TRADE TALK: All change on the regulatory front

The funds industry has had to comply with a raft of new regulation in recent years and more is on the way. Key players in the regulatory space tell Funds Europe about the challenges they expect in the year ahead.


Has the industry’s response to the heightened regulatory atmosphere since the global financial crisis been sufficient?
Regulation has increased significantly since the financial crisis. January saw MiFID II come into force, and the EU Money Market Fund Reform, Benchmark Regulation and GDPR are all on the 2018 horizon, to name just a few.

The majority of financial institutions have become accustomed to preparing for these: beefing up their internal compliance and regulatory teams and partnering with specialists to support the requirements associated with such new reforms. The dominant trend emerging as a direct by-product of this is a greater focus by these financial institutions on technology and regtech, with the ultimate objective of improving risk management and compliance tools whilst (hopefully) reducing the associated costs and increasing efficiencies.

It’s no secret regulators are asking for more data. MiFID II, for instance, is substantially changing trading models, transaction reporting and how the buy-side sources research and distributes its products.

Market participants now have to report considerably more to regulators, often differing from product to product and country to country. All of which makes this work increasingly challenging, fuelling interest in regtech. This will likely escalate as firms both large and small look for – and demand – best-practice tools to help them meet new regulatory requirements, as well as avoid errors and non-compliance.


What, from a regulatory point of view, will asset managers need to prepare in 2018 in order to be ready for 2019?
When considering regulatory priorities in 2018, we must look at what happened in 2017 and what will happen in 2019. MiFID II dominated the agenda and budgets through 2017 but there is still work to be completed in 2018, both in terms of direct compliance and to adjust business models.

Included within MiFID II were provisions around costs and charges, and for some firms this overlapped with the Packaged Retail and Insurance-based Investment Products Regulation that came into effect at the start of 2018. These changes, combined with the FCA’s Asset Management Market Study and similar reviews from Esma and other regulators, suggest costs will be a theme that continues through 2018 and beyond.

There is no let-up in regulatory change post-MiFID II. The 2018 list of material regulatory projects includes: the General Data Protection Regulation as an immediate priority that will have widespread impact across Emea and due for implementation by May 25; further changes under Basel III; changes to the German Investment Tax Act that will impact those with funds domiciled in Germany; further changes under the Central Securities Depositary Regulation; and the start of the exchange of tax information under Common Reporting Standard.

On top of this, many firms may have to implement changes due to Brexit.

The impact of these regulations will vary between organisations, but the list suggests a shared challenge of dealing with the volume and complexity of regulatory change.

This has spurred the growth of the emerging regtech sector within technology firms. Perhaps in 2018 we will see that regtech can truly help mitigate the increased costs related to regulatory change and compliance.


How is Brexit impacting regulation of the asset management industry?
In the coming months, the industry will start to feel the effects of the UK’s withdrawal from the EU on policymaking. Going forward, all new rules will be viewed through the lens of Brexit, with the EU eager to ensure that the UK does not gain any advantage from exiting the EU.

This Brexit effect will come to the fore this year when the European Securities and Markets Authority reviews the AIFMD and Ucits frameworks.

As a result of the UK’s pending third-country status, the extension of the AIFMD passport to non-EU jurisdictions now seems less likely. Additionally, spurred by Brexit, some EU policymakers would like to have the Ucits framework incorporate third-country provisions that would govern what activity must be conducted within the EU.

Despite this, it’s not all bad news. The Brexit effect has also galvanised the EU to push ahead with its Capital Markets Union project, which is creating opportunities for asset managers – such as the proposed Pan-European Personal Pension Product.

While the industry anxiously awaits details of the final Brexit deal, it should be aware of the role that the Brexit effect is already playing on EU policymaking.


What could Europe learn from recent American regulatory experience?
Anyone wishing to know where financial regulation is heading in the European Union would be advised to study recent developments in the US.

In the decade since the credit crisis, asset managers have seen lots of new regulation. Mostly, US regulators have taken the lead, with their European counterparts following suit. The regulation has been largely driven by a shift focus from investor protection to systemic risk monitoring.

