In 2015, the United Nations announced its Sustainable Development Goals (SDGs), 17 targets that member states should strive to reach by 2030. In order to achieve these ambitious objectives, trillions of dollars of private capital will need to be invested into sustainable programmes and initiatives. Since then, the European Union (EU) has been at the forefront of developing new regulations supporting the SDGs. From March 2021, a new EU Sustainable Finance Disclosure Regulation (SFDR) will come into force putting sustainability at the heart of the EU financial system.

SFDR will have a wide-ranging impact. It applies at both the asset manager and product level and captures a broad range of firms – as opposed to just those which market themselves as being ESG (environment, social, governance) focussed. In summary, it will affect managers regulated under the AIFMD (Alternative Investment Fund Managers Directive), UCITS and MiFID (Markets in Financial Instruments Directive). The rules will also impact managed accounts. So what does it mean?

SFDR will require all asset managers to publish policies on their website outlining how sustainability risks are integrated into their investment decision making processes. Asset managers will also need to disclose – on a comply or explain basis – details about these policies and the potential adverse impacts of investment decisions on sustainability factors. The transparency requirements for investment firms managing ESG focussed products will need to be even more comprehensive.

The proposals have elicited a mixed response from the investment management industry. Some industry bodies – including the European Fund and Asset Management Association (EFAMA) warned that the March 2021 deadline for SFDR compliance was unrealistic. Moreover, EFAMA said that a lot of the data required to fulfil the SFDR’s disclosure obligations was simply not available, before adding that ESMA (European Securities and Markets Authority) had yet to publish ESG standards. Conversely, several asset management groups have thrown their support behind the new regulations and the go-live date, arguing it will prevent firms from greenwashing their portfolios.

Elsewhere, Brexit is creating all sorts of logistical challenges for SFDR. As things stand, the UK is expected to implement SFDR in March 2021 once the Brexit transitional period expires. However, the UK Government has not confirmed if the next level of requirements (the Regulatory Technical Standards) will be implemented. As a result, there is uncertainty about how UK firms will be affected by the SFDR in practice. Despite this, SFDR is crucially important for the industry, and it something all investment firms should be paying close attention to.

Notwithstanding that SFDR will become a compliance requirement, both institutional and retail investor interest in ESG continues to grow apace and has arguably accelerated dramatically as a direct result of the ongoing Covid-19 crisis. With competition for investor capital expected to ramp up as the recession takes effect, managers cannot afford to ignore client demands for greater transparency around how they take ESG factors into account.

There is also a compelling performance argument for managers to incorporate ESG assets into their portfolios with reports suggesting ESG products have performed strongly relative to non-ESG products during the crisis and associated market downturn. This has translated into inflows. Recent data from Morningstar confirms global inflows into sustainable funds were up 72% in the second quarter of 2020, buoyed by the broad market recovery from the first quarter sell-off. As a result, assets in ESG-focused funds now stand at around $1.1 trillion, more than double the levels in 2016.

The continued inflows speak volumes of the growing investor interest in ESG issues, especially in the wake of the Covid-19 crisis. Asset managers that do not embrace ESG both at a management company level (factors such as the firm’s carbon footprint, diversity and inclusion, social responsibility) and within their investment processes (how they consider or incorporate ESG factors into their decision making), are at risk of being left behind.

SFDR is an excellent opportunity for managers to articulate how seriously they are taking ESG. With little more than six months to go, managers need to turn their attention to documenting their ESG policies and procedures.

By Victoria Gillespie, Head of ESG, INDOS Financial

This article was first featured in ESG Clarity: https://esgclarity.com/sfdr-will-highlight-the-asset-managers-serious-about-esg/

The role of the depositary was introduced under the AIFMD in 2014 to address failings of the alternative fund management industry. AIFMD sought to help restore confidence among investors and regulators in the alternatives sector.

The depositary, alongside the fund auditor and directors, has subsequently become an important part of the governance structure that provides independent assurance to investors, boards, managers and regulators. The responsibilities of depositaries include daily cash-flow monitoring, asset ownership verification and oversight of fund valuations, shareholder dealing and compliance with fund offering terms.

