Business continuity planning (BCP) and maintaining operational resilience have been two of the overriding priorities for alternative asset managers since the Covid-19 crisis kicked off. However, regulators have been equally busy too. While a handful of regulatory deadlines have been pushed back by several months, a number of new proposals are being considered, which could have significant implications for alternative asset managers.

Tightening up on leverage

The ongoing market volatility and asset price fluctuations have prompted the European Securities and Markets Authority (ESMA) to launch a consultation on leverage risks in the alternative investment funds (AIF) industry. In a statement, ESMA confirmed its consultation was in response to the European Systemic Risk Board’s (ESRB) recommendations on liquidity and leverage risk at investment funds – a set of suggestions published back in mid-2018.

ESMA added that highly geared AIFs – including hedge funds and private equity – can increase systemic risk during stressed market conditions, especially when they are deleveraging. ESMA said deleveraging could potentially amplify the price impact of adverse market movements; cause contagion in the banking system; disrupt credit cycles and heighten the risk of asset fire sales. Consequentially, ESMA said it was essential member states adopt a harmonised approach when assessing leverage and imposing limits around it.

Regulators will need to base their assessments on the Annex IV reports they receive from managers under AIFMD (Alternative Investment Fund Managers Directive). The proposals not only focus on those AIFs that employ substantial leverage (defined by AIFMD as when an AIF’s exposure calculated using the ‘commitment method’ exceeds 3 times its net asset value), but funds with greater than €500m of ‘regulatory AUM’ (i.e. a gross exposure calculation of fund assets), as well as potentially other funds which fall below these thresholds. The proposals may apply to all AIF types, and not just hedge funds, but private equity and real estate too.

Cracking a nut with a sledgehammer

Leverage is often derided as being an inherently risky and destabilising activity, but this assumption is factually incorrect. The majority of hedge funds and some private equity firms deploy leverage to enhance their return generation, but it can also be used to offset portfolio risk, a point that has been made repeatedly by industry bodies. In addition, most hedge fund managers only use a modest amount of leverage, which is rarely ever more than three times their overall assets. Labelling individual hedge funds as being systemically important is therefore misjudged.

ESMA’s proposals also do not address the findings of the on-going IOSCO review on leverage nor any changes which may be implemented to the leverage measures as a result of the “AIFMD 2” review. We believe these should be tackled as soon as possible in order for regulators to compare apples with apples across funds and regulatory jurisdictions. The current AIFMD leverage measures are still, in several areas, subject to different interpretations across the industry leading to inconsistent reporting to national regulators.  Industry participants have also previously put forward recommendations for an alternative to the current gross and commitment methods on the basis these can distort the leverage numbers for funds using  certain types of derivatives. They argue an alternative measure – which better reflects the actual market risk of a fund –  should be used by regulators to assess risk.

Short-selling under fire

The consultation on leverage comes amid other regulatory clampdowns, most notably the recent constraints being imposed on short-sellers. In March, ESMA announced it would lower the threshold for reporting details about short sales to regulators although some markets including Belgium, Austria, Greece, France, Italy and Spain have introduced temporary bans on the practice. Spain’s regulator, for example, has prohibited short-selling altogether for one month although other supervisors such as the UK Financial Conduct Authority (FCA) have set a very high bar for imposing bans.

This patchwork approach is creating challenges for fund managers, as it is forcing firms to comply with different rules across multiple markets. Compounding matters further is that there is also a  lack of regulatory clarity over what is banned. For instance, France introduced its short-selling ban when markets had opened for the day but simultaneously failed to clarify what securities the restrictions applied to. Moreover, there is limited evidence that such bans actually help markets, a fact that has been outlined by the FCA.

Private markets and leverage

Although hedge funds are the asset class most commonly associated with leverage, private capital strategies – namely private equity and private debt – could face some existential challenges as a result of the Covid-19 volatility and its impact on asset price valuation. Prior to Covid-19, private equity leverage stood at 6.5 times EBITDA, levels far higher than what we saw in 2007, according to McKinsey. Oliver Wyman, meanwhile, points out that 41% of all major leveraged buyouts (LBOs) and public to private transactions are exposed to companies vulnerable to Covid-19.  While private capital is currently sitting on a lot of dry powder, many investments will face some large write-downs.

Are we focussing on the wrong issue?