With money market, alternative fund and commodity pool systemic risk reporting in place, this year US asset managers are dealing with the mammoth of them all, Form N-PORT, as the SEC is imposing ‘modernised’ reporting and disclosure rules. Impacting about 12,000 mutual funds, the scale and processing aspect of the rule is a huge burden.

Such monitoring continues to widen in the EU. Asset managers are complying with AIFMD reporting and money market reform is being implemented in 2018. Is the next logical step to extend this requirement to Ucits funds, the last major asset class not currently subjected to such centralised reporting?

This will present a huge data-handling and reporting challenge. Given there are about 31,000 Ucits funds, the obvious question is how will they cope with the time-consuming business of monthly reporting?

The answer, which has already been arrived at by US asset managers, is to use machines for the heavy lifting, helping those in the industry perform their jobs more effectively. Those who prepare for this well in advance will find themselves best placed to cope when the change takes place.


Following MiFID II implementation, what challenges do firms face sourcing and presenting the data for year-end client reporting?
Following MiFID II implementation, wealth management firms are busy sourcing costs and charges data for the products they offer. Many firms will opt to use data providers to gather this information on their behalf. But despite the European MiFID template standardising the sharing of this information, this is just an industry standard and firms are not obliged to use it. There’s a risk that some providers won’t adhere, especially if they are not EU-based.

Firms need to prioritise putting in place systems that can take this data and combine it with the portfolios they manage so that they can provide year-end costs and charges disclosures for their retail clients. They will then need to think carefully about how they present this data to their clients.

These aren’t new costs and charges but it’s likely they’ve never been presented in pounds and pence before. Investors may start questioning where these charges have come from, only for firms to have to explain that they have been paying them all along without realising.

MiFID II might already be here, but January’s deadline was really more of a starting point. For many, the wider impact remains to be seen so it’s crucial that wealth managers spend these first few months ensuring that they are able to meet obligations long-term.


How has the regulatory environment evolved in recent years – from a funds/management industry perspective? 
That regulatory scrutiny has not only increased, but its attention has become more finely set towards the funds industry, is not an overwhelmingly insightful comment. We are all aware of the proliferation of legislation since 2008.

What is interesting is the industry is no longer sat on a petri dish, prey to microscopic attention. Instead it has garnered ownership of the lens and is duty-bound to present its own evidence. Gone are expectations that entities will be truly guided on what amounts to compliance. Here to stay is the need to subjectively interpret requirements and apply them in a manner specifically suited to the organisation in question.

Simply put, regulated entities must evidence control. The burden of proof in GDPR being a clear example.

Principles-led legislation, like the SM&CR, will soon supplement existing duties. The difficulty is when duties conflict with requirements.

The Financial Conduct Authority has recently advised that firms who feel the performance scenarios attributed to their Priips KID are too optimistic (and thus conflict with their duty to be ‘fair, clear and not misleading’) should explain this to their clients, providing any further documentation they feel to be necessary.

Whilst the obligation to provide information that goes beyond and may contradict with the output of EU-mandated requirements cannot be a long-term solution, the responsibilities on the industry will no doubt remain.


What are the main challenges facing the cross-border fund distribution business?
The regulation of cross-border fund distribution is at a time of unprecedented change. The global investment and fund management industry faces potentially the single biggest impact on cross-border financial services in a generation: Brexit.

Brexit is not just about the future of London as a financial centre, or of the UK-based investment and fund management industry. Firms within other EU member states and elsewhere will be impacted.

A lot of business takes place between the UK via the EU using regulatory passports. In only a few instances are such passports available to non-EU firms. There are increasing signs that the ability to delegate whole functions out of a fund’s home member state will be tightened.

There are a range of different third-country provisions under different pieces of EU legislation. But, unless we get a final trade agreement between the EU and the UK, including arrangements for UK firms to continue to benefit from all EU passports – which is a very big ask – Brexit will result in EU27-UK cross-border business being prohibited or at least severely restricted.


Why is the rise of digital technology of importance to asset managers under the Senior Managers Regime and what is the chief risk that stems from it?
The pace of regulatory change remains high. The Senior Managers Regime (SMR) – which will apply to asset managers in 2019 – could drive significant changes to the way firms are run. Straddling everything is the rapidly evolving role of technology.

