Category: Member Update

Having implemented the first phase of the Sustainable Finance Disclosure Regulation [SFDR] in March – a set of provisions which requires asset managers to publish detailed information about how ESG (environment, social, governance) criteria are incorporated into their decision-making processes –  the EU has since confirmed that the second phase of the regulation will be delayed by a further six months until July 2022. The Phase 2 requirements relate to rules surrounding content, methodologies and presentation of the sustainability disclosures which managers must now provide to their EU investors.

This comes as the European Commission [EC] seemingly conceded a delay was necessary to ensure the seamless implementation of the rules. It noted in a letter that the length and technical detail of the RTS [Regulatory Technical Standards]; late submissions to the EC and the likelihood of further amendments had also contributed to the postponement. The decision to push back the rules, however, has been welcomed across the industry. With the EU’s Taxonomy Rules also coming into force in January 2022, many argued that introducing the Level 2 SFDR measures simultaneously – as was originally planned – risked creating too much work for asset managers.

Some lawyers argued that the delay will give fund managers more time to prepare their SFDR templates resulting in better and more transparent disclosures. In an article, Pinsent Masons said the delayed introduction of the Level 2 measures was in part an acknowledgement of the rushed and piecemeal implementation of the Level 1 SFDR requirements, which obliged managers to implement the rules even though the Level 2 provisions were not in place.

The UK takes its own position on ESG

However, the UK has chosen not to onshore the SFDR’s provisions and is instead pursuing its own ESG regime. Under proposals recently published by the Financial Conduct Authority (FCA), UK asset managers will be required to align their climate-related disclosure procedures with the recommendations outlined by the Financial Stability Board’s (FSB) Task Force on Climate-Related Financial Disclosures (TCFD). The rules will apply to all managers with more than £5 billion in AUM (assets under management) from January 2023, with the first reports expected to be submitted by June 2024.

An ESG maze

The multitude of different ESG regulations being introduced is creating problems for asset managers. It is not just the UK and EU who are adopting their own ESG regulations, but so too are a number of markets in Asia (i.e. Hong Kong, Singapore) and potentially even the US under its new administration. With this patchwork approach to ESG rulemaking, asset managers could find themselves being forced to comply with a wide variety of competing or even contradictory regulations. These risks adding to their compliance costs at a time when margins are under enormous pressure. If ESG is to truly thrive, then regulators need to adopt a more uniform and standardised approach towards its implementation.

Despite the stop-start nature of lockdown restrictions together with all of the uncertainty over the last 18 months, financial institutions – including asset managers – are busily assessing the logistics of bringing their staff back into the office once again.  This process, however, will not be straightforward  – while a number of ethical issues remain unanswered. The Independent Investment Management Initiative (IIMA) – formerly known as the New City Initiative [NCI] – conducted a survey of its diverse membership – in which it asked them about their preparations for returning to the office.

 69.7% of respondents to the survey said they had already returned to the office, while a further 18% intend to do so during Summer, and 10% by Autumn. Many boutique firms are currently requiring their employees to come into the office on a rotational basis. The overwhelming majority (76.7%) of IIMI members said that they planned to adopt a flexible working approach while 11.6% confirmed they would not. Of the firms which said they would adopt flexible working, just over half [51.3%] plan to let their employees work from home 1-2 days per week. A further 32.4% said they would allow staff to work from home 2-3 days/week, while 16.2% of members are open to letting employees work from home 4-5 days/week.

Of the firms who are reticent about introducing flexible working, 28% cited productivity concerns as the primary reason for being sceptical, whereas a further 28% warned it could have an adverse impact on training. This comes amid growing concern among senior leadership that staff training and the ability to innovate are not as conducive when performed behind a webcam or through intermittent attendance in the office.

