Our panel discusses the European Commission’s cross-border funds distribution proposal and, in the post-Brexit world, Luxembourg’s role as a hub for cross-border distribution of traditional and alternative funds.
Marc-André Bechet (director of legal and tax at Alfi)
Louis Wright (director of sales and relationship management, Calastone)
Florence Stainier (partner, Arendt & Medernach)
Noel Fessey (CEO, EFA)
Justin Partington (group fund solutions leader, SGG Group)
Funds Europe – The European Commission’s cross-border funds distribution proposal aims to reduce regulatory barriers and streamline distribution across Europe, but do the proposals go far enough, and what impact would they have on Ucits and alternative investment funds (AIFs)?
Marc-André Bechet, Alfi – It’s a proposal, subject to discussion and trilogue negotiations among the Parliament, Commission and Council. The compromise struck by the European Parliament is not good enough. The current proposal doesn’t help the industry in terms of facilitating pre-marketing. The European Parliament has introduced a requirement to notify pre-marketing before you start, which was not anticipated. The text is also contradictory. Pre-marketing – contacting potential investors without registering funds – is key for asset managers.
Furthermore, if you enter a market, you should be able to pull out if you don’t meet success. The proposal’s denotification conditions are not helpful. You must demonstrate that you have no investors left, which is nearly impossible. We don’t see the legal basis for that. We have legislation in MiFID II that provides a solution for investors who want to remain in a fund.
This doesn’t facilitate distribution in smaller markets. The danger is that people will be reluctant to enter markets where they aren’t certain they can generate enough business.
Florence Stainier, Arendt & Medernach – The stance in the latest draft may be disappointing, but at least it aims at improving cross-border fund distribution. There is progress on the pre-marketing definition, although the industry would have preferred a clearer definition of marketing. If you define marketing, anything outside that doesn’t require registration. Defining pre-marketing, as the Commission tries to do, is far more difficult.
Noel Fessey, EFA – They facilitate this pre-marketing idea, then define marketing as anything that results in a sale. The authors of the proposal probably feared it would be abused, which is a regrettably defensive posture in an otherwise well-intentioned initiative.
Justin Partington, SGG Group – Looking at AIFM and Ucits separately would have been helpful. Some private equity (PE) clients enter an EU country for marketing to one or two investors, which they may or may not secure, which could mean they register in a country they don’t use, whereas a Ucits platform may have hundreds of investors in each EU country. Unlike Ucits, for private or closed-ended funds, it’s all about conversations, and what is permitted varies by country. It’s created a lot of confusion.
Fessey – Perhaps regulators are thinking of the long-term trend of Ucits and alternatives converging and are concerned that the latter will find their way into retail investors’ hands. They’re trying to create a broad regime that doesn’t adequately discriminate between the various regulatory fund formats and are capturing a broader section of industry activity than is wise. That interferes with legitimate dialogue between fund promoters and professional clients. We should be clearer about the difference between the controlled regimes for retail and professional-only products.
Stainier – The initial definition excluded any pre-discussion with investors because you couldn’t use draft documents or discuss an existing fund to test another market, so there is progress.
Bechet – There’s a definition that can apply to existing funds, sub-funds and new funds, which is progress, and there’s a uniform definition across Europe, whereas before we had a patchy situation. It provides some legal certainty but doesn’t go as far as we expected and some of the requirements, such as pre-notification of pre-marketing, are useless.
Funds Europe – Marc-André, is the Commission listening to the criticisms? Do you know what the timeline is?
Bechet – We hope it will be finalised by the end of February. Then everybody is in listening mode. There’s a true discussion, and we can make our voice heard by speaking to Parliament, the Commission and the Council, meaning the Luxembourg representative.
Funds Europe – Are other national funds associations saying the same things to the Commission?
Bechet – Yes, there is consensus. Nobody is more impacted than Luxembourg, which is a cross-border distribution hub, so Alfi is spearheading discussions, but other associations are engaged.
Fessey – It’s about protecting investors and reducing costs.
Stainier – And increasing the size and efficiency of EU open-ended funds.
Partington – Which conduct of business failures do they want to address before adding new restrictions over the alternatives sector? Hopefully, the motivation isn’t that everything must be regulated or defined. Humans are innovative. Things change.
Stainier – We had a discussion with some MEPs about investor protection. They certainly had mis-selling in mind but were not clear which experiences they might have come across. We had long conversations to explain why we need a pre-conversation with some PE investors.
Fessey – Investor protection was the core idea behind AIFMD, but are investors asking for more protection in this context? More investor engagement would be good to ensure that this initiative meets a real need.
Stainier – You also have the MiFID directive, which places additional obligations on professionals selling these products, so why increase the product regulation? That’s a double protection. It doesn’t ease distribution and asset-raising, which is the purpose of creating PE funds.
