law on January 3, 2018, one year later than its original implementation date. For NCI members, MiFID II will introduce significant change, most notably in their ability to source sell-side research. Inducement bans mean research cannot simply be given to managers in exchange for equity commissions. Instead, the cost of research needs to be unbundled and managers must pay for it out of their own pocket.

Larger fund houses have confirmed they will pay for research out of their P&L, but smaller firms are likely to face more serious cost pressures. Most NCI members and asset managers generally are either paying for research directly out of their P&L; increasing management fees, or establishing separately funded research payment accounts (RPAs) in order to keep accessing sell-side research.


GDPR imposes strict standards on data governance and protections across EU-wide companies including investment funds. Breaches of GDPR will lead to significant fines, and potential reputational damage and even client redemptions. Firms need to be preparing for the rules, identifying the location of any client data that they possess, in addition to obtaining consent from clients if customer data is used for purposes of analytics, distribution to third parties and marketing.

GDPR also lays out a framework for organisations to report data breaches, and requires firms with more than 250 people to appoint a chief data officer. For asset managers, GDPR needs to be a business priority in 2018.


The Senior Managers & Certification Regime (SMCR) has been bedded down for more than a year now, although it currently applies only to banks and PRA regulated financial institutions. It will, however, be extended to asset managers in 2018. Its core demands are fairly uncontroversial with a number of organisations welcoming the regulation. Put simply, SMCR introduces prescribed responsibilities for senior managers, and subjects them to greater accountability when rules are breached.

David McNair Scott, CEO at Trailight, highlighted the biggest SMCR challenge for buy-side firms was around allocating responsibilities and functions to designated persons within an organisation. He added a number of asset managers had yet to systematise and document their SMCR processes, something which can be quite painstaking. McNair Scott also acknowledged that most of the contents of SMCR were proportionate and the FCA had sought to curtail any destabilising impacts on smaller managers.

AMMS Consequences will be felt

SMCR is only one part of the FCA’s efforts to heighten standards in asset management. The FCA’s AMMS was released in June 2017, and it was a report many in the industry considered to be fairly even-handed. Most significantly, the industry is not staring down at a Competition and Markets Authority (CMA) probe unlike the investment consultants. Overall, the AMMS is likely to bring about tougher standards and greater competitiveness in asset management.

One of the proposals being put forward is to require managers to independently assess whether they deliver value for money to clients, a process which will be overseen by an impartial board of directors who are all subject to the SMCR. This recommendation is a regulatory reaction to concerns that retail investors sometimes struggled to understand precisely what the objectives of their managers were.

The AMMS also led to the creation of the Institutional Disclosure Working Group (IDWG), a body looking at formulating a template to be provided to investors about cost disclosures across different segments of asset management. Anecdotal reports suggest the template will be detailed, which may be a problem for smaller asset managers, although many will probably outsource data aggregation to third party vendors. Creating a framework for transparency and competitiveness is certainly not a bad thing for asset management during this period of Brexit uncertainty.

And finally Brexit…..

At the time of writing, nearly all newspapers appear to give the impression that Brexit negotiations are finally making progress, as the UK confirmed a willingness to pay a substantial divorce bill to the EU. NCI members have repeatedly urged there be a transitional arrangement in place to enable its constituents and their clients to manage Brexit risk in a calm and composed manner.

A cliff-edge Brexit would be devastating for asset managers, leading to rushed decision-making, potential redemptions and possible relocations. NCI urges the government and the EU to minimise any instability in financial services that may come about through Brexit.

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Complacency is not an option

Complacency is not an option


Clarity about the UK-EU future relationship may be provided later this year, a full seven months after Article 50 of the Treaty of Lisbon was invoked by PM Theresa May, which ratified the start of Brexit talks. It is hoped the EU will sign off on a transitional arrangement for the UK in December 2017, a milestone which would significantly reduce the risk of a sudden, hard Brexit. 

A transitional agreement would allow impacted organisations such as fund managers, their staff and clients to accustom themselves gradually to the new UK-EU relationship, with limited disruption. A transitional agreement is fully supported by New City Initiative (NCI), as we believe it will provide essential stability in what could potentially be a highly uncertain process. The likelihood of a transitional arrangement may be assisted by the increasingly rational and pragmatic approach being taken by EU and UK negotiators, who realise that a traumatic Brexit could aggravate systemic risks and economic damage.