The deployment of robotic process automation, machine learning and artificial intelligence promises to deliver significant efficiencies for firms.

But these systems also bring real challenges and risks, particularly for senior managers. It all comes down to the concept of individual accountability in the SMR: if an autonomous system takes decisions without human intervention, who is accountable if it fails to perform as expected?

Clearly identifying a responsible senior manager will be the first challenge. And that person must then understand what the system is doing, what risks it is running and how to mitigate them. Establishing appropriate governance, oversight and testing will be also be key to satisfying the FCA that the systems are robust, both in supervision and (should the worst happen) in enforcement.

Nobody expects senior managers to be technologists, but with machines taking over the world, a clear understanding of the benefits and risks will be vital, not only to firms, but also the senior managers that run them.


What will be the key theme for asset managers in the year ahead?
The simple answer is regulation.

It’s true to say that the agenda of the moment feels very regulatory-heavy – whether it’s dealing with EU-wide regulation such as MiFID II, Priips, GDPR or ‘hot topics’ such as costs and charges, risk framework and liquidity.

Unquestionably, regulation is at the heart of what we do, being central to competition and senior management accountability.

That’s not forgetting, of course, the challenges of Brexit. The question is, how do asset managers make their response to a regulatory topic a point of difference rather than falling into a reactionary stance of rule-by-rule adherence?

Consider themes such as value for money, benchmarking, transparency, the value chain and cross-border access.

Innovation and embracing new technology will also be key. Regulation is pushing the agenda and properly tackling these themes could have a huge positive impact to the end-investor and, ultimately, an asset manager’s growth and competitive edge.

Everyone will be talking about regulation in the year ahead, but only those who fully embrace the opportunities and understand the strategic implications will thrive in this new environment.


How will GDPR challenge the investor know-your-client (KYC) process in the funds industry?
Fund managers and administrators in particular are caught between the proverbial rock and a hard place with respect to know-your-client (KYC) documentation. On the one hand, they must comply with KYC regulations by collecting private and potentially sensitive information on their investors (the ‘data subjects’), while on the other hand, they are obliged to respect the evolving rights of investors in relation to data protection.

The territorial scope of the GDPR is far-reaching and will apply not only to firms operating within the European Union but also to firms gathering data in, or offering services to, citizens of the EU.

Applying this to the funds industry, GDPR will affect both funds based in the EU and funds based outside the EU which have EU-domiciled investors or where the ultimate beneficial owners of their investors are EU-domiciled.

Fund managers, their general partners and service providers such as administrators cannot avoid such challenges as they are likely to be ‘data controllers’ under the GDPR: the natural or legal persons who determine the purpose and means of data processing.

Funds with offices in several countries find that the information collected and held on investors needs to be shared across multiple borders between fund managers, administrators and group entities to comply with Fatca, the Common Reporting Standard, AIFMD and KYC requirements for international investments.


What are the shortcomings in the current regulatory reporting of capital, and how can they be improved?
The policy objectives underpinning the regulatory capital regime are to both ensure the stability of the financial system through the good governance of risks faced by financial services firms and to confirm they remain adequately capitalised at all times.

However, the current prudential regime was originally designed for banks whose main risk is credit risk, which is much less of an issue for investment firms. Moreover, the regime has evolved in layers over time and across national boundaries, which has resulted in a patchwork of rules applying to different firms, where the burden of reporting is sometimes more closely aligned with the political compromise of the day than the systemic risk of the activity.

The current shortcomings in the reporting regime are:
    • Good risk governance is about looking forward to anticipate problems. In practice, the current reporting regime provides a lot of data focused on looking back. The forward-looking information collected by the regulator tends to be less detailed and less frequent.
    • To support the objective of good risk governance the reporting regime must be focused on the right risks. The investment management industry has a set of risks distinct from the banking industry, but a lot of the banking regulation has been carried over in bulk. AIFMD and Ucits tried to draw a boundary around AIFMs/ManCos but by allowing firms to stray into MiFID activities, the lines have become blurred, and in the UK at least the old banking rules are back in play.
    • The current reporting regime includes anomalies, such as where firms with limited FCA permissions report more frequently than those with broader FCA permissions. For example, investment advisers report quarterly whereas investment managers, with more FCA permissions, reports biannually.