This is prompting a handful of large organisations to take a forceful line on returning to the office. Employers recognise this carries risk, which has led to some organisations demanding that only staff who have been fully vaccinated can return to the office. This is the policy among several high profile US financial institutions – including Morgan Stanley – which recently announced that only staff or clients who have been vaccinated can enter its New York office. A similar policy was adopted by BlackRock. Meanwhile, Goldman Sachs recently said staff must confirm their vaccination status although the bank added that unvaccinated staff could still come into the office but they must socially distance and wear masks. Interestingly, 55.8% of IIMI members said they would not make it mandatory for staff to be either tested and/or vaccinated. 20.3% of respondents said staff must be regularly tested but not necessarily vaccinated. 6.98% of IIMI members will insist that employees be regularly tested and fully vaccinated although 16.2% said they are unsure.

Of those firms which will not require staff to be fully vaccinated or regularly tested, 27.2% said indirect discrimination risk was an issue,  while 22.7% said such a policy would pose serious ethical concerns. “We are a small team where we expect everyone to take collective responsibility . We provide the ability for all staff to undertake testing regularly and encourage it, but we do not mandate it,” said one member.

IIMI will be conducting qualitative interviews with its membership about their post-COVID-19 working practices in the next few weeks. The findings of this more detailed paper will be published in the early Autumn.

For many asset managers – including members of the Independent Investment Management Initiative (IIMI) – outsourcing has been a fantastic enabler, allowing firms to net meaningful operational savings and transition away from a fixed to a more variable costing structure. With returns so volatile and margins being eroded away by rising management fee compression, an intelligent and thoughtful outsourcing strategy can be a huge value-add. Nonetheless, the pandemic has exposed some serious deficiencies in the conventional outsourcing approach, which urgently need addressing.

Outsourcing has been an area of focus for the Financial Conduct Authority (FCA) for a long time. Nine years ago, the FCA’s predecessor – the Financial Services Authority – admonished asset managers for being too reliant on their outsourcing partners, warning that a failure by a service provider could result in serious operational disruption at their businesses. Since then, improvements have been made although in 2020 the FCA issued a note – published before the seriousness of COVID-19 became so obvious – warning asset managers that they had inadequate governance; oversight; risk management and clear contractual arrangements with their outsourced providers. The FCA continued that it expected fund managers to have in place processes to deal with outages and wind downs. It also urged managers to keep an eye on concentration risk, and the impact this could have on business continuity.

COVID-19 will be a case study in business continuity for many years to come. During COVID-19, a number of problems emerged with managers’ outsourcing arrangements. There were those firms who externalised a lot of their operational activities albeit to a number of different providers. While sound from a counterparty risk perspective, it can have drawbacks. Just as too many cooks in the kitchen can spoil the broth, an abundance of outsourced providers creates an additional layer of operational complexity, increasing the scope for errors or mistakes, especially during a fast moving pandemic situation. At the other end of the spectrum,  some service providers are encouraging managers to consolidate their outsourcing relationships. While it is economical and easier to have processes like administration, custody, depositary, collateral management, FX and prime brokerage being carried out by a single entity, it is a major counterparty risk , and one that could elicit scrutiny from institutional investors, especially those who have the Lehman Bros’ default etched in their memories. A balanced, sensible approach towards outsourcing therefore needs to be adopted by asset managers.

Outsourcing practices have also been found wanting by events in India. At the beginning of the pandemic – when India implemented one of the world’s most draconian lockdowns – a number of outsourcing providers were caught off guard. With a number of staff working in back office roles prohibited from going into work, providers were forced to dispatch laptops, mobiles and even install home Broadband networks to ensure that processes such as NAV calculations and trade reconciliations were not disrupted. Barring a few glitches, the industry weathered the initial storm successfully. A year later and with India suffering a catastrophic second wave, disruption to back office operational activities caused by staff sickness is an issue many providers are having to confront. In response, asset managers need to scrutinise their own providers’ outsourcing arrangements, and ascertain that they too have contingency plans in place to weather the ongoing COVID-19 disruption.

It is highly likely that institutional investors and regulators will conduct a thorough review of asset managers’ outsourcing arrangements and business continuity processes. As a result, investment firms will need to think very carefully about how they outsource core operational activities moving forward.