The key to any future UK-EU relationship has to be certainty. Even if the net outcome is poor, businesses need to know specifics in order to adapt. At present, there does not appear to be a tsunami of businesses moving operations into the EU. Many firms will probably retain a strong presence in the UK, while partially increasing their footprints on the continent. So far, financial services have not shifted operations into the EU at a pace or scale that many had envisaged following the referendum last year.  

UBS, for example, publicly said the number of staff likely to relocate into the EU post-Brexit would be far lower than initially forecast. Some attributed this to the absence of flexible employment laws in parts of the EU jostling for business. This business commitment, however, should not be taken for granted, as an absence of a transitional agreement and a lack of substantive progress on trade talks could force organisations to execute Brexit contingency plans. This could seriously threaten and impede the UK’s competitive edge over the next few years.

The Risk of Domestic Change

There are other risks to UK businesses not emanating from the EU, but rather domestic forces. The decision to hold an election in June 2017 cost incumbent PM May her majority and there is a very real possibility of a change in government prior to Brexit talks concluding.

This would lead to serious disruption in the Brexit negotiation process, particularly if there was a material change in policies and priorities put forward by an incoming regime. This could result in delays to Brexit and further uncertainty at a critical point. 

Domestic policies by any new government could also exacerbate business disruption. The opposition Labour Party, which many believe could win the next election, has made a number of statements – which if implemented - would seriously impact financial services. These have included calls for an introduction of a Financial Transaction Tax (FTT) and mandatory nationalisation policies. The Shadow Chancellor of the Exchequer also suggested capital controls could be implemented in the event of capital flight.

If such events transpired and domestic policies became hostile to free enterprise and financial services, there is a very real risk businesses that had once remained committed to the UK after Brexit may leave on their own volition, either for the EU, North America or APAC.  Several industry experts have said that Brexit is manageable, but the spectre of FTT or capital controls unleashed by a government unreceptive to free markets could prompt a number of organisations to hoist business from the UK.

NCI is engaging with its members and external service providers about how they would react to the possible introduction of forced nationalisations, the imposition of capital controls and an FTT. This will form the basis of a research paper being produced over the course of the next few months looking at what these potential policies could mean for financial services and most importantly, its customers, and how the industry can best prepare themselves.

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ESMA Delegation

ESMA Delegation

The simplicity by which an AIF or UCITS can structure itself in an onshore EU market (Luxembourg, Ireland, Malta) and delegate the running of its portfolio and oversight of risk management back to the manager in a third country is a fundamental reason as to why both of these brands have enjoyed considerable popular appeal and global success.

Put simply, delegation is a cost-effective way of getting an AIFM or UCITS running without having to invest in onshore physical infrastructure. That the European Securities and Markets Authority (ESMA) is potentially calling into question this existing set-up should alarm not just UK asset managers, but investment firms all over the world.

Brexit is obviously the impetus behind ESMA’s proposals. It is no secret that some of the EU 27 have been trying to capitalise on the uncertainty in the UK to attract business into their domestic markets. ESMA has repeatedly warned these countries that standards cannot be loosened otherwise it risks creating regulatory divergences.

The regulator has also warned UK financial institutions against setting up letterbox entities in the EU 27 as a tool by which to continue passporting cross-border. The funds’ industry opposes the creation of letterbox entities, but the present regulatory structure in major onshore European fund domiciles around delegation is mature and substantive, a point made by industry groups including the Association of the Luxembourg Fund Industry (ALFI).

Some of the core proposals include forcing managers to appoint at least three people in their EU fund domicile, and it is also very probable that delegated activities will be subject to even more regulatory scrutiny. This will inevitably bring added costs and requirements to the funds world, eating into the revenues and returns of boutique asset management providers.

The cost of running an AIFM and UCITS – with its existing depositary and reporting obligations – is high, and many boutiques could end up shunning both brands, particularly if their European flows are small relative to other markets. In short, this protectionist measure would immediately reduce European investor access to boutique providers as non-EU firms look to distribute their fund vehicles elsewhere, and outside of the EU’s regulatory oversight.

UCITS has had a stranglehold on APAC and Latin American markets for quite a few years now. At a recent ALFI Conference in Luxembourg, financial services professionals from APAC and Latin America spoke extensively about their own various regional fund passporting initiatives. If delegation is scrapped or impeded, a manager in Sao Paolo or Hong Kong will likely pivot towards a regional fund passporting solution as opposed to UCITS.

