REGULATION: how to handle change

Regulatory deluge has afflicted fund managers for at least a decade. Martyn Cuff, managing director at Allianz Global Investors Europe, present his must-keep guide to regulatory and industry change and advice on handling changes.

Regulatory deluge has afflicted fund managers for at least a decade, but Martyn Cuff says the next four years could be even more hectic.

The next four years are going to see significant regulatory and operational changes within the European asset management industry. In fact, in recent times it is difficult to think of another period when such an amount of change was faced by our industry. Here is a short summary checklist of some of the major initiatives that must be dealt with across the European landscape and the implications for the industry. They have been sorted into two categories, namely those developments that have been initiated by regulators and those that have been initiated by the industry itself.

Example regulation affecting the European asset management industry between 2010 and 2014
MiFID II – update to the MiFID Directive to tackle issues missed in the first version and possibly expand rules to the OTC (over-the-counter) derivative markets. Originally the directive focused on harmonising investment services across Europe. Of particular importance to fund managers were requirements on brokers to provide ‘best execution’.
Ucits IV – the core objectives are to increase investor protection, increase industry efficiency, facilitate cross-border distribution, reinforce cooperation between supervisors and lower overall costs.
Ucits V – speculation is that work will start in 2011 on a new directive aimed at increasing investor protection and creating a level playing field for Ucits investors in Europe. One of the main areas of focus is to be depositary liability.
AIFM – the original objectives of the Alternative Investment Fund Managers Directive are twofold. First, in accordance with the agreement reached by the G20, to provide regulators with the ability to identify, monitor and, where necessary, address potential systemic issues arising from the activities of alternative investment fund managers. Secondly, to provide appropriate protection to investors in the context of the universal passporting regime for alternative investment asset management and alternative investment fund managers.
Solvency II – this is a fundamental review of the capital adequacy regime for the European insurance industry. It aims to establish a revised set of EU-wide capital requirements and risk management standards that will replace the current Solvency requirements to reduce the likelihood of an insurer failing and to reduce the possibility of consumer loss or market disruption in insurance.
Basel III – the intention is to update the existing Basel II Framework to strengthen the resilience of the global banking sector in the wake of the recent financial crisis. This will include the quality and size of capital bases, leverage ratios and liquidity coverage ratios.
Prips – the European Commission has committed to delivering improvements to investor protection measures for the main investment products bought by retail investors. Inconsistencies in existing standards can be detrimental to investors and can lead to competitive distortions in the retail investment market. The commission’s conclusions, set out in the Communication on Packaged Retail Investment Products, are that product information requirements and rules on product sales need to be improved and made more coherent.
Market Abuse Directive – market abuse consists primarily of insider information and market manipulation. The Market Abuse Directive provides an EU-wide market abuse regime aimed at reducing the incidence of market abuse.
Cesr morphing into Esma –  there are proposals for the creation of a European financial supervisory framework, comprising a European Systemic Risk Board, charged with macro-prudential oversight, and new European supervisory authorities, the European Banking Authority (EBA), the European Securities and Markets Authority (Esma) and the European Insurance and Occupational Pension Authority (EIOPA), intended to create an overarching European framework for the supervision of individual regulated businesses. Esma will replace
the existing Committee of Securities Regulators (Cesr).
Regulation on Credit Rating Agencies – the regulation will have a major impact on the activity of credit rating agencies, which issue opinions on creditworthiness of companies, governments and sophisticated financial structures. Credit rating agencies will be expected to comply with strict standards of integrity, quality and transparency and will be subject to ongoing supervision of public authorities.
European Market Infrastructure Legislation (Emil) – its aim is to meet the need for greater stability and transparency in OTC derivatives markets.
Capital Requirements Directive (CRD) IV – this is the latest set of amendments to the CRD which is the common framework for the implementation of Basel II in the EU and provides rules on capital requirements for credit institutions and investment firms aim to put in place a comprehensive and risk-sensitive framework and to foster enhanced risk management amongst financial institutions.
Dodd-Frank Wall Street Reform and Consumer Protection Act – now requires that non-US asset managers who manage assets greater than $25m (€19.8m) attributable to US clients may need to register with the SEC.

