Although the risk has slightly reduced recently, at the end of this month the UK could leave the European Union (EU) without a deal, If a deal is agreed, there will be a transitional period whereby existing funds’ industry legislation and practices will continue to apply until December 2020. Irrespective of this, many firms are still preparing for a no-deal scenario. As Brexit creeps closer, INDOS Financial takes a look at some of the issues facing the industry.

Temporary permissions regime for EU firms

In December 2017, the UK Government announced it would introduce a three year temporary permissions regime for inbound passporting EEA firms and investment funds.

Under a no-deal Brexit, the temporary permissions regime will ensure (subject to FCA notification) that EEA firms and investment funds can continue operating in the UK within the scope of their current permissions while seeking full UK authorisation. It will also allow investment funds with a passport to continue temporarily marketing into the UK.

Retention of AIFMD and the depositary requirements

While some firms had hoped for a dismantlement of EU legislation after Brexit, this was out of sync with the UK government’s thinking. EU legislation is being transposed into UK law including the Alternative Investment Fund Managers (Amendment) (EU Exit) Regulations 2018. As a result, AIFMD will continue to apply to UK managers. The affirmation that AIFMD will stay in place confirms there will still be a role for depositaries in a post-Brexit regulatory environment. This was not unexpected as the FCA had previously stated depositaries are an important component of sound fund governance.

Prime brokerage post-Brexit

Post-Brexit, a UK-based prime broker will not be able to leverage its MiFID (Markets in Financial Instruments Directive) cross-border permissions to conduct business inside the EU. This has prompted some prime brokerage providers to relocate operations into other EU jurisdictions. Whilst UK based managers of UK or non-EU funds should not be directly affected, there could be some knock-on effects such as contractual repapering.

Dual listings in a bind

EU asset managers could be precluded from purchasing shares in approximately 90 London-listed companies, which are also listed on EU exchanges. As things stand, EU firms can only trade shares in those impacted companies on EU exchanges, despite London venues being larger, more liquid and offering better pricing than their EU equivalents. This impasse also risks putting EU firms in breach of their MiFID II requirements to obtain best execution.

While a number of EU institutional investors have lobbied the European Securities and Markets Authority (ESMA) to rethink this policy, the Paris-based regulator is reportedly under significant political pressure to hold its ground. This uncompromising position, however, may prove to be self-defeating for the EU as a number of lawyers have suggested that affected companies may simply jettison their European listings in favour of London.

A clearer picture

Conscious a failure to find tacit agreement on CCP (central counterparty clearing) recognition risked causing enormous disruption to European derivatives’ markets and adding to companies’ margining costs, an MOU (memorandum of understanding) has been reached between ESMA and the Bank of England (BOE), in what should soften the blow of a no-deal Brexit by giving UK CCPs recognition. In February 2019, ESMA confirmed LCH, ICE and LME would be allowed to continue offering services into the EU even if there is no deal. ESMA followed this up with an announcement in March 2019 that the UK CSD, Euroclear UK and Ireland will be recognised as a third-country CSD to provide services in the EU.

Fund managers access rights

A multilateral MOU was reached between market regulators inside the EU and the FCA covering supervisory cooperation, enforcement and information exchanges related to investment management under a no-deal Brexit. The multilateral MOU also enshrines the continuation of delegation of portfolio/investment management into the UK. This MOU came nearly seven months after the FCA announced its Temporary Permissions Regime.

Brexit reaching its conclusion

While many financial institutions in the UK and EU would have preferred a well-laid out and orderly transitional arrangement to prevail come-March 29, there is a sense of relief nonetheless that some agreements and MOUs have been reached to mitigate the risk of a no-deal in key areas such as CCP recognition and delegation of investment management. 

In 2017, the European Commission (EC) commenced an extensive review of the Alternative Investment Fund Managers Directive (AIFMD) entrusting KPMG with soliciting feedback from stakeholders who had been most impacted by the regulation including AIFMs (alternative investment fund managers), depositaries and investors.

The results of the review – which were published in January 2019 – concluded that AIFMD had played a major role in creating an internal market for alternative investment funds (AIFs) along with a stringent regulatory and supervisory framework for AIFMs. However, the report also noted several areas in need of improvement, which could potentially be weaved into future AIFMD iterations. 

Distribution under AIFMD

The industry response towards the pan-EU marketing passport, which is currently only available to EU AIFMs marketing EU AIFs, has been mixed, principally because of inconsistencies in member states’ application of the AIFMD itself. Respondents identified the divergences in marketing requirements between EU member states, as well as different interpretations of what constitutes marketing versus pre-marketing as being major impediments.  

