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

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

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.

SMCR

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.

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.

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.

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.

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. 

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

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

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

Governance 

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

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

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

An All in one Fee

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

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

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

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

Switching Share Classes

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

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

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

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

Future FCA Areas of Scrutiny

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.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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