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Monthly Update

Expect Scrutiny of Outsourcing Post-COVID-19

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.

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Monthly Update

Europe Begins a Digital Regulation Drive

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.

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Monthly Update

Fund managers should ready themselves for CSDR

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

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Monthly Update

Awaiting the Next Stage of Brexit

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.

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Monthly Update

A UK funds regime post-Brexit: Making it happen

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.
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Monthly Update

2021: Liquidity, resiliency and ESG

To say that 2020 was a shock to the system would be an understatement, although the financial services sector has largely held its own during the crisis. Despite this, a number of regulatory changes aimed at the asset management industry are likely to be unveiled over the next 12 months. The New City Initiative (NCI) looks at some of the potential developments that could unfold in 2021.

Liquidity risk management – expect new rules

Liquidity risk management was an area of concern for the UK’s Financial Conduct Authority (FCA) long before COVID-19 struck. The preceding summer had seen Neil Woodford’s Equity Income Fund forced to suspend redemptions after investing into difficult-to-dispose of assets. The FCA and Bank of England are currently reviewing liquidity risk management practices at managers with one possibility being that redemption notice periods be lengthened to reduce the risk of panic selling, particularly at daily dealing funds whose portfolios contain difficult to sell assets. In 2020, the FCA sent a survey to asset managers asking them about their financial resilience during COVID-19, the findings of which are likely to feed into any future policies concerning liquidity risk management.

COVID-19 did cause a handful of short-term liquidity issues, especially for entities exposed to real estate assets and corporate debt. The European Securities and Markets Authority (ESMA) subsequently issued a report in November 2020 urging AIFMs and UCITS to implement changes to ensure they are better prepared for future shocks, including improved liquidity profile reporting and ongoing supervision checking there is alignment between the fund’s investment strategy, liquidity profile and redemption policy.

Operational resiliency will continue to be a priority

While the FCA has applauded the asset management industry’s response to COVID-19, it is likely to continue focusing forensically on the sector’s operational resilience. Rather fortuitously, the FCA published a guide to operational resiliency in 2019 just ahead of COVID-19. Among some of its main requirements are that financial institutions consider how disruption to their business services can have an impact beyond their own commercial interests; that firms set a tolerance for disruption for each important business service and ensure they can continue to deliver these critical services during serious crises; and a requirement for financial institutions to map out and test important business services so as to identify vulnerabilities in their operational resilience.

ESG and a new era of regulation

The absence of regulation and a litany of different standards has meant that investing into ESG (environment, social, governance) assets can be a complicated activity. The EU – conscious of the challenges facing investors when allocating into ESG funds – has sought to make the process more straightforward through the passage of the Sustainable Finance Disclosure Regulation (SFDR), which will oblige fund managers to disclose on their websites how they incorporate sustainability risks into their investment decision-making and remuneration policies. A template specific to sustainability funds will need to be produced from next year, while it is expected the taxonomy will also be published in 2021. Although the UK has yet to introduce its own equivalent ESG rules, few expect the country will deviate too much from the EU. Furthermore, many existing non-EU AIFMs leveraging the national private placement regimes will still need to comply with SFRD and the taxonomy rules.

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ESG Disclosure: Get Preparing

Although a number of asset managers purport that their investment products embrace ESG (environment, social, governance) principles,  EU regulators are now insisting that they be able to prove it. This intervention comes following widespread regulatory and investor concern that some fund managers have been mis-labelling their funds as being ESG-compliant when they are not, a practice otherwise known as greenwashing. In order to put an end to this behaviour, the EU is pushing ahead with its Sustainable Finance Disclosure Regulation (SFDR), which comes into effect from March 2021, and will impose heightened ESG transparency requirements on asset managers.

SFDR in a nutshell

SFDR applies at both an entity and fund level, although larger managers (i.e. those with more than 500 employees) are subject to tougher disclosure requirements. At a firm-level, managers must now provide information on their websites articulating clearly their policies on how they integrate sustainability risks into their investment decision-making process and remuneration practices. At a product-level, there needs to be a pre-contractual disclosure outlining how sustainability risks are factored into investment decisions, along with the potential impact sustainability risks could have on returns. Even if sustainability risks are deemed irrelevant to a product, investment firms must give a comprehensive explanation as to why this is the case. Where firms are promoting ESG products, SFDR will require them to fill in a template in which they mustoutline their sustainability features.