Financial services regulators that comprise ESMA often applauded the UK’s Financial Conduct Authority’s (FCA) contributions to policy discussions, acknowledging that it curtailed some of the worst excesses of protectionist rulemaking in favour of free market thinking. With the FCA's role within ESMA much diminished now as a consequence of Brexit, the risk of protectionist market initiatives such as the restrictions around delegation have risen and UK firms need to keep a close eye on developments.

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

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

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

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

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

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

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

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

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


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MiFID II - Five months to implementation

MiFID II - Five months to implementation

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

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

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

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

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

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

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

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

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

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

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The FCA's plan for Asset Managers

The FCA's plan for Asset Managers

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

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

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


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

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

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

An All in one Fee

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

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

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

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

Switching Share Classes

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

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

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

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

Future FCA Areas of Scrutiny

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

Back to the Drawing Board

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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...And so begins Brexit

...And so begins Brexit

It has taken nearly nine months for the UK government to invoke Article 50, thereby setting off the process by which the country will leave the EU. While many financial services firms would have preferred to maintain Single Market access, it became abundantly clear this would not be possible in the face of strong political opposition.

For fund managers, the loss of Single Market access raises uncomfortable questions. Some have openly expressed apprehension about being cut-off from the EU, which will deprive them of the right to sell or market their funds into the mainland without barriers or restrictions. Any firm that set up a UCITS or AIFM in the UK to distribute into the EU will lose their passport.

All UK UCITS or AIFMs will be classified as third country managers irrespective of whether they fully comply with these Directives. A handful of firms explored whether innovative EU master-feeder structures could be created to offset third country designation, but lawyers have roundly dismissed such ideas as fanciful.

In addition, regulators have warned UK managers that substance is unconditional if they wish to continue to take advantage of the passport. Setting up a letterbox entity and delegating processes back into the UK will not be accepted. It is reported regulators in Luxembourg are said to be particularly alert to this risk.

Those major asset managers with large quantities of EU investors are setting up subsidiaries and branches in EU fund domiciles such as Ireland and Luxembourg, but most are sitting tight. The majority of firms are reluctant to add significant costs to their balance sheets by relocating to an EU country.

Brexit is potentially a plethora of hypotheticals, and until there is a degree of clarity over the outcome, firms should avoid rash moves. Most fund managers are nimble unlike the banks and market infrastructures, and can afford to hold off executing their Brexit plan for the time being.  However, fund managers ought to have a contingency plan in place to deal with any eventuality.

Talking to lawyers or service providers in EU fund centres is recommended, and investors should be kept fully notified of any conversations. Certain investors – such as EU institutions – will be particularly sensitive to matters on Brexit. A failure to coherently inform and communicate with clients on Brexit could have negative implications.

So what issues should fund managers be thinking about between now, and the supposed 2019 conclusion of Brexit talks? Firms should certainly not be disregarding their EU regulatory obligations. Rules such as the Markets in Financial Instruments Directive II (MiFID II) will be introduced in 2018, and compliance efforts should not be watered down.

The UK Financial Conduct Authority (FCA) has been a key driver behind MiFID II, and it will not be impressed if firms avoid their compliance responsibilities. Testing the FCA’s patience – given recent public statements and reports – would not be a sensible strategy for asset managers.

Nonetheless, there is a problem as to what managers will do when rules are being proposed by the EU during the Brexit negotiation process. Some firms have questioned whether they will need to work towards complying with EU proposals in the interim, which post-Brexit may not be enacted by the UK government, or interpreted in a different way.

This is complicated further as Brexit talks could go on much longer than anticipated. Many believe some sort of transitional arrangement will be negotiated, which should help manage business continuity risk to a degree. As such, it is likely that any transitional requirements will oblige financial institutions in the UK to adhere to EU rules until Brexit is fully realised.

In addition, the UK government has alluded that it is hopeful equivalence for financial institutions can be achieved post-Brexit, and this means domestic law has to be comparable to that of the EU. The UK is unlikely to do away with existing or incoming EU directives if it is serious about meeting equivalence. This implies that post-Brexit, there will be some similarities between UK and EU law. Arbitraging or heavily conflicting regulations post-Brexit will just add to fund managers’ costs, and this is in nobody’s interests.