Private placement should be maintained

While the pan-EU marketing passport’s effectiveness is certainly open to debate, respondents called for the EC to retain the national private placement regimes (NPPRs) currently available to non-EU AIFs managed by EU AIFMs and non-EU AIFMs, highlighting that this structure provides added value to the EU. Such a move would help preserve competitiveness and uphold investor choice in the EU in the absence of an extension of the marketing passport to third countries.

Making authorisation easier

Despite the best efforts of the AIFMD – and more recently the Capital Markets Union (CMU) – to homogenise the authorisation processes for AIFMs looking to distribute cross-border, more work is necessitated. The findings conceded a number of member states had applied additional authorisation provisions on sub-threshold AIFMs which could impede the ability of smaller fund managers to market their products cross-border.

No singular approach taken by depositaries

AIFMD’s depositary requirements were identified as another area of potential focus.  The report highlighted some of the depositary duties – namely look-through provisions and cash flow monitoring responsibilities – had been applied differently across member states. However, the report said it was hard to gauge whether this disjointedness had adversely impacted AIFMD’s operating model, although it accepted the current one size fits all approach towards depositary “does not accommodate for different asset classes or geographies.”

A new reporting model on the cards

AIFMD’s approach towards regulatory reporting has come under scrutiny, with the KPMG study pointing out that while large volumes of data are being supplied by AIFMs to national competent authorities (NCAs), questions are being asked about the usefulness of a lot of this information. Some AIFMD disclosures are, for example, duplicating regulatory submissions elsewhere, while a handful of regulators have gold-plated Annex IV and adopted their own bespoke filing processes, creating additional costs for the funds’ industry.

Valuation: Room for change

The provisions around valuation have also been queried, most notably the liability standard that is applied to external valuers which has resulted in few firms willing to take on this role. As a result, many AIFMs are themselves taking responsibility for valuation instead.

Tinkering with leverage

The report concluded that AIFMD had no noticeable impact on the level of leverage employed by AIFMs and that high levels of leverage – based on respondents to the survey – were rare. The measurement of leverage under AIFMD has always been a contentious issue, especially as there are divergences in calculation approaches between AIFs and UCITS and many argue the calculation methodologies are too crude and misleading. It is possible that revisions to the existing methodologies could be made once IOSCO (International Organisation of Securities Commissions) publishes its own findings on leverage.

Where next for AIFMD?

Even prior to the KPMG report, AIFMD had been subject to some revisions, with a tightening up of the rules on pre-marketing and imposition of new asset segregation requirements in the custody chain. While very few – if any – of the report’s findings have come as a major surprise to the industry, it is still hard to assess which suggestions will be onboarded by the EC, who now need to issue a report on the functioning of the AIFMD to the European Parliament (EP). The EP may in turn propose its own amendments in due course.

by Matthew Querée, Head of ESG, INDOS Financial

Introduction

Environmental, Social and Governance (ESG) are three words which conjure an extensive range of interpretations across investors, regulators, governments and investment managers.

While many articles look to define ESG, its purpose within the investment sector and its wider impact on environmental protection, societal issues and corporate governance, this piece will simply acknowledge that ESG is now (and for many has always been) a fundamental criterium in the investment decision making process and will continue to gain prominence.

Regulators start to show their mettle

In May 2018, the European Commission announced a set of measures and actions to help bring about its plan on sustainable finance. For many, this commitment by a major body alongside the UN’s agreed sustainability goals firmly illustrate the shift towards ESG within the financial sector.

Included within these EU measures are:

ESG Taxonomy – The creation of an ESG taxonomy to establish clear parameters and definitions around what is considered to be “green” in terms of investment;

A taxonomy will assist asset managers when making sustainable investments. However, asset managers and investors still face many challenges when making determinations about what constitutes green, particularly when analysing large multi-faceted companies who may have a plethora of complex structures or supply chains which are not easily dissectible from a taxonomy perspective. Needless to say, the work required is substantial and delicate. With EU regulators making a push on ESG, it is something firms need to rapidly acquaint themselves with.

Disclosure Obligations – Proposed new regulations that will require institutional investors and asset managers to demonstrate how they are integrating ESG into their investment risk analysis and decision-making process.

This places a direct onus on institutional investors and the asset managers who are investing their funds to demonstrate how ESG is factored into their decision-making processes. As investor ESG sentiment grows alongside increasing regulation encouraging greater sustainable and ethical investing, the importance of clear, transparent reporting on ESG becomes even more paramount.

Benchmarking – Benchmarks are set to be introduced to provide investors with a comparative indicator identifying carbon footprints across their different portfolios.

Elsewhere, the UK government has proposed legislation requiring pension scheme trustees  to consider ESG – as part of their fiduciary obligations – during their investment decision making and capital allocation processes. Furthermore, proposed measures by the Financial Conduct Authority to require financial services firms to publicly disclose how they manage climate financial risk have also been announced and are under consultation.