SFDR’s impact will be widely felt

The rules will impact any asset manager currently regulated under the MiFID (Markets in Financial Instruments Directive), AIFMD (Alternative Investment Fund Managers Directive) and UCITS regimes. According to a legal note prepared by Sidley Austin, it also appears that the SFDR (and the Taxonomy Regulation) will simultaneously apply to non-EU AIFMs which are marketing AIFs into the EU through national private placement regimes (NPPRs). “The product-level requirements may also indirectly affect non-EU asset managers that act as delegates of non-EU financial market participants (such as EU AIFMs or UCITS management companies). As such, EU firms are likely to require the information from the non-EU delegate to comply with their own regulatory obligations. That is, a non-EU manager might not have a direct regulatory obligation to prepare the disclosures but might be contractually required by the delegating EU manager to do so,” continued the Sidley Austin briefing.

So what does it mean for UK asset managers post-Brexit? With the UK transition period ending on December 31, EU rules introduced after that date will no longer apply. This will include the SFDR. However, the SFDR is extraterritorial meaning it will affect UK AIFMs distributing AIFs via NPPR. It is also clear that the UK is unlikely to deviate substantially from EU rules, especially if it wants to ensure fund managers can continue to access EU investors in the months and years after Brexit. As a result, most legal experts advise that UK managers prepare for the SFDR or something very similar.

NCI members should be planning for the incoming requirements ahead of their implementation. NCI is conducting a survey of its membership on SFDR, and will be producing a white paper on this topic.

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The Retailisation of Illiquid Assets

Illiquid assets are not for retail

While asset managers have largely navigated COVID-19 – both in terms of investment performance and operational resiliency – a number of longer-term risks are starting to emerge. Ultra-low interest rates are unlikely to disappear anytime soon, nor will the widespread equity market volatility, both of which are going to negatively impact investment returns. In response, there are now growing calls by some in the industry for retail investors to be given easier access to illiquid asset classes such as private equity. NCI believe this is a mistake, and risks doing major harm to the industry’s reputation.

Leave illiquids for the institutions

In theory, there is a robust case for greater investment into illiquid assets. The collective performance of private capital managers – namely private equity and private debt – has been impressive recently, and both asset classes are attracting record inflows from institutional investors. In fact, distressed debt is one of the very few asset management strategies to have benefited from COVID-19. But that does not mean illiquid asset classes are suitable investment products for retail.

Firstly, the appetite among retail investors for illiquid assets is not there. Retail investors – young and old – want liquidity on a daily or weekly basis. Unlike institutions with long-term investment horizons, retail investors will simply not accept the 10-year plus lock up periods accompanying private capital strategies. This is one of the principle reasons why the ELTIF (European Long-term Investment Fund) – an EU fund structure designed to give retail investors and smaller institutions access to illiquid assets like infrastructure, loans and real estate totally failed to generate interest.

Going against the prevailing tide

Although a number of asset managers have repeatedly expressed frustration about some of the (many) flaws around investor reporting, templates such as the UCITS KIID (Key Investor Information Document) do serve a useful purpose insofar as they provide a digestible summary of what a fund’s core objective is. Unlike conventional equities and bonds, illiquid assets are complex instruments, as are the funds that invest in them. While explaining the operating model of a vanilla UCITS vehicle to retail clients is a fairly simple exercise, it is naïve for people to assume the same will be true for private capital, which use intricate distribution waterfall methods to allocate capital gains to clients.

Making illiquid assets available to retail investors also goes against the prevailing regulatory tide. The Financial Conduct Authority (FCA) in the UK is currently examining the liquidity risk management practices at asset managers following the Neil Woodford Equity Income Fund gating incident back in 2019 and the trading suspensions by a number of daily dealing property funds during the height of the pandemic. Any attempt by asset managers running illiquid strategies to broaden their distribution reach into the retail world would risk regulatory scrutiny given these recent events.

Is it worth the risk?

As enticing as it may be for managers to offer retail investors access to illiquid assets, it is not a sensible policy to pursue. The reputational damage, which the funds industry would face should something go spectacularly wrong – is too great. At a time when investment firms are gradually rebuilding trust with retail investors, shifting into illiquids would be a terrible and ill-advised move.

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Beware the threat to delegation

Having had more than four years to prepare for Brexit, the majority of UK investment firms appear to be in a reasonably robust position to withstand any challenges that may arise. In July 2020, the European Securities and Markets Authority (ESMA) and national EU regulators reiterated that the memoranda of understandings (MOUs) it agreed with the UK Financial Conduct Authority (FCA) on cooperation and information exchange in the event of a no-deal Brexit were still valid. According to ESMA, the MOUs will help facilitate continuity for financial institutions if no UK-EU deal is obtained.