It is clear that Brexit will be challenging for asset managers and fund managers should be conducting regular assessments and analyses on Brexit outcomes and the impact it will have on their businesses, and this should be shared with investors. Firms should be engaging with regulators during this period of transition and change. Investors will not look kindly on managers who fail to approach their Brexit planning thoughtfully and without due consideration. 

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The FCA’s scrutiny continues…

The FCA’s scrutiny continues…

The UK Financial Conduct Authority (FCA) has been in a pugnacious frame of mind lately. Its AMMS review published in November 2016 was a stern warning to active managers, criticising their fee structures and return generation in comparison to cheaper passive alternatives. On March, 3, 2017, the FCA issued a robust indictment of commission dealing arrangements, based on a sample study of asset managers.

Four years have elapsed since the UK financial services regulator published its “Dear CEO” letter, and over two years have passed since the FCA outlined changes to COBS 11.6 covering the use of dealing commissions. These changes required asset managers to minimise customer charges via commission payments, and prevent firms from obtaining non-eligible goods and services from sell-side brokers in exchange for client dealing commissions.

Despite this, the FCA believes the majority of asset managers in its study have fallen short of expectations. In a strongly worded statement, the FCA said firms had not met its standards in a number of areas including verifying whether research goods or services are substantive; attributing a price or cost to substantive research if they receive it in exchange for dealing commissions, and recording their assessments to demonstrate they are meeting COBS 11.6.3R, and not spending excessive client money.

“We expect to see clearly documented evidence to support the acquisition of permitted goods and services. In subsequent reviews we will also seek confirmation of boards demanding satisfactory management information on the subject. Firms are required to have adequate systems and record keeping processes,” read the statement.  

The FCA also said that many firms were unable to demonstrate meaningful improvements to their processes. In extremis, the FCA said a handful of firms were still deploying dealing commissions to purchase non-permissible items like corporate access and market data services.

“The majority of firms continued to treat the receipt of corporate access from brokers as a free provision. Where these firms also operated limited controls and record-keeping over research expenditure, this leaves them exposed to the risk that corporate access or other non-permissible services might still influence the allocation of dealing commission expenditure. Some firms failed to record details of corporate access meetings and in some cases, had to rely on estimates when responding to our questions,” it read.

The FCA warned that continued breaches would be met with regulatory intervention.  A failure to act could result in serious reputational damage for impacted managers. The FCA also criticised the research budgeting process at asset managers, citing firms with an absence of a research budget process had research spending levels closely correlated with trading volumes.

Nonetheless, the FCA acknowledged improvements had been made with 79% of organisations in the regulator’s sample using research budgets compared to 34% in 2012. A failure to budget researching spend properly can lead to wastage, and may result in firms being in breach of FCA rules requiring organisations to act in the best interests of their customers. “Greater scrutiny around budgetary requirements, including a comprehensive approach to valuing research, could result in lower costs and/or a more efficient use of dealing commission. This in turn may lead to better returns for investors,” read the FCA statement.  

The FCA did have praise for firms where thoughtful research budgeting was implemented, with some organisations benchmarking their spend against external sources to validate value for money. Other firms, added the FCA, switched to execution-only arrangements once their periodic research budgets hit a certain threshold.

A handful of firms cover the cost of externally produced research from their own resources as opposed to using dealing commissions. The FCA said this reduces conflicts of interest, and enhances transparency about the charges clients pay. Such a policy also helps ensure best execution, while research will only be purchased if warranted. This means firms will buy better albeit less research.

Smaller firms are naturally concerned by the likely added research costs, not to mention the provisions outlined in the Markets in Financial Instruments Directive II (MiFID II). Asset managers have a fiduciary duty to work in the best interests of clients, but if firms are unable to afford quality research, it could deter them from executing certain trades. This would potentially undermine performance and investor returns. 

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Clearing and Brexit

Clearing and Brexit

Most UK fund managers are trying to reconcile quite what leaving the Single Market – as outlined by Prime Minister Theresa May – means for their business. Single Market withdrawal means the right to unequivocally distribute funds – whether they are UCITS or AIFMs – into the 27 EU member state countries looks precarious, and this concern has understandably dominated Brexit discussions among managers at industry events. This is fair enough but a growing band of buy-side firms with heavy OTC exposures are now fretting about the impact of euro-denominated swaps clearing moving from London to the EU – possibly Paris or Frankfurt.