Fessey – Yes, the regulations are already quite comprehensive. Therefore, what more protection is necessary? I totally understand the investor-protection point, but this probably goes too far. That said, some things in this initiative are welcome, such as the review of obligations to have a physical presence in national markets. Changes there would bring advantages in terms of operational simplicity and potential cost reduction for investors, promoters and distributors.
Bechet – It brings more transparency on the applicable rules in every market, because the National Competent Authority (NCA) will have to publish information that Esma [European Securities and Markets Authority] will then compile in a summarised form on its website. Getting the most up-to-date information is a struggle for all firms engaged in distribution. Good progress as well on fees charged by regulators.
Fessey – Eliminating the obligation to appoint a paying or placement agent or legal representative in a country is welcome. Sometimes that appointment is imposed by law, creating a captive market. These agents arguably don’t add value and can be expensive. Proposals in another EU legislative package to improve further the EU’s simplified payment regime and to lower cross-border payment costs, particularly when paying from a non-Eurozone country into a Eurozone country, are also attractive.
A question for the industry is: how to replace these agents? Promoters will still need a presence, though not necessarily a physical one, and not necessarily in the host member state. And even if promoters eliminate local paying or placement agents, they will very likely still work with local distributors. Furthermore, promoters must still meet their regulatory obligations to present sales documentation clearly and make the prospectus, dealing and settlement process and complaints process clear, open and transparent to investors in the official language of the member state in which they are marketing their funds. So, very welcome as some of these proposals are, it will take some time for the industry to work out how to adopt them in their European cross-border businesses.
Funds Europe – The year ahead will see Brexit and a new European Parliament. What effect will these developments have on the funds industry in terms of policy-making for financial services?
Partington – It comes down to the kind of Brexit we have: negotiated or no-deal.
Under a negotiated Brexit, our clients are preparing for the UK to be deemed an equivalent country, whether or not it is in the single market or customs union, meaning no cooperation agreement is necessary and they can distribute in the EU using UK managers. Probably they’ll end up having a Luxembourg AIFM for EU distribution, keep risk management in Luxembourg and delegate the portfolio management back to the UK. The key advantage of this model is minimal disruption.
We recently polled our clients, and 76% feel it’s going to be more difficult post-Brexit. Very few have migrated fund structures to Luxembourg or elsewhere within the EU. As a contingency, they are expanding in Luxembourg, so they’re ready to flip over or move if they need to.
Bechet – From the policy-making point of view, the UK was and still is still the largest financial centre in Europe, with a wealth of expertise, and was prominent in shaping regulation at the European level in the Commission and Council. We will miss that expert knowledge in future.
Partington – We miss it today, because it’s already happened.
Bechet – If you take the example of MiFID, that came from the UK driving a discussion based on the RDR [Retail Distribution Review] experience. That demonstrates the UK financial community’s capabilities and expertise. In future, the breakdown of financial centres across Europe will be more balanced. Frankfurt, Paris, Ireland and Luxembourg will get more business depending on specialties. More asset management will be based in Luxembourg and Dublin. Asset managers and AIFMs are reinforcing their presence in these two jurisdictions. Unfortunately, it’s a trade-off. The UK is losing part of that, and the European countries are gaining.
Delegation is the remit of the NCAs, but it is reassuring that the Commission and Esma have clearly said that delegation is here to stay. The discussion is still open on whether it will be more difficult, but there is no intention of closing the door on non-EU countries advising European funds, and we have that in place with the US and Asia.
Stainier – Luxembourg is not comparable to the UK in terms of size, and we will be losing a member state that was vocal in our industry and had an aligned position, and we will miss that as a small country. A question: do you think Brexit might lead to deregulation?
Funds Europe – You mean within the UK?
Stainier – Within the UK, and then driving something different in the EU comparable to what is happening with Mr Trump in the US. We hear voices in the UK saying that once the UK is no longer part of the EU, it might be time to relax the rules in terms of remuneration policies and add some flexibility. Does that mean a more flexible position in the long term because we went so far at the regulatory level? And what about Esma’s role?
Fessey – These are huge political questions, and it’s hard to predict where Brexit goes politically. Post-Brexit, there will be calls for deregulation on the UK side, but government agencies will be preoccupied with coping and there won’t be much capacity for new projects.
Assuming Brexit happens, the loss of British influence may be regretted, but the comprehensive European legislative programme will continue. The Capital Markets Union (CMU) programme has many facets, and the European Parliament knows what it wants to achieve. The UK asset management industry will continue to participate through its European subsidiaries – just as the US financial services industry is – but its influence will be diminished.