The depositary’s oversight is on-going throughout the year and includes a review of every NAV and therefore arguably is more valuable to investors than a point in time audit where the results are not known generally at least 15 months after the start of the accounting period of the fund.

The outcome of the Brexit Referendum in 2016 initially created uncertainty about the future role of the depositary for UK managers. After Brexit, there have been calls in the industry for the UK government to replace AIFMD and other funds regulation with looser, less prescriptive rules. So far, this has not happened and AIFMD will continue to apply to UK managers following the UK’s departure from the EU at the end of 2020. This is not surprising since equivalence with the EU would be a basic condition for continued access to European investors. Given the depositary is viewed by the regulator as one of the cornerstones of good fund governance, it is also no surprise the depositary requirements will continue to apply, at least to UK based managers that are marketing to UK investors.

In recent years the role of the depositary has been under more regulatory scrutiny (for example two Luxembourg based depositaries have been fined by the local regulator, the CSSF, so far in 2020). This focus should improve standards and consistency across the industry. One area of focus would be to address conflicts of interest in the depositary industry. Frequently, depositaries affiliated to the fund administrator are appointed by managers as part of a bundled service offering, which can also extend to custody or prime brokerage. There are inherent conflicts in a model whereby one part of a business oversees and ‘marks the homework’ of another division within the same group.

Largely driven by regulatory requirements, depositary businesses are established as separate legal entities within the group. However, despite this legal separation there cannot be complete assurances that a depositary would self-report issues identified within its administrator or custody arm as this could result in financial or reputational harm at the broader group level.

A second area of focus surrounds consistency and quality of service to ensure all depositaries undertake the required duties to a high standard. Since AIFMD was introduced, a number of managers have reported a lack of engagement by their depositaries,, while others acknowledge rudimentary errors have been missed by providers. Such deficiencies have prompted managers to question the value being provided.

This inaction has led several large fund managers to switch from an affiliated depositary model to an independent provider. It is not just the managers who are growing frustrated, but institutional investors, consultants and fund directors also taking a more active role instigating these decisions. Managers have also expressed their dissatisfaction at seemingly reducing risk appetites from some depositaries making new fund launches more difficult.

Operational due diligence teams continue to recognise the benefits of a well implemented depositary model and are asking questions about how it functions. ‘Tick the box’ depositary models that add no value could contribute to a vetoed investment.

All managers should keep their service providers under regular review and depositary is no different. A properly functioning depositary that can and will challenge the process will enhance the governance of the fund, providing increased confidence to investors, fund directors, and regulators.

Introduced into local law in 2014, the EU’s AIFMD (Alternative Investment Fund Managers Directive) has implemented a number of wide-ranging reforms in the alternative asset management industry as regulators looked to address some of the risks and weaknesses in the financial system post-2008. Since then, various amendments have been made to AIFMD, including revised asset segregation requirements; tighter rules around marketing; and enhanced liquidity risk management obligations, the latter of which will take effect from September 2020.  Despite these changes, AIFMD remains incomplete and there are several outstanding issues that have yet to be addressed.

In August 2020, the European Securities and Markets Authority (ESMA) published a letter to the European Commission (EC) outlining its proposals on further reform of the AIFMD. The letter is the culmination of ESMA’s multi-year review of AIFMD which also included an extensive study conducted by KPMG in 2018, the findings of which were published in January 2019. Although ESMA’s letter made some AIFMD related recommendations, there were some notable omissions and a troubling focus on substance and the delegation of asset management tasks by EU managers to firms outside the EU which could have a material impact on the management of EU domiciled funds in the future.

Marketing: Still none the wiser

While ESMA’s letter made a brief reference to the need to deliver more clarity on reverse solicitation amid concerns that some member states have interpreted the provisions very differently, there was no mention about extending the AIFMD marketing passport to non-EU third countries. Subject to regulatory equivalence, the EU previously said in 2015 that non-EU AIFs may eventually be able to avail themselves to the AIFMD marketing passport, enabling them to distribute products across the EU without having to resort to country-specific private placement regimes. A handful of markets were initially expected to be granted the AIFMD passport, but the Brexit vote in 2016 derailed the initiative. Since then, no country has been awarded AIFMD passporting rights, widely thought to be because of concerns on the EU side that it could set a bad precedent for Brexit talks.