The proposed investment firm prudential regime appears to recognise the shortcomings identified above by addressing the specific risks that non-banks are subject to. It aims to ensure those firms hold sufficient capital taking account of the risks to their clients, the market and the firm itself.

However, the main objectives to make the new regime proportionate and simple to administer seems to have been lost.

For some small non-systemic, non-interconnected investment firms dealing solely as agent, simplicity has remained. For larger, connected firms that deal on their own account, the outcome seems to have resulted in similar complexity combined with the prospect of higher minimum capital requirements.


How close is the industry to having ESG investing become a regulatory requirement?
In its final report, the EU High-Level Expert Group on Sustainable Finance (HLEG) has clearly put forward its opinion that key EU financial services directives, e.g. IORP II, MiFID II and Solvency II, as well as regulations such as Ucits and AIFMD do not factor in sustainability to the level required.

The expert group suggests an EU omnibus proposal to clarify fiduciary duty, requiring the amendment of multiple EU directives.

Building up on the HLEG recommendations, an EU action plan on sustainable finance is in the pipeline which might bring an extensive due diligence exercise regarding sustainability practices to the asset management industry.

Such a regulatory agenda could entail less free-riding, but the cost-benefit relation must be clarified to market practitioners.

With the retail market being largely untapped, the deployment of standardised ESG information within MiFID and as already foreseen in the Priips KID will give a strong boost in demand.

For new adopters, in the long run the strong potential for customer acquisition and retention might make up for initial efforts in becoming compliant.

Obviously, those who already currently factor in sustainability will have a competitive advantage over those who are not yet in the loop.


Last year EFAMA voiced its concern that Priips rules would mislead investors. Is there an imminent risk for fund management firms arising from this?
There is a clear and present risk for the funds industry arising from the new Priips rules, as they are threatening to cause serious investor detriment by mandating figures that will at best confuse investors and at worst mislead them.

In its current form, the Priips KID forces manufacturers to make products disclosures that breach the fundamental principle that investor communication must be ‘clear, fair and not misleading’.

In particular, the methodology for calculating transaction costs and the new rules around future performance scenarios are fundamentally flawed.

This in turn drastically challenges investors to make good investment decisions – given both disclosures around the fund’s projected performance and its cost are seriously skewed.

While Efama has been warning of such negative consequences for some time now, evidence from fund managers, based on ‘real’ data, is now confirming these fears.

Efama thus urges EU policymakers to support investors by working urgently with the industry and relevant stakeholders to rectify these serious issues. In the meantime, they also need to help explain the nature of the figures given to investors.

It is vital that trust in investment products, and in the information to be provided to investors, is maintained and enhanced.


Which aspects of the AIFMD framework should be the focus of the current review?
The implementation of AIFMD just four years ago was a major undertaking for regulators and the industry. Now, with a wide-ranging Commission review seeking stakeholder opinion on the operation of AIFMD, we are conscious that fundamental changes could again bring costly and disruptive impacts.

The AIFMD regime is detailed and complex. Its implementation had very significant business impacts with associated costs. We therefore recommend the Commission focuses only on targeted measures at level 2 and 3 to alleviate certain unnecessary administrative burdens, address compliance challenges and in this way provide stability and certainty to the market.

This approach would be consistent with the Commission’s approach under its ‘Call for Evidence on the EU Regulatory Framework for Financial Services’.

Regulatory reporting would benefit from further streamlining. The review should provide perspective on the significant costs incurred by the Annex IV reporting.

The EU needs to focus on making regulatory reporting more ‘manageable’, both for regulators, who use the data, and industry, which compiles it.

The depositary framework is another area where change is likely to reflect Esma’s ‘Opinion on asset segregation and application of depositary delegation rules to CSDs’.

A guiding principle should be addressing mismatches between the EU and third-country regulatory frameworks to facilitate the smooth operation of AIFMD in a globalised marketplace.

By focusing on a number of targeted measures at level 2 and level 3, we believe the AIFMD review could have a positive outcome, avoiding major market disruption while dealing with administrative and compliance challenges.

©2018 funds europe



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