The European Union won’t lack vision or an agenda. Issues on the table include non-performing loans, SME growth markets, sustainable finance, crowd funding, prudential requirements and supervision for investment firms, pan-European personal pension products (though that’s probably not going to be significant), cross-border distribution of funds, and calibration of the likes of Solvency II and EMEA. Also, central counterparty and central securities depository recovery and resolution, which brings us back to Brexit because institutions such as [clearing house] LCH are based in the UK.
The UK probably won’t achieve the independence it hopes for. To do business with European clients, you must submit to the EU’s requirements, which means regulatory equivalence, and cooperation with EU regulatory authorities such as Esma and the ECB [European Central Bank], and national competent authorities. Looking to immediate concerns, on Brexit day, a cooperation agreement must be in place in respect of CSDs [central securities depositaries] and CCPs [central counterparty clearing houses]. There’s not much time now to do that, and it’s complicated by political confusion in the UK.
Bechet – Esma is working on a multilateral MoU [memorandum of understanding], which should be ready by March 29. The question is whether a multilateral MoU is sufficient and/or whether you need bilateral MoUs.
Louis Wright, Calastone – In the unlikely event that there is a second referendum, it’s going to take some time to get back up that hill because of the damage done in the UK.
Stainier – On the third-country regime, two angles might give it more importance in years to come. First, MiFID II has introduced a third-country regime that the EU Commission might revamp because of interaction with Brexit. Second, the private placement regime is supposed to disappear in 2020.
Fessey – Brexit has dislocated the UK politically and may dislocate it economically. It will have a political and economic effect on the EU, but it hasn’t dislocated the major EU legislative programmes. Brussels is getting on with business. CMU will continue, along with developments in areas such as cross-border funding of the real economy. They’re welcome because they help to support the real EU economy, and from our industry’s perspective, they allow us to make the most of opportunities. Banks are not active on as broad a stage as they used to be. There’s more space for asset managers and their clients to play a role.
Partington – Efficient capital markets are beneficial for investment flows, but how does Brussels retain that philosophy without one its most pragmatic and experienced members in the financial services sector? If regulation is highly prescriptive, it could reduce the CMU’s efficiency gains.
Funds Europe – Luxembourg for Finance (LFF) has said it intends that Luxembourg will continue to be a partner for UK asset management firms after the UK leaves the EU. How can this be achieved?
Wright – Luxembourg has often said it’s doing everything possible to be open to UK companies. It’s giving derogations to Brits living in Luxembourg to stay without visa hurdles, which is very positive. We’ve seen a lot of companies come across here in the insurance and banking sectors, and our company is looking to increase its size in Luxembourg.
Funds Europe – But it could be a problem if you were to bring in anyone else from the UK.
Wright – That’s true, but we have 16 nationalities in our company in London, so we can easily bring in people from Ireland and other countries. The thing is the expertise. There’s huge expertise in London, and we don’t want to lose out on that.
Fessey – The bridge between Luxembourg and the UK will remain, and we’ll do business together within the terms of the final EU-UK settlement. The legislative programme in Luxembourg is very attractive to British companies and companies all over the world. The relationship between the government and industry through LFF and the regulator is open, and the dialogue is clear. English is an effective working language for the state, which is also attractive to business. If anything, Brexit will make that relationship more important and more fruitful for everybody.
Beyond our industry, the Luxembourg government continues to support the economy through infrastructure investment. There will be mobility in future between the UK and Luxembourg, because it’s in both countries’ interest. It’s regrettable how the freedom of movement issue came to the forefront of the Brexit debate. Luxembourg will remain an open place to do business.
Bechet – Luxembourg is an open economy that welcomes foreigners, and we should value that. Forty-eight percent of the population is foreign, we have international schools and you can do business in four languages. All of us around the table today are foreigners.
Eighteen percent of Luxembourg funds are established by UK asset managers, which is the second-largest group. Most of them have large operations in Luxembourg, and the UK firm often delegates the management back to the parent company in the UK. This will keep happening.
Delegation is permitted under Ucits and AIFMD, and the requirements under the Ucits and AIFMD framework are very strict. The Luxembourg regulator’s requirements in terms of substance and oversight are very onerous if you delegate to a UK-based asset manager or anybody else. That’s good, because we have certainty and a robust framework.
Partington – It’s about the cooperation, not competition. We did a Brexit survey that’s being released soon. Almost three-quarters of our clients haven’t changed their structures because of Brexit. The 28% that have made changes have all chosen Luxembourg.
Stainier – All necessary cooperation agreements will be in place, because our regulator and other regulators are working with the UK regulator to achieve that. That should make it easier to continue the asset management and discretionary portfolio management delegation. The approach might be similar to the one with Switzerland. We have built bridges through pragmatism and a common interest in working together.