The vice-chairman of BlackRock recently told Reuters that he could not visualise euro-denominated clearing taking place in a non-EU jurisdiction. Any forcible resettlement of these transactions would hurt the UK, particularly as it controls around 70% of euro denominated clearing, far more than second placed Paris, which holds just 11%, according to Bank for International Settlements (BIS) data from 2013. The UK has fought off similar challenges from the ECB before – successfully – having argued in European courts that location policy went against the EU’s Single Market principles allowing for free movement of goods, people, services and capital.

As the UK has confirmed it no longer wants to be party to the Single Market and those governing principles, the ECB is naturally having another stab at redrawing the boundaries for euro-denominated clearing. Benoit Coeure, a member of the ECB’s executive board, said that euro-denominated clearing’s presence in the UK was contingent on whether the country developed a sufficiently robust regulatory framework, something he conceded would be challenging. He added the UK’s market dominance was a result of solid cooperation with the Bank of England and the ECB, which was based on a foundation of EU law under the authority of the European Court of Justice (ECJ). The rejection of the ECJ by the UK puts this at threat.

The ECB is certainly within its remit to make a play for euro-denominated clearing, but it could have negative ramifications elsewhere.  Firstly, the euro – like the USD, Pound Sterling and Japanese Yen – is a global reserve currency meaning it is traded and cleared all over the world. If euros can only be cleared in mainland Europe, it could result in tit for tat reprisals, which will simply exacerbate protectionism. A land-grab for euro denominated swaps clearing by a Eurozone economy would infuriate non-Eurozone EU countries. It could also prompt legal action from aggrieved non-EU banks and CCPs. In short, any regulatory attempt to prise business away from the UK – which is clearly where the derivatives market wants to be – would be counterproductive and highly complex.

Most importantly, a protectionist OTC clearing policy by the ECB would be very costly for derivative users, particularly if markets become fragmented. The costs would not just be borne by UK asset managers, but firms and investors within the EU, and globally. Unfortunately, rational behaviour should never be taken for granted, particularly given the factitious disorder that may result through Brexit.  Asset managers and their investors will face a massive rise in operating costs of euro denominated swaps clearing if the process is decentralised. The European Market Infrastructure Regulation (EMIR), which the UK has fully enacted, obliges firms to clear vanilla OTC contracts through CCPs. As part of this, fund managers need to post initial and variation margin to CCPs so that transactions are fully collateralised were a counterparty to fail. Collateral must be high quality and variation margin calls will be cash only.  

A fragmented clearing set up would mean firms would have to make more margin calls to a greater number of CCPs. Obtaining collateral that is suitable for CCPs is not always easy, and it is particularly challenging during stressed markets. As such, firms would see a jump in their clearing costs to potentially unsustainable levels. The lack of a centralised clearing venue would also mean cost benefits through netting and portfolio compression could be lost. The costs may be so great that some managers exit OTCs, or worse stop hedging transactions properly. Others may simply enter OTC transactions in lesser regulated markets.

Optimists believe the UK – having implemented EMIR to the letter of the law – ought to have no problems obtaining equivalence. Even so, equivalence is far from perfect as it can be arbitrarily taken away by EU policymakers. If UK CCPs do not receive recognition, the costs of clearing will increase for European banks as they must centrally clear OTCs through qualifying CCPs or face increased capital charges. Again, this would be a major blow for Eurozone banks and may be an unsustainable stance for EU policymakers to adopt. Any challenges to the UK’s position as a centre for clearing would be hugely damaging for both UK financial institutions including asset managers, as well as those in the EU.

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FCA Asset Management Study

FCA Asset Management Study

Investor protection is at the core of the Financial Conduct Authority’s (FCA) Asset Management Market Study Interim Report published in late 2016, but some of its proposals could have unintended and adverse consequences for the industry.  The FCA has laid down a number of recommendations including enhanced transparency of fund charges and performance and a revamping of governance standards. 

Perhaps the most critical component of the FCA’s report was that it said active asset manager charges did not correlate with performance and that the sector as a whole had underperformed benchmarks after charges. It pointed out that while competition in the passive funds space had led to a race to the bottom on fees, the same had not occurred in active asset management. 