As regulators enforce sporadic short-selling bans and initiate discussions which could lead to  limits on fund leverage,  they may do well at focussing on some other burning issues, namely liquidity. While regulators were initially very fixated on asset managers transacting in illiquid instruments post-Woodford, the extreme volatility being caused by Covid-19 is creating new, unexpected problems for the industry. In many instances, equity securities considered to be highly liquid, safe and revenue generating at the beginning of the year – such as airlines, travel companies and hospitality services – are facing panicked, mass sell-offs and even potential defaults.

Since the crisis unfolded, the FCA and Bank of England have opted to push back their consultation on liquidity mismatches at daily dealing funds. Given that several daily dealing property funds have gated client assets, it is widely expected regulators will clamp down further on fund redemption terms. It is also possible regulators could demand that investors making short-term withdrawals from open-ended funds be given their assets back albeit at a discount versus someone who has given the manager more time to offload the securities. Swing pricing arrangements of this type are quite common in other markets. At the very least, it is likely managers will need to be more open about their fund liquidity terms and ability to meet investor withdrawal requests during periods of market stress.

What does the market need?

Regulators need to clearly communicate with the market about their intentions and the measures they are adopting. As we have seen with the recent short-selling bans, a lot of investors have been left confused by the conflicting regulatory policies being introduced. On leverage, there are potential challenges facing certain private capital strategies, but hedge funds are generally not that highly geared and certainly do not pose a systemic risk. Longer-term issues also need to be resolved quickly. Take Brexit, for instance. With the EU looking to potentially curb leverage, questions are now being asked about whether this will apply to the UK post-Brexit.

Alan Davies, former Director of SS&C Depositary Services Limited, has joined INDOS Financial, the independent fund depositary and oversight business as Managing Director.

Mr Davies will be drawing on his extensive experience at SS&C, where he led the depositary service offering, and formerly at HSBC, where until 2014 he served as Head of Client Services – Trustee & Depositary Services, to develop and roll-out INDOS’ full depositary services for the UK funds sector.

Mr Davies will also be responsible for the continued international growth of the business, including in Ireland and Luxembourg, as well as other jurisdictions which are beginning to adopt the European depositary oversight model to strengthen their fund regimes.

“One of the unique strengths and attractions of the INDOS Financial model is that, at its core, is the independence from other service providers and in particular the bundling of depositary with fund administration,” said Mr Davies.  “This independent focus has been one of the key drivers of INDOS’ growth over the past five years. I am really excited about supporting the continued development of the business.”

“I welcome Alan to INDOS Financial and look forward to working with him on the expansion of INDOS’ depositary and related services,” said Bill Prew, CEO, INDOS Financial.

“I have always believed that the bundled administrator/depositary structure embodies inherent conflicts of interest and it’s clear that many of our clients, including hedge funds, private equity and real estate funds, and others, share this view and the way it strengthens their governance and oversight model” Bill Prew continued.

“There are significant opportunities to expand our existing UK full depositary business, most notably by growing our market share in the UK investment trust sector, and also to roll out our independent model to other markets. INDOS is well placed to provide depositary services to all UK “unauthorised” funds as well as future developments such as the Overseas Fund Regime currently out for consultation by HM Treasury”.

Founded 2012, INDOS has grown organically, developing solutions recognised as industry-leading within the fund oversight and depositary service space. As of April 2020, client assets under depositary oversight had grown past $35 billion and a further $10bn which form part of the INDOS MLRO (Money Laundering Reporting Officer) service clients.

The Cayman Islands Monetary Authority (CIMA) has recently announced several changes to the Cayman Islands Anti Money Laundering (AML) / Combatting the Financing of Terrorism (CFT) regime.

Equivalent Jurisdictions List to be removed 

The Equivalent Jurisdiction List currently operated by CIMA will no longer be in place from 5 August 2020. Thereafter, all Financial Service Providers or their AML/CFT service providers must perform their own assessment of the level of money laundering and terrorist financing risk a country presents.

Risk Based Assessment in Practice 

Clarification of the areas of risk that should be considered and factored into any working risk-based assessment include:

• Customer / investors
• Products and services being offered
• Geographical risks; and
• Delivery channel risk.

Senior management should agree and document a risk tolerance they are willing and not willing to accept during the course of business. The risk assessment should be documented and reviewed annually.

Application of Simplified Due Diligence

The process of assessing a country’s risk should be documented, and factor in reports published by leading international bodies such as FATF, UN and IMF. CIMA has further clarified that the application of simplified due diligence by AML/CFT service providers is only allowed from a country deemed to be low risk from an AML/CFT perspective.