Digitalisation has swept through the asset management industry over the last 18 months as investment firms embrace new technologies together with esoteric asset classes such as crypto-assets. Simultaneously, the COVID-19 pandemic has also reinforced the importance of technology and effective BCP (business continuity planning) in financial institutions’ day to day operations. Both crypto-assets and digital resiliency are now areas of focus for the EU’s proposed Digital Finance Package (DFP), a set of reforms designed to promote digital transformation within the EU.

Bringing a semblance of law and order to the Wild West

Although the $2.5 trillion crypto-currency market is overwhelmingly dominated by retail investors, institutions are slowly building up their exposures.. Many boutique asset managers are sceptical about crypto-currencies – viewing them as unacceptably volatile, speculative, difficult to value and lacking in any basic fundamentals. Despite these objections, a  study by Fidelity Digital Assets in 2020 found that  26% of institutional investors invested in Bitcoin, while 11% had exposure to Ethereum. Embedded within the DFP is the Regulation on Markets in Crypto-Assets (MiCA). Under MiCA, crypto-assets will be split into two distinct buckets, namely regulated (i.e. security tokens) and unregulated (e.g. crypto-currencies). In the case of the former, pre-existing EU regulations such as the Markets in Financial Instruments Directive II (MiFID II) and the Central Securities Depositories Regulation (CSDR) will continue to apply. The EU is also proposing a pilot regime that would allow market infrastructures to facilitate trading and settlement in these regulated crypto-assets. By providing regulatory clarity, the EU believes trading in security tokens – which has been fairly muted so far -could be accelerated.

Crypto-currencies – which are not subject to EU regulations – are a totally different story. Aside from their appalling environmental footprint, the absence of regulation means investors incur significant risk if they trade these assets. In addition, a number of the providers offering services linked to such crypto-currencies (i.e. crypto-exchanges, crypto-custodians) are themselves unregulated. While a handful of EU member states have introduced their own rules around crypto-currencies, the approach has been fragmented. Under MiCA, issuers of these crypto-assets and crypto-asset service providers must apply for authorisation. Further “safeguards include capital requirements, custody of assets, a mandatory complaint holder procedure available to investors and investor rights against the issuer,” according to a DLA Piper briefing. The DLA Piper briefing continues that once authorised in a member state, operators can passport into other jurisdictions, while the provisions also outlaw market abuse in the secondary market for crypto-assets.

Ensuring digital resiliency

COVID-19 has made financial institutions – including asset managers – increasingly dependent on technology. Consequentially, a technology outage  – for whatever reason –  has the potential to cause untold damage to financial stability. To mitigate this risk, the European Commission is introducing the Digital Operational Resilience for the Financial Sector (DORA) regulation, which will force financial institutions to have measures in place to insulate themselves against IT disruption. McCann Fitzgerald  highlights these provisions will require financial firms to have a dedicated IT risk management; a management process to monitor and report major IT related incidents to regulators; digital operational resilience testing; and processes to monitor IT risks at third party providers. DORA also permits information sharing between financial institutions on issues relating to cyber-crime.

Brace for new digital regulations

Digitalisation creates both opportunities and risks, and it is clear the EU is looking to strike a balance between the two with its latest proposals. Accordingly, this is something which asset managers should be paying close attention to.

Efforts to improve clearing and settlement processes inside the EU have been ongoing for two decades now as regulators look to facilitate better cross-border investment. A number of regulations have been introduced over the years to abet this, including the Central Securities Depositories Regulation (CSDR). Unveiled seven years ago, the CSDR established a standardised regulatory framework for EU central securities depositories (CSDs). It also sought to harmonise trade settlement practices across the bloc by forcing member states to adopt a T+2 rolling settlement cycle. So why is the CSDR – a piece of EU regulation that overwhelmingly applies to post-trade intermediaries – an issue for IIMI members?