Although fund managers are confident that existing distribution channels will not be disrupted when Brexit takes effect on January 1, there are some more longer-term concerns about the ease in which investment firms will be able to sell into the EU. This trepidation stems in part from a letter penned by ESMA in August 2020. While the bulk of the letter’s contents were not especially controversial or substantive in nature (i.e. calling for greater harmonisation between UCITS and the AIFMD [Alternative Investment Fund Managers Directive]), its comments on delegation elicited criticism.

Delegation is the process whereby an EU entity – known as a ManCo (management company) – outsources investment and risk management activities to a third country manager – enabling them to seamlessly passport or distribute their funds into the EU. For non-EU managers, this allows them to maximise their distribution footprint. It is also one of the reasons why UCITS and AIFMD structures are so universally popular, especially among SME (small to medium sized) asset managers who otherwise would be unable to afford the costs of building up a physical presence inside the EU.

While the ESMA letter did not say it would ban delegation outright, it did acknowledge there were flaws in the model. ESMA accepted that delegation arrangements did generate efficiencies for investment firms but added it “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 that is permitted so as to ensure supervisory convergence and that authorised AIFMs and UCITS management companies maintain sufficient substance within the EU.

Any attempt to impose additional barriers around delegation is likely to frustrate third country asset managers – including those located in the UK post-Brexit, as it could force them to increase their operations and headcount inside the EU at significant cost. In the past, there have been attempts by some member states to restrict delegation but these efforts came to nothing, owing to effective lobbying by industry groups and representatives from onshore fund domiciles such as Ireland and Luxembourg. However, fund managers are under no illusion that future bids to roll back on delegation by European policymakers could potentially gather more momentum over the next 18 to 24 months. As a result, this is an issue, which UK fund managers should be paying close attention to.

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Well-intentioned but light on substance: The ESMA review of AIFMD

In August 2020, the European Securities and Markets Authority (ESMA) published a letter to the European Commission (EC) outlining its recommendations on future potential amendments to the Alternative Investment Fund Managers Directive (AIFMD). The letter’s contents have yielded a mixed response from the asset management industry. The NCI takes a look at some of ESMA’s proposals.

Greater harmonisation

The lack of harmonisation between UCITS and AIFMD has been a source of frustration at asset managers for a long time. Accordingly, ESMA has asked the EC to align AIFMD and UCITS where possible. ESMA also said there needed to be greater consistency between AIFMD/UCITS and MiFID (Markets in Financial Instruments Directive) to ensure that entities providing similar services are subject to comparable regulatory standards. Again, this is a welcome development for the funds’ industry. Having made improvements to AIFMD’s Annex IV reporting, ESMA also said it was vital that UCITS reporting should now become more harmonised and less duplicative. The lack of reporting standardisation in member states has been a significant barrier for asset managers undertaking cross-border distribution. The implementation of a more homogenised regulatory and reporting regime for UCITS would help provide a much-needed boost to cross-border distribution and sales.

ESMA added there needs to be greater EU-wide consistency on liquidity risk management, an issue which has become more crucial following the Covid-19 crisis. “In ESMA’s view, the EC should take the opportunity to  review the availability of all liquidity management tools outlined in the European Systemic Risk Board’s (ESRB) recommendation A. In addition, the availability of tools should also be included in the UCITS directive.” Among the ESRB’s suggestions were that additional provisions be inserted into AIFMD and UCITS clarifying the roles of regulators when using their powers to suspend redemptions in situations where there are cross-border financial stability implications. For instance, there is still uncertainty as to which regulator is responsible for supervising redemptions and subscriptions– when the fund and its management company are located in different member states.

Delegation in the spotlight

Delegation arrangements at asset managers have been subject to intense scrutiny ever since Brexit. While ESMA accepts delegation promotes efficiency, it warns the practice can increase operational and supervisory risk, especially if more strategic activities take place outside of the EU. In response, ESMA said “further legal clarifications on the maximum extent of delegation would be helpful to ensure supervisory convergence and ensure authorised AIFMs and UCITS management companies maintain sufficient substance in the EU.” Although previous attempts by some member states to limit delegation were rebuffed, it continues to be an ongoing risk for non-EU investment managers.

A damp squib

While advocating for further harmonisation of UCITS and AIFMD is not a bad thing, the ESMA letter is deliberately vague. The section on reverse solicitation simply calls for greater clarity owing to the fact different member states are adopting their own interpretations. This is a sensible recommendation but ESMA provides little detail on how this should be achieved. Similarly, ESMA takes a fairly ambiguous position on the establishment of a pan-EU depositary passport – a topic which has been under discussion since the early 1990s – by  kicking the issue into the long grass. Even though ESMA’s message is generally positive, the letter is extraordinarily light on substance.