Lacking on depositary detail

The letter is also notable for its lack of guidance about depositaries. While ESMA opined in 2017 that depositaries do not need to apply the delegation rules (and associated strict liability) when delegating safekeeping to an Issuer CSD (central securities depository), this provision has unfortunately not been extended to Investor CSDs as well. A uniform extension to CSDs would have facilitated competition in the depositary market and enabled depositaries to provide more flexible client solutions. ESMA was also quite elusive on the idea of creating a pan-EU depositary passport.

Despite having previously conceded the lack of a depositary passport ran counter to the Single Market’s guiding principles, ESMA did not explicitly call for the establishment of a depositary passport, but advised the EC analyse the risks and benefits of such a concept in its AIFMD review.

Most disappointingly, the AIFMD review has not addressed the conflicts of interest facing depositaries which are affiliated to other service providers such as fund administrators or custodians. As INDOS has repeatedly stated, there is an all too real risk that an affiliated depositary might not flag breaches in other parts of the business, potentially compromising investor protection. This is a problem, as seen by recent events, which regulators need to recognise and find a resolution to.

A more meaningful measure of leverage

Leverage has been an area of dispute in AIFMD since its inception. ESMA has in the past warned that highly geared alternative investment funds can increase systemic risk during stressed market conditions, especially when they are deleveraging. Leverage is often derided as being an inherently risky and destabilising activity. However, funds deploy leverage not just to enhance returns, but to offset and manage portfolio risk. The AIFMD requirement that managers use the gross notional exposure (GNE) method for calculating leverage often means that their funds appear to be more geared than they actually are. Although the latest ESMA letter is light on detail about leverage, it does concede that the GNE calculation method may need reviewing and aligned with more recent IOSCO guidance, something which industry bodies have been lobbying for extensively.

After six years, more progress is required

Six years have now elapsed since AIFMD came into force. Even though the rules have been fine-tuned, there needs to be further improvements and clarity on issues including leverage, the role of the depositary and third country marketing. After multiple reviews and industry consultations on the directive, progress on AIFMD has been scant. While Brexit and Covid-19 have caused significant challenges for policymakers, AIFMD cannot be allowed to wither. Instead, it is time the inconsistencies and uncertainties that have blighted AIFMD over the last few years are remedied.

INDOS featured in The NED, discussing the role played by depositaries. You can read the article here.

If you’d like to find out more about The Ned, please contact Tamara Sims ([email protected]) or go to The NED’s website: http://www.nedglobal.com.

On 5^th August 2020, the Cayman Islands Monetary Authority (CIMA) discontinued and removed its “Equivalent Jurisdiction Regime” (EJR) list from use and application to Cayman Islands domiciled investment entities and funds (Funds).

The EJR list, which had previously contained over 40 separate countries, allowed persons conducting relevant financial business from or within the Cayman Islands to place reliance on AML/CFT legislation of specified countries for simplified customer due diligence. Now removed, the responsibility of determining the anti-money laundering (AML) risk ratings applicable to the countries detailed in the EJR list has moved to the persons conducting the relevant financial business (e.g. Fund Board / Fund Administrator) (FSP).

Following the removal of the EJR list, it is possible that previous regulatory exemptions applied to certain countries may no longer meet the Cayman Islands AML requirement for the application of SDD. The AML regulations and accompanying guidance notes say that in order for SDD to be applied, a person, or applicant for business who is or appears to be acting as an agent or nominee for a principal, must be based or incorporated in or formed under the law of a country which the FSP assesses as having a low degree of risk of money laundering and terrorist financing.

The immediate effects of the list’s removal; and any reliance which has continued to be placed on it by FSP are yet to be determined, however, a review of the internal country AML risk classifications and the application of SDD on investors is warranted to ensure continued compliance with the AML regulations in place.