Fessey – Luxembourg’s international nature is such that the regulator is used to working in a college with non-EU regulators. The quality of the cooperation between the FCA and the CSSF will continue, and that will be important for the mutual supervision of businesses that are inherently cross-border, even if in future they will cross an external border of the EU.
Funds Europe – Do you expect the steady growth of AIFs in Luxembourg in recent years to continue?
Fessey – Yes. Reasons include banks funding the real economy less than they used to because their balance sheets are under pressure. Asset managers have filled that gap.
AIFMD has been successful. Luxembourg implemented it early and well and innovated with the reserved alternative investment fund (RAIF). Managers find that attractive and the ecosystem here facilitates growth.
Partington – The ecosystem makes the difference. The SCSp [Luxembourg special limited partnership] is another example of great innovation. Emulating the UK limited partnership, it’s a flexible product alongside AIFMD.
Bechet – We also see growth potential in the PE sector, and in the loan funds sector. If you compare AIFs in Luxembourg to neighbouring countries, we have more cross-border structuring and distribution expertise. A KPMG survey for the Commission’s AIFMD review showed that 37% of AIFMs use Luxembourg as a domicile for their AIFs. The next country has a 19% market share. It’s evidence of Luxembourg’s success as an international hub for AIFs.
Partington – A challenge for PE and real estate managers is rising interest rates. That makes it harder to leverage assets and maintain the premium on public markets. But Luxembourg continues to get a bigger market share, with growth at 20% in private equity last year. On the debt side, the growth rate is even higher at 23%. US debt managers are increasingly coming here.
Funds Europe – Which are the top one or two regulatory changes by the CSSF over the past year and what’s important about them?
Stainier – The circular on substance. For once, the CSSF has codified an existing practice. It adds some constraints, but on the positive side it creates a framework, and Luxembourg is the first EU country to come up with a framework, giving certainty to what kind of substance management companies need to have on the ground. This may be an occasion to work on the passporting of management companies. Some are still using different management companies across the EU, and it may make more sense to have one hub with one management company that meets substance requirements. In some cases, Luxembourg might be a good jurisdiction.
Bechet – Yes, it’s really a landmark for Luxembourg. It’s the longest circular ever issued by the CSSF, and the intention was to create one reference text with all the conditions that must be met.
Fessey – The regulator is more active in terms of dialogue with firms and site visits and in enforcement where it sees breaches. That’s important because it demonstrates to investors and the industry that it’s serious.
Partington – The management substance circular also addresses concerns about the renting of management companies and whether they have substance, which is welcome.
The AIF depositary circular 697 is also helpful. There was confusion around procedures and contracting with different firms taking different views. This helps to provide a level playing field for clients.
Funds Europe – Where do you see the Luxembourg fund industry in five years’ time? We always finish these roundtables with a general question of this sort.
Wright – The biggest challenges are rising costs and declining fees. There’s a lot of new regulatory demand, and we’ve got evolving investors, looking at the funds differently.
There must be a change in how we manage funds’ back-office operations. There’s a lot of inefficiency, which is costing investors money. At Calastone, we’re already switching to a distributed ledger technology (DLT) in May. It won’t replace everything, but it will speed up the process, reduce costs and improve efficiencies. We’ve seen good initiatives across the industry to try to have a central KYC/AML [know your client/anti-money laundering] database. There was a problem with GDPR [General Data Protection Regulation], but it seems they’ve found a solution.
Fessey – Luxembourg will continue to grow in the fund industry. A PwC report up to 2025 suggests a compound annual growth rate of about 5%. Growth could be stronger than that, although economic circumstances – China slowdown, trade protectionism, etc – provide reasons to be cautious. Private assets will increase their market share, but the industry will still be dominated by classical funds. We may see cyclical change, but the long-term secular trend will be growth.
Bechet – Fintech will change the way we do business.
ETFs and passive funds are on the rise, and Luxembourg is involved with close to €200 billion under management in ETFs. That has increased dramatically over the past two years because providers have moved their funds here from other domiciles. Alternatives are on the rise too. The market share is currently 16% but is growing. This will bring more substance and more AIFMs to Luxembourg, with asset management teams based here.
We boast that we distribute in 70 markets and we keep trying to open up new markets. Over the past years, we added three countries – Brazil, Australia and Mexico – and there are more to come. When we open up a new market, Ireland and other Ucits centres come in as well, so it benefits the entire European asset management sector.
Stainier – We need to continue building a strong professional infrastructure and be as pragmatic as possible, because that’s always been Luxembourg’s added value.
Partington – There will be higher added value through the value chain because of automation through fintech, which Luxembourg and the industry are supporting. Another trend is increasing interest from Asia in Luxembourg funds. Clearly, there is a growth story in Asia despite the headwinds in China.
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