Sanction Guidance Updated

All new and existing clients should be screened regularly by the Financial Service Provider (FSP) against the list of designated persons/entities, and the consolidated list, maintained by the United Kingdom Office of Financial Sanction Implementation (OFSI). The Financial Reporting Authority’s website provides a link to the consolidated list of financial sanctions targets issued by the UK’s OFSI.

It is the responsibility of every FSP to keep itself updated on and comply with the TFS in force in the Cayman Islands. Official sanctions order applicable in the Cayman Islands are published in the Cayman Islands Gazette.

Ongoing Monitoring

FSPs and / or their AML / CFT service providers should ensure they have documented policies and processes in place regarding the on-going monitoring of their investors / customers. Monitoring of customer due diligence, ensuring documents and know Your Client (KYC) information remains up to date, alongside periodic and trigger event-based reviews are all expected measures which need to be in place to demonstrate sufficient on-going monitoring. Processes and controls surrounding transaction monitoring and the required steps for reporting any suspicious activity must also be documented.

10% Beneficial Ownership Threshold 

CIMA has clarified the application of the Cayman Islands AML regulations to all jurisdictions where the standards are less strict than those set forth by AML regulations.

Eligible Introducers

Eligible Introducer arrangements have also been amended to include the identity of the applicant and their beneficial owners. It is noted that all Eligible Introducers and nominees should be located in a low risk country, as per the risk rating decided upon the AML / CFT service provider. It is important to note that the removal of the Equivalent Jurisdiction List may require an internal review and risk rating currently in place. Eligible Introducer testing remains in place with periodic testing to ensure that the Eligible Introducers can provide the requested due diligence documentation and information in a timely manner upon request.

Virtual Asset Services

Virtual asset services will become “relevant financial business”. A registration and licensing regime for virtual asset service providers will be implemented following a consultation phase which is due to end on 8 April 2020.

For further details about these requirements and how they will impact Cayman Islands domiciled funds and their services, please contact Matthew Queree (Head of AML Services) at [email protected].

The guidance notes and Anti-Money Laundering Regulations can be viewed here:

CIMA Guidance Notes

Anti-Money Laundering Regulations (2020 Revision)

Anti-Money Laundering (Amendment) Regulations (2020 Revision)

Covid-19’s sudden escalation has not only exposed the fragility of financial markets, but it has forced asset management companies to think carefully about their business continuity planning (BCP) and operational resiliency to a level that few would have ever imagined.

While investment firms’ BCPs have been tested in the past by technology outages (i.e. cyber-attacks) or extreme weather events (e.g. typhoons in Hong Kong, Hurricane Sandy in New York, to name just a few examples), Covid-19 presents an altogether different challenge insofar as it is a global crisis with no clear resolution in sight. Despite the extreme market conditions and unprecedented levels of disruption, INDOS Financial believes that fund depositaries can play an important role in helping asset managers weather the storm.

The role of depositaries in protecting investors

Conscious of the rising Covid-19-induced volatility, the UK’s Financial Conduct Authority (FCA) recently sent a memo instructing depositaries and their UK authorised fund manager clients to provide more detailed information in the event of their funds running into trouble.

According to the memo, depositaries must issue an alert to the FCA with a full explanation if a fund is about to suspend shareholder dealing. Depositaries will also be obliged to inform the FCA if a fund incurs a NAV (net asset value) drop of more than 10% on any single day, caused either by volatility, client redemptions or other factors. Simultaneously, depositaries must notify the FCA when a fund suffers a disproportionate number of failed trades or if it is struggling to meet its margin calls. As a result, depositaries will play a significant role in ensuring that investor interests are fully safeguarded during this crisis.

Although the new reporting requirements are targeted at UK retail funds, many alternative fund managers will face similar challenges. It is crucial that any issues are managed carefully so investor interests can be protected.

Valuation and fund oversight

Regulators including the FCA and Central Bank of Ireland had made it clear that liquidity risk management ought to be a priority for asset managers after a series of high-profile fund suspensions in 2019. Elsewhere, new ESMA measures will soon require depositaries to affirm that UCITS and AIFMs have well-documented liquidity risk management processes in place. These rules were primarily introduced to stop daily dealing managers accumulating exposures to illiquid assets, potentially preventing them from meeting redemption requests.

However, the volatility is creating new, unexpected problems for regulators. In many cases, equity securities considered to be highly liquid and revenue generating at the beginning of the year – such as airlines, travel companies and hospitality services – are facing panicked, mass sell-offs and potential defaults. Given the uncertainty about how long the pandemic will last, the valuation of once vanilla assets is expected to become more difficult.