An inefficient corner of the market

Existing settlement processes are woefully inefficient and manual intensive –  increasing the likelihood of trade fails. Incidents of late and/or failed settlements as a result of manual processing are  fairly ubiquitous in capital markets, and this is driving up industry costs. Data from the European Securities and Markets Authority (ESMA) found failed trades account for 3% of the trades’ value in corporate bonds and sovereign debt markets, rising to 6% for equities.¹ During the worst of the COVID-19 volatility last year, there was a substantial spike in the number of trade fails. ESMA said that trade failures on government bonds and equities doubled to 6% and 12% respectively, while ICMA (International Capital Markets Authority) analysis found settlement failures in the European repo market jumped by 4-5 times in April 2020.² The costs of these trade fails are non-trivial for the financial institutions involved with the DTCC  estimating that a trade settlement fail rate of 2% equates to losses of $3 billion.³ Although CSDR came into force in 2014, certain components of the regulation are yet to go live, having been delayed because of COVID-19 . The Settlement Discipline Regime (SDR), a rather loaded provision designed explicitly to reduce the number of settlement fails, is one of them.

SDR and its impact on fund managers

IIMI members need to pay close attention to the SDR requirements for several reasons. Firstly, the rules apply across multiple asset classes and will impact any financial institution that trades inside the EU irrespective of where it is located. However, the UK Treasury has confirmed it will not implement the SDR.  But what is the SDR? In order to promote better settlement discipline, market participants will be hit with penalties under SDR should a transaction not settle on T+2.  If a financial institution responsible for a trade fail cannot deliver securities to the receiving participant within four days of the intended settlement date, then they will be hit with a mandatory buy-in.  Although many within the industry accept that the threat of fines will encourage the market to improve its settlement discipline, buy-ins are more controversial. Industry groups point to COVID-19 as a case and point. With trade fails peaking during March and April 2020, experts argue the market would have taken a seismic hit had buy-ins been in place during COVID-19. Not only would managing the buy-in process have commanded enormous resources at a time when staff were stretched but any attempt to buy in illiquid securities in a chaotic market would have increased volatility, potentially resulting in heightened systemic risk.

Most asset managers have historically presumed that it is their custodians or brokers who are primarily responsible for ensuring trades settle on a timely basis. Not anymore. Under CSDR, CSDs will be entrusted with imposing fines for settlement fails on brokers/custodians – who unless they are themselves  to blame – will  in turn offload these costs to the underlying clients responsible for the fails, namely asset managers. As such, managers will now need to augment their settlement processes if they are to avoid CSDR penalties and mandatory buy-ins. While the rules have been delayed until February 2022 because of the pandemic, investment firms still need to make urgent improvements to their systems so as to ensure that trade settlements happen on time. Asset managers should also interrogate their custodian banks to ascertain the causes of any trade fails to establish if a third party is responsible, as this could potentially enable investment firms to make counter-claims. Now is the time for asset managers globally to start paying serious attention to CSDR and its wider implications.

¹ Cognizant (July 18, 2020) Reduce the costs and burdens of trade settlement fails with predictive analytics

² Global Custodian (May 29, 2020) Trade settlement fail spikes at height of COVID-19 crisis spark debate about CSDR

³ Cognizant (July 18, 2020) Reduce the costs and burdens of trade settlement fails with predictive analytics

Three months have intervened since Brexit, but how is the asset management industry finding the transition? Although the UK Financial Conduct Authority (FCA) introduced a Temporary Marketing Permissions Regime (TMPR) allowing EU-based UCITS and AIFMs to distribute funds into the UK without impediment, the EU has been less accommodating – opting instead to end pan-EU passporting rights altogether for UK-based managers of AIFs and UCITS. Since January 1, 2021, UK firms can only access EU institutions via the national private placement regimes (NPPR) in place in the member state(s) in which they are marketing. This set-up is unlikely to change until the UK and EU reach an equivalence deal – allowing for unfettered access into each other’s respective markets.

Ahead of Brexit, a number of asset managers developed onshore EU subsidiaries so as to enable them to continue marketing frictionlessly to EU investors. Alternatively, some firms are electing to use the delegation model, whereby an EU entity outsources investment and risk management to a third country manager. The delegated model allows for managers to leverage the pan-EU passport without having to invest money into building up a physical EU presence. This is one of the primary reasons why the delegation model appeals to small to medium-sized asset managers. However, delegation is vulnerable to disruption, especially if EU regulators were to shift the Brexit goal-posts.

