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

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

The Death of CMU

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

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

SMCR: Get ready

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

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

ESG moves onto the statute books

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

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

Good luck in 2019

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

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

What businesses are in scope?

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

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

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

The Big Risks

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

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

Getting SMCR ready

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

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

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

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

ELTIFs: Good in theory, bad in practice

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

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

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

Harmonising distribution does not go far enough

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

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

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

Fixing a broken CMU

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

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

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

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.

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. 

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.

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. 

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).

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.

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.

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.

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.

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.