Investors ultimately are paying for performance. A failure to deliver returns to investors should not be rewarded with generous fees. That being said, smaller active managers have generally outperformed larger managers for a variety of reasons. Small firms are more agile meaning they can execute trades seamlessly, something that is not always possible at a major firm.  Those managers which consistently beat benchmarks and deliver good returns for investors should not be bucketed with organisations that fail to produce gains.

So what is the FCA proposing? One idea is for an “all-in fee model” covering transaction costs. The manager would – in this scenario – have to pay for additional transaction costs in the event of them being higher than anticipated. Such an approach does pose challenges, and could disadvantage investors as it may lead to some managers executing fewer trades.

While the FCA has said firms could charge for transactional costs in extremis, the likelihood is that fixed fees will increase. This will make active asset managers more expensive for end investors and potentially even less competitive. Proposals around governance are fairly prosaic and include the appointment of a board comprised overwhelmingly of independent directors. This is hard to falter as strong governance oversight is a complement to fund managers and their operational integrity.

Increased transparency forms the bedrock of EU regulations including the Markets in Financial Instruments Directive II (MiFID II) and the Packaged Retail and Insurance linked Investment Products (PRIIPs) rules. Both PRIIPs and MiFID II demand managers disclose their charges, although the FCA – according to Deloitte – is now demanding that asset managers explain more clearly the impact charges have on returns on an on-going basis and to identify the total cost of investment – including distribution – on both a pre-sale and continuous cycle. 

Deloitte highlighted the FCA’s proposals would make summary cost figures more prominent and remove confusion between fund and distribution charges. Performance disclosure is another theme of the FCA, and it wants managers to be wholly transparent about whether they are meeting their target benchmarks to investors.

Competition is core to the FCA, and the regulator wants it to become easier for investors to switch products more easily if they feel they have not received value for money. Switching, however, is not always straightforward for investors and can incur charges and taxes, thereby disincentivising many from doing so. Managers point out that obtaining permission from investors to switch products is not always assured, a point that has been clearly on-boarded by the FCA.

The FCA is consulting on these proposed remedies with the industry and feedback must be submitted by February 20, 2017. The New City Initiative recommends that all of its members participate in this discussion and provide written or oral feedback to the FCA as part of this consultation.

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The Alternative Investment Fund Managers Directive (AIFMD) is bedded down, and the costs have generally beenabsorbed by the asset management community without too much disruption. The European Commission (EC) is obliged to review AIFMD’s progress in 2017, but managers should not brace themselves for radical change. It is hoped that uncertainties about asset segregation rules will be settled, but remuneration provisions are unlikely to be amended. Reporting requirements under Annex IV could be reassessed although the specificities have not been laid out.  

Anecdotally, there is talk that liquidity risk management and leverage rules are being tightened or at least synchronised with policy guidelines due to be outlined by the Financial Stability Board (FSB) and International Organisation of Securities Commissions (IOSCO). AIFMD is already pretty robust on liquidity risk management and requires firms to carefully document and manage it, through stress testing, for example. As such, any additional requirements should be fairly straightforward for firms to deal with. 

In the meantime, it is becoming obvious that third country passporting rights are not going to happen, or at least not anytime soon. Third country equivalence – as the regimes of Guernsey, Jersey and Switzerland will not dispute – has been an exercise of endurance. Affirmation from the European Securities and Markets Authority (ESMA) that these countries met equivalence way back in 2015 has not led to any meaningful developments or substantive progress. A handful of large fund markets including the US, Hong Kong and Singapore, have subsequently been reviewed by ESMA and given a broadly positive opinion although there were some conditions. 

The structure of the EU is such that approvals are required from multiple policymaking entities before anything can be actioned. Even before the market shake-up that was Brexit and the election of Donald Trump, the process was unwieldy. Brexit has prompted EU regulators to put the brakes ongranting equivalence. The AMF, the French regulator, has publicly said the EU should reopen negotiations with certain countries to guarantee reciprocity, an issue that has not been discussed in several years. In short, the passport extensions look to be on shaky ground. 

The shock election of Donald Trump, who has promised a raft of deregulatory measures, could also provide an excuse for the EU to slow down on equivalence. Promises to scrap Dodd-Frank should be taken with a degree of scepticism but the mood in the US is certainly gearing towards less government intervention in capital markets as evidenced by some of the cabinet appointments in the new administration. Any revisions to the US fund regime could put AIFMD equivalence on the backburner.  