Example operational infrastructure changes affecting the European asset management industry between 2010 and 2014
Target2Securities (T2S) – The objective of the T2S project is to integrate and harmonise the currently highly fragmented securities settlement infrastructure in Europe. It will reduce the costs of cross-border securities settlement within the euro area and participating non-euro countries, as well as increase competition and choice amongst providers of post-trading services.
CCP for OTC derivatives – to improve risk management and transparency there is a general global push to see the clearing and settlement of over-the-counter derivatives undertaken through central counterparties.
Collateral management – as part of improving risk management, there is an increased focus on collateral usage and management related to securities lending and over-the-counter derivatives.
Fund Processing Passport – this is the Efama initiative to see each European mutual fund having a set of standard characteristics published and publicly available for use by a wide range of people such as distributors, administrators, auditors, etc.
Trading of mutual funds on stock exchanges – in Europe mutual funds are not generally traded on stock exchanges (except for exchange-traded funds – ETFs) though there are calls from some quarters for this to change.
International Securities Services Association (Issa) Investment Asset Management Working Group – identified ten guiding principles to achieve higher efficiency and convergence of market practice in asset management processing. This was issued in October 2009 in its Investment Asset Management Processing in Europe report aimed at identifying and documenting core investment asset management processing models and patterns in Europe.
Beyond these initiatives there are many regulatory and operational changes taking place at individual country level which add to the overall change agenda; for example, the Retail Distribution Review (RDR) in the UK. So will all this activity result in a stronger industry and how should fund managers cope?

Towards a stronger industry
The asset management industry exists to protect and enhance wealth. Within a capitalist system, it also plays a key role in linking providers of capital (investors seeking a return) with the users of capital (entities such as companies and governments). Given that most societies have chosen some form of capitalism as their economic model there is, in fact, no choice but to have a strong industry. In this sense, the definition of strong industry could include the running of acceptable levels of risk at systemic and individual levels, providing a robust market-based mechanism (country, regional and global) which is trusted by investors and hence complementing governmental efforts to generate economic growth and keeping friction costs low between investors and users of capital.

For these reasons, governments around the world are taking a real interest in the asset management industry, particularly given the well-documented financial crisis and its subsequent implications over the past two years.

Looking at the long list of initiatives mentioned above, they are, at least in theory, aligned with the idea of a stronger industry. However, how do we know whether they will be of practical use? Two ways adopted to assess this are Feed Forward and Feedback (familiar to those who know System Theory). Feed Forward is forward looking and ensures that sufficient debate takes place with a wide enough range of stakeholders to design these new initiatives before they are enacted. This process brings wisdom and balance to the situation. However, as the military says: “A plan rarely survives first contact with the enemy.” Therefore it is vital to have an accompanying Feedback process. This involves reviewing the impact of the changes after they have taken effect, identifying deficiencies in the outcome of the initiative and most importantly of all, showing a willingness to adapt to address these deficiencies.

So, is there sufficient Feed Forward and Feedback? It might help to categorise the changes into two groups: market-led and governmental-led.

Market-led – this involves the application of ‘market forces’ and there is plenty of evidence to suggest that this is a very powerful ‘control’, since it is based around free choice. For example, the eventual leader in the CCP space for OTCs will be decided largely by their clients. Market-led initiatives are much more biased to Feedback than Feed Forward.

Governmental-led – this is where governments decide, for various appropriate or questionable reasons, that leaving the situation to be sorted out through market forces is insufficient and so they enact legislation. This process is more biased towards Feed Forward. For example, most legislation is debated vigorously before it is finalised, such as with the AIFM. That said, there could be concern that the extraordinary economic challenges faced by many countries today could lead to politicians pushing through changes before they are fully evaluated. This is why the Feedback mechanism is also important and is utilised by the authorities; for example, the sequels to previous incarnations of the MiFID, Basel and Solvency directives. However, the speed of this Feedback tends to be much slower than the Market-led process.

Will the changes help?
It is hard to escape the feeling that the sheer scale of at least some of the change agenda is a natural human overreaction to the depth of the financial crisis. We will certainly have more and not less regulation four years from now. However, the reality is that at this stage we simply do not know whether it will fully deliver the practical benefits that everyone seeks and the answer will progressively appear over the next few years. While it may seem disappointing not to be able to give a definitive answer now, comfort should be taken that both government and market forces are hard at work trying to balance the influences of different stakeholders.

Addressing the change agenda
Handling all of these forthcoming changes in an effective manner will be one indicator of a well-run asset management company. Some possible ideas in this regard are:

The change agenda described here focuses upon regulatory and operational changes. Of course, there are many other diverse developments that asset management companies must address, such as the need for European citizens to better tackle their pension deficits, the rapidly developing trend in social media/business and the competitive threat from the rise of asset management in Asia. As a consequence, there is plenty ahead to test our individual, company and industry adaptability.

This is the second in a series of articles by Martyn Cuff on major asset management themes

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