As we head into the March month end NAV cycle  which is also incidentally the financial year end for many UK fund structures, depositaries will play an important role and must perform their NAV and general fund oversight responsibilities as thoroughly as possible.

Facilitating BCP and a leaner operating model

 Covid-19’s disruption is making life particularly tough for smaller asset managers, many of whom will often only have a handful of key operational staff carrying out core back office activities. If one or more member of the operations team falls ill or is unable to access the relevant IT system, this could cause serious problems for small to medium sized (SME) firms.

Larger managers are also needing to adapt to a leaner operating model. During such critical times, it is essential the industry collaborates so that it can emerge from this crisis stronger and more resilient. Depositaries and other fund service providers should support clients experiencing any operational issues. INDOS, for example, stands ready to perform its usual detailed independent NAV reviews for clients who are unable to conduct their own checks.

Once the Covid-19 situation has passed, many firms are likely to re-think their operational processes moving forward. There are already suggestions that home working will become more commonplace, enabling firms to make cost savings by reducing their office space. If service providers such as depositaries are able to fulfil their obligations effectively and independently during these challenging circumstances, and demonstrate the value of the oversight they perform, then managers may also consider placing more reliance on this oversight thereby generating operational efficiencies.

Strong fund governance

Robust and independent fund governance during this critical time is more important than ever. Boards need to be assertive with managers if they are to fulfil their fiduciary obligations. This means probing managers about their BCP initiatives,  service provider resilience and risk management processes. Boards should also be evaluating the quality and level of management information being provided to them in a timely manner too.

Given these testing circumstances, boards should be meeting more frequently than on a quarterly basis as is the norm now. Despite today’s significant challenges, boards cannot afford to let standards slip or to take short-cuts. Right now, directors have a duty of care to investors to perform their governance commitments to the highest of standards.

Monitoring and review of service providers

Post-financial crisis, hedge funds learned some stark lessons about being overly reliant on a single prime broker relationship. Faced with the prospect of being unable to access their assets, hedge funds began to multi-prime in response and took a more vigilant approach towards regularly monitoring the creditworthiness of their counterparties. It is essential that fund managers continue to conduct thorough oversight of their providers.

It is equally important that managers have a clear oversight of what is happening at their fund administrators and other providers such as depositaries and IT suppliers. If one of these vendors were to suffer a credit or business continuity event, then it could put managers in an awkward position. It would therefore be wise for managers to engage with their providers about their operational resilience.

Even before Covid-19, a lot of managers adopted the multi-service provider model as they did not want to be over-exposed to any one entity. However, it is very probable more firms will now shift towards the multi-provider model as they look to mitigate their operational risk.

INDOS has attended several compliance conferences and briefings over recent months. Common themes arising include the regulatory focus being applied to fund operational resilience, cyber security and manager and fund governance.

Operational resilience is currently being heavily tested by the extreme pressures on businesses resulting from the significant measures which have been implemented to tackle COVID-19.

Cyber security is becoming more challenging given the significant growth in cyber attacks and therefore the high level of disruption risk posed to markets and businesses.

Under the new Senior Managers Certification Regime (SMCR), which came into effect in December 2019, the FCA has delivered a clear message that senior management will be held accountable for weakness in procedures in these and other business areas.

It is important that firms document and stress test their contingency plans to deal with major events including assessment of operational risk and the firm’s ability to continue to operate effectively to serve and support their clients.

Away from the immediate operational challenges currently faced by firms, there are a wide range of other regulatory changes and areas of focus, including:

• Product disclosure regulations come into force in March 2021, where there will be focus on sustainability and sustainability risk. Large firms will be expected to review the impact of their investments on the globe.
• FCA review of implementation of research rules has shown most firms have a clean bill of health, however, FCA reviews are likely to continue into research and inducements.
• Product and fund governance is another key area of focus as there are concerns that some products are not in the best interests of investors and also how product and fund governance and compliance responsibilities are being undertaken.
• SMCR – the aim of which is to deliver a cultural transformation. The FCA can take action if they believe a firm has not taken reasonable steps to avoid a breach. The burden on a firm is greater now with the onus on certification staff to demonstrate their responsibilities through documentation and a proper audit trail. We are likely to see testing as the quality of firms’ statement of responsibilities varies across the industry. It is essential that there is a full firm buy-in to SMCR so that it is not just seen as a compliance project.
• Compliance monitoring has moved away from being a tick box exercise, firms need to explain what effective controls they have in place for monitoring and documenting meaningful evidence to support the effectiveness of controls is key.

Good governance in firms is key in order to enable a firm to address these challenges.