APAC markets who are big buyers of UCITS will be particularly frustrated by the delays, and were notably incensed by their initial exclusion back in 2015 following ESMA’s first AIFMD equivalence opinion. This second set-back could embolden regional regimes to push more vigorously ahead with pan-APAC fund projects such as the ASEAN CIS and ARFP. Competition should always be supported, although if these fund schemes draw inflows over the next few years, some UCITS with Asian clients could struggle to win further mandates

The EU’s renewed opposition to equivalence presents a huge issue for the UK. Admittedly, the terms of Brexit are unknown and predicting anything in today’s market is rife with challenges. However, if single market access for the UK was withdrawn, UK-based UCITS and AIFMs would effectively be excluded from passporting. It is highly probable that National Private Placement Regimes (NPPR) are going to end with markets moving towards the German model (i.e. a total ban). Non-EU firms may struggle to access EU markets when this occurs, although some could use reverse solicitation. It is true EU investors do call upon non-EU managers on occasion,but it is not something to be counted upon and it carries with it huge regulatory risk. 

These political changes will probably force some UK firms to move parts of their infrastructure to onshore domiciles such as Luxembourg or Malta to maintain access to the EU investor base. The general trend in the EU appears to be moving towards protectionism and this will only grow once the UK leaves EU bodies such as ESMA post-Brexit. Again, it is foolish to rush to any conclusion. Firms should delay any structural alterations until there is greater clarity, although they ought to have a rough idea of how to act if Brexit does leave UK managers isolated from the EU

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SM&CR: What now for Asset Managers?

SM&CR: What now for Asset Managers?

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. 

[1] Clifford Chance Briefing Note, May 2016 – Extension of the Senior Managers and Certification Regime: Impact on Asset Managers
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What now for EMIR?

What now for EMIR?

What now for EMIR?

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. 

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AIFMD Update

AIFMD Update

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. 

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The Imminence of PRIIPs

The Imminence of PRIIPs

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. 

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Brexit: The Unknown

Brexit: The Unknown

What is happening? The Big Picture

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.

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A CMU Consultation Opportunity

A CMU Consultation Opportunity

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.

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MiFID II's Delegated Acts and its impact on fund manager research

MiFID II's Delegated Acts and its impact on fund manager research

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. 

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Fund Passports in Asia

Fund Passports in Asia

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.

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The Liquidity Conundrum

The Liquidity Conundrum

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. 

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Loan origination funds: What next?

Loan origination funds: What next?

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.

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Securities Financing Transaction Regulation

Securities Financing Transaction Regulation

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

What is not an SFT under SFTR?


Any derivative contract as defined by EMIR


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

  1. Amount of securities and commodities on loan as a proportion of total lendable assets
  2. 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.[3] 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.



[1] Clifford Chance –“The SFTR: New Rules for Securities Financing Transactions and Collateral” – January 2016

[2] Freshfields – The Securities Financing Transaction Regulation  - November 2015

[3] Dechert – New EU Regulation on Securities Financing Transactions and Reuse of Collateral – December 2015

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Marketing reforms in the EU

Marketing reforms in the EU

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. 

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MiFID II: A delay is not an excuse for complacency

MiFID II: A delay is not an excuse for complacency

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.

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Where now for UCITS?

Where now for UCITS?

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.

What next?

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.

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BEPS: Another tax initiative for fund managers

BEPS: Another tax initiative for fund managers

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. 

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Cyber-threats: a huge risk for asset managers

Cyber-threats: a huge risk for asset 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.  

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ESMA publishes AIFMD passport advice: The Key Issues

ESMA publishes AIFMD passport advice: The Key Issues

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. 

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The risk of asset managers being dubbed SIFIs

The risk of asset managers being dubbed SIFIs

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. 

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Wealth management client suitability

Wealth management client suitability

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. 

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FATCA is just the beginning

FATCA is just the beginning

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. 
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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. 

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What does MiFID II mean for research?

What does MiFID II mean for research?

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.

Going forward

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.

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What is Solvency II?

What is Solvency II?

What is Solvency II?

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].

Investment type                                              

Capital charge

Hedge funds,  ‘other equity’


Private equity, OECD listed equities


Real Estate


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.

Going forward

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. 

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What is the European Market Infrastructure Regulation (EMIR)?

What is the European Market Infrastructure Regulation (EMIR)?

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.

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