Delegation: Will it stay or will it go now?

An ESMA (European Securities and Markets Authority) letter published last year said it had no intentions of banning delegation, conceding the model was positive insofar as it generated efficiencies for fund managers. However, the ESMA letter added delegation “may also increase operational and supervisory risks and raise questions as to whether those AIFs and UCITS can still be effectively managed by the licensed AIFM or UCITS management companies.” ESMA continued there needed to be legal clarification on the maximum extent of delegation which is permissible. This should facilitate supervisory convergence and ensure authorised AIFMs and UCITS management companies maintain sufficient substance within the EU. A consultation on AIFMD was issued by the European Commission (EC) in October 2020, the findings of which are likely to be published shortly.

The consultation has set industry alarm bells ringing. According to the Financial Times, the consultation contained some loaded questions including whether or not there should be quantitative limits on delegation, and queries if it is prudent for core or critical functions to be performed inside the EU. The consultation also appears to be taking a tough line on letterbox entities, although this nothing new.  Most experts doubt delegation will be banned outright but it could be hit with added restrictions to the detriment of UK-based fund managers. Should delegation face constraints, it could force UK firms to strengthen their EU headcount. In contrast, some managers may choose not to market into the EU anymore, especially if the costs of doing so become prohibitively expensive.

Clampdowns on delegation risk not only hurting UK asset managers but alienating EU fund domiciles – namely Ireland and Luxembourg – both of whom have made clear their opposition to any restrictions being levied on delegation. The Association of the Luxembourg Fund Industry has warned against unpicking the delegation rules adding it is a tried and tested mechanism which has contributed to the global success of AIFMs and UCITS. With AIFMD II rules expected to emerge from the findings of this EC consultation, UK asset managers will need to keep an eye out for any changes.

Since 2017, the New City Initiative (NCI) has been campaigning vigorously for the UK to develop a new branded post-Brexit fund structure based on globally-accepted best practices, which could potentially compete and improve upon the EU’s widely regarded mutual fund wrappers, principally UCITS (Undertakings for the Collective Investments in Transferable Securities) and AIFs (alternative investment funds). If the UK were to successfully establish its own unique fund structure, then it could result in either the onshoring or creation of asset servicing roles in areas such as fund administration – which have historically been based in places like Luxembourg and Ireland. Not only would this help generate new jobs during this unprecedented period, but it could potentially stimulate economic growth outside of London and the South East, as fund administration is an activity which does not necessarily need to be performed in an existing UK financial services hub.

The government is listening

In January 2021, HMT issued a consultation asking for input on how it could enhance the attractiveness of the UK as a location for asset management and funds in particular. In the document, the UK government acknowledged that while its domestic funds regime facilitated tax efficient outcomes in most circumstances, it conceded there were areas in need of improvement. Some of the recommendations made by the UK Funds Regime Working Group include changing the tax rates as to how they are applied to UK funds, insofar as introducing a lower tax rate on authorised funds. The government is also mulling over whether to develop a tax-exempt fund structure – although it accepts that this proposal could impact a fund’s ability to access treaty benefits when investing in foreign markets and may even result in tax revenue shortfalls at HMT. HMT also indicated it would be open to re-examining its approach around charging VAT (value added tax) on fund management services, something which has incentivised many investment firms to domicile their funds outside the UK in onshore EU markets such as Ireland and Luxembourg.

Under UK legislation, the FCA (Financial Conduct Authority) must authorise UCITS applications within two months. For other fund structures such as QIS (Qualified Investor Schemes) and NURS (non-UCITS retail schemes), the FCA has up to six months to provide approval following receipt of a complete application. The government has said it would like to explore ways in which the FCA authorisation process can be expedited or further refined. The HMT paper added: “The government considers that the FCA’s 1-month target for authorisation of QIS applications seems an appropriate timeframe given the rigour of the process demanded by the complexity of the product, its availability for sophisticated retail investors, and the standards associated with FCA authorisation.”