The end of green-washing and window dressing

By strengthening ESG transparency, reporting and accountability at asset managers and large investors, the ease at which some organisations have been able to green-wash their portfolios (i.e. give the appearance of adopting ESG compliance without actually doing so in order to falsely attract investors) will recede.  

In addition to regulation, there is a continuing shift in attitudes towards investing as the transfer of wealth from the Baby boomer generation to Generation X and Millennials accelerates. Many of these younger investors are more conscientious about where their returns come from, which in turn is prompting a shift towards ESG mandates. As pension funds seek new beneficiaries, they too must adapt to meet the investment needs of a more ethically / morally conscious investor base who will provide funding for the next generation of pension funds.

Staying ahead of the curve – ESG Oversight and Assurance

ESG has been thrust into the spotlight, having previously existed in the shadows of bespoke funds and niche investments. This has led some investment managers to ramp up their presence within the space to ensure they can benefit from the momentum of the ESG movement.

ESG adoption does require managers to differentiate themselves from the competition. One way this could be achieved would be through engaging an independent, conflict free service provider who can review, monitor and report to fund managers and their investors confirming that ESG mandates are being properly followed and adhered to.

2018 was a challenging year for asset managers from both an investment and operational perspective. On the investment side, managers had to navigate sporadic violent swings in the market, partly inspired by the so-called “Trump trade tariff tantrum,” an event which – for a while – turned Brexit into something of a sideshow.  Simultaneously, the uncertainty surrounding Brexit itself continued, causing headaches for managers already focused on meeting the regulatory challenges of MIFID II, and the implementation of GDPR. 

Regulation

AIFMD and Brexit: no change to depositary

Even though some UK managers had hoped that EU legislation such as the Alternative Investment Fund Managers Directive (AIFMD) would evaporate after Brexit, it is clear this will not happen. In fact, the UK government confirmed the regulation will not be weakened when it published a document – “Alternative Investment Fund Managers (Amendment) (EU Exit) Regulations 2018” – in October 2018 affirming that European law would be retained for domestic and EU managers operating inside the UK after Brexit.

The document effectively states that depositary will remain mandatory for UK based managers marketing to UK investors irrespective of what the final Brexit outcome may be. As the depositary performs such an integral governance role, this confirmation will be welcomed by some institutional investors, who are clearly supportive of the added protections that come with having an independent provider overseeing the activities of the funds in which they invest.

AIFMD: What comes next?

In the second half of 2017, the European Commission (EC) engaged KPMG to conduct a review of the AIFMD. The review sought to assess whether the AIFMD, introduced across Europe during 2013-14 , had achieved its general objective of providing an internal market for EU and non-EU alternative investment fund managers (AIFMs) along with a harmonised and stringent regulatory and supervisory framework.  

KPMG’s final report was recently published and concluded that AIFMD’s objectives had largely been met. The report did not contain any major surprises but, as widely expected, highlighted weaknesses in the effective functioning of the EU’s marketing passport, burdensome regulatory reporting requirements, and inconsistencies around leverage calculation methodologies between operators of UCITS and AIFs.

It also noted that private placement regimes, the route which many managers use to market to EU investors, should be allowed to continue. The EC has already made some amendments to the AIFMD pre-marketing and asset segregation rules in 2018, and the industry will await possible further changes following the KPMG review.

SMCR reinforces the need for effective oversight

The Senior Managers & Certification Regime (SMCR) will be extended from banks to asset managers from December 2019. Governance is at the heart of SMCR, as the UK Financial Conduct Authority (FCA) seeks to create a stronger framework for accountability within the asset management industry by requiring senior managers to sign a statement of responsibility and certifying staff as being fit and proper.

Given the UK regulator’s decision to prioritise governance, asset managers need to make a concerted effort to demonstrate that their oversight processes are watertight. An independent depositary overseeing fund operations is one tool managers can leverage in this regard. The FCA will be scrutinising managers’ arrangements in detail and the regulator has already started to reach out to firms to discuss their preparations for SMCR ahead of its 2019 year-end deadline.

Investment strategies

Environmental, Social, Governance (ESG)

2018 was the year that ESG investing gathered momentum, both from a bottom-up (driven by investor demand) and a top down perspective (driven by regulation). On the latter, the EU’s proposed Sustainable Finance Action Plan (announced in March 2018) is still a work in progress, and the finer details are yet to be ironed out, something which is likely to happen in 2019.

In any case, asset managers will increasingly need to demonstrate to clients that they are implementing ESG in their investment processes, following concerns that some organisations are greenwashing their products. Independent oversight of ESG compliance will give investors comfort that their managers are doing what they say they are.

