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Monthly Update

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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Monthly Update

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.