Areas for improvement

While the consultation is welcome, NCI believes there could be areas of further improvement. For instance, Section 1.18 points out that the government does not currently intend to make material changes to onshored legislation such as UCITS and AIFMD. Some NCI members have said this is a missed opportunity, and argue that the UK should take advantage of its common law heritage to pursue reforms. Similarly, members add there could be huge gains to be made if the UK were to streamline UCITS liquidity and dealing frequency rules to suit institutional and professional investors.

Driving regional development

By encouraging more asset managers to domicile funds in the UK under a new regulatory regime, there will – by design – be a greater requirement for more service providers too – including fund administrators. Activities such as fund administration do not need to be carried out in London. In fact, fund administration is a process that can be performed nearly anywhere. Of the 12,000 existing UK fund administration jobs, a decent proportion are located in Manchester, Leeds, Nottingham, Bolton, Glasgow, Stirling, Swindon and Dorset. “The government considers that by paving the way for more fund administration jobs, enhancements to the UK funds regime can generate more jobs outside of London.” This is something which NCI has repeatedly advocated for in its lobbying efforts. The roll-out of an effective domestic UK fund structure could materially strengthen the UK’s financial services industry, potentially offsetting some of the job losses being inflicted by the COVID-19 crisis.

HMT should not focus solely on generating jobs outside of the South East in fund administration. The government should incentivise more asset managers to base themselves outside London.  Asset managers are facing sizeable cost overheads as a direct result of increasing operational and regulatory spending. This is making it increasingly difficult for start-up fund managers to establish themselves. Moreover, the industry as a whole is likely to find itself under severe revenue pressure as a result of Covid-19, and its impact on performance. In response, it could make far more economic sense for start-ups or existing managers to set up branches outside of London, where cost overheads and office rents are markedly lower. In fact, this trend is already happening. A growing number of asset managers are now incentivising their sales and relationship management staff to relocate outside of London, especially given the tectonic growth in video conferencing facilities.

Moreover, there is also a huge amount of talent in the regions owing to their excellent higher education facilities and universities. One NCI member suggests that the government could help stimulate start-up managers in the regions through the establishment of UK asset management campuses across the whole country with subsidised facilities for new or fledgeling managers. Ideally, these facilities – which could be biased to certain fund or asset class types – would be located near University Towns so as to attract talent. On a personal level, living costs are also much lower in many areas outside of London and the South East. With COVID-19 having accelerated remote working practices, there is nothing to stop more asset management businesses from establishing subsidiary offices in different parts of the UK. This is something NCI believes the government should firmly encourage.

Beyond the regional cities

By incentivising the asset management industry to widen its geographical footprint within the UK, it could result in a trickle-down economic effect with wealth becoming more evenly distributed away from affluent regional cities to nearby towns, which are among some of the country’s most depressed areas. If less well-off towns are to thrive moving forward, however, there needs to be more government investment in core transport links and infrastructure. Another innovative solution could be to encourage asset managers and other financial institutions to invest in some of the UK’s most deprived regions by offering them tax incentives to do so. One expert concedes this would be a long-term initiative. “Financial institutions need to be located in areas where there are strong links to universities. In many of the more deprived parts of the UK, there are obvious talent shortages, and that will prevent firms from relocating there. That said, if financial services firms and other organisations were motivated to invest in further education, skills-development and infrastructure in these deprived regions, then that could yield positive results albeit over the long term,” he explains.

Key Proposals

In order to stimulate asset management and asset servicing jobs following Brexit, the UK should create its own fund brand. This is something which NCI is willing to engage with the government on.

• If this fund structure is successful, it could spark further growth in UK asset servicing and asset management roles. The government should encourage these businesses to launch outside of London.
• Similarly, incentives – potentially tax benefits – should be given to financial institutions to invest in infrastructure and education in especially deprived parts of the UK. This could help promote long-term economic regeneration.
• NCI is willing to facilitate conversations between the industry and regional economic bodies to help support the funds industry’s development outside of London.