Digital assets

January 7 marked the 10-year anniversary of the introduction of Bitcoin.  However, digital assets (including cryptocurrencies and tokens) remain a nascent market and they have yet to make a significant impact on the wealth management sector. Regulators globally have been gradually adapting their rule books to address digital assets, and the market is seeking to become more institutional over time.

Despite significant price drops during 2018, the digital asset market is expected to continue to develop in 2019. The provision of independent oversight and monitoring will help institutionalise and build trust in the sector. As more managers begin trading these instruments, they will need to engage with depositary providers who are conversant with and able to support this new asset class.

Conclusion

The depositary function, which forms one component of the AIFMD, was part of a series of proposals designed to protect investors and ensure good fund governance. Since the AIFMD first began to be implemented in 2013, this role is now seen as an important element of good fund governance. Furthermore, there is growing scope and demand for depositaries to engage with investment managers in different ways beyond its original AIFMD mandate.  

Substance has been a prevailing theme across the funds industry globally as national regulators and international authorities seek to ensure firms have an appropriate level of local operations, internal controls and management in a domicile in order to access the associated benefits of being there. An absence of fund manager substance can allow systemic risks to proliferate or potentially fraudulent activities to go unchecked, deficiencies which have an adverse impact on the integrity of the industry as a whole.

European regulators demand substance

In the lead up to Brexit, fund manager substance is a primary concern for EU regulators as they became increasingly uneasy about the prospect of foreign firms setting up so-called ‘letterbox’ entities inside European fund domiciles in order to acquire continued access to European investors. Initially, there was speculation the European Securities and Markets Authority (ESMA) would restrict delegation, whereby an asset manager subject to UCITS or AIFMD can outsource portfolio management from an EU management company back to the manager, often located in a third country outside of the EU. Delegation will not be restricted provided managers demonstrate appropriate operational substance within the EU entity delegating activity outside of the EU.

The efforts of EU regulators to ensure substance have been varied. For example, the Central Bank of Ireland’s (CBI) CP86 framework, which came into effect in July 2018, introduced changes around how fund management companies should structure themselves with a heavy emphasis placed on managerial roles that need to be undertaken, including a requirement for firms to have two resident Irish directors. Meanwhile, in August 2018, Luxembourg’s Commission de Surveillance du Secteur Financier (CSSF) issued detailed guidance on the organisation and substance of Luxembourg based management companies.  

Offshore hubs also ratchet up their responses

In response to the Financial Action Task Force’s (FATF) recommendations on combating money laundering and terrorist financing, the Cayman Islands introduced changes to domestic legislation. Through its revised AML Regulations, all funds domiciled in the jurisdiction – irrespective of whether they are registered or not with CIMA (Cayman Islands Monetary Authority) – must take meaningful steps to identify, assess and understand the money laundering and terrorist financing risks in relation to each of their investors. This will require firms to strengthen their existing compliance processes.

The EU Code of Conduct Group on Business Taxation has published its demands for companies located in non-EU countries to demonstrate economic substance in order to avoid being included on the so-called blacklist of non-cooperative non-EU, third countries. Non-EU fund centres, such as Jersey, Guernsey, the Isle of Man, Mauritius, and the Cayman Islands are introducing legislation in response to the EU’s demands.  

SMCR: Extending accountability to the funds industry

In the UK, the Senior Managers & Certification Regime (SMCR) will be extended from banks to asset managers from December 2019. Governance is at the heart of SMCR, as the UK Financial Conduct Authority (FCA) seeks to create a stronger framework for accountability within the asset management industry by requiring senior managers to sign a statement of responsibility and certifying staff as being fit and proper.

Given the UK regulator’s decision to prioritise governance, asset managers need to make a concerted effort to demonstrate that their oversight processes are watertight. The FCA will be scrutinising these arrangements in detail and has already started to reach out to managers to discuss their preparations for SMCR ahead of its 2019 year-end deadline.

The global shift towards substance and how the depositary can assist

The regulatory push on substance is a global one. The boards of fund managers and their funds need to be able to demonstrate effective local management and decision making is taking place. In order to do so, they will need regular, reliable and independent information from fund service providers. In particular,  independent depositaries, which perform on-going oversight over fund and manager operations, are ideally suited to help managers and funds ensure they are operating in accordance with these new obligations as they have:

• access to accounting and other records for the fund;
• regular dialogue with administrators, independent directors and senior management;
• oversight of all other major fund service providers;
• a thorough understanding of firms’ compliance obligations.

As a result, leveraging their relationship with the depositary is an excellent way for funds, managers and their governing bodies to demonstrate to regulators that they are “serious about substance”.