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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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Monthly Update

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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Not the time for deviation on ESG standards

Although interest in ESG (environment, social, governance) investing has been gathering momentum for several years now, Covid-19 has accelerated this trend exponentially. Data released by Morgan Stanley shows issuance of social and sustainable bonds topped $32 billion in April 2020, a monthly total surpassing that of green bonds for the first time ever. The market share grab by social bond issuers has been extraordinary, but it is reflective of a wider shift into ESG by investment managers.

The rise of ESG has been organic, fuelled by institutional clients becoming more aware about societal and environmental issues, and who in turn are demanding asset managers plough more resources into ESG investing. It has also been regulatory-led. The EU’s Sustainable Finance Action Plan is widely seen as being a trailblazer on ESG. Assuming deadlines are met, the European Commission has said it wants financial institutions – including fund managers – to be compliant with the new rules by 2021. 

The Brexit effect

Although the UK has said repeatedly that it does not intend to deviate from EU regulations following the Brexit transition, the government has yet to publish comprehensive legislation on sustainable finance, something which could result in ESG requirements coming into force later in the UK than in the EU. A senior official from the Department for Work and Pensions (DWP) also said the extent of the UK’s application of EU directives and regulations – such as the adoption of sustainable finance disclosure rules – would be conditional on the ease of market access following the Brexit transition.

A handful of industry associations are beginning to sound the alarm. The UK Sustainable Investment and Finance Association (UKSIF), a body that represents financial institutions with assets totalling more than £7 trillion, implored the Treasury to outline its regulatory approach on sustainable investing. This comes amid fears the UK is at risk of undermining its reputation as an ESG leader in financial services. Moreover, asset managers with cross border operations have warned they could face added costs if the UK develops ESG regulation that does not correspond with the EU’s rules. 

Standards correspond with success

The Treasury’s plans are not yet known , but it has said that more information about its ESG disclosure regime will be released in due course. The issue of the UK arbitraging with the EU is worrying, particularly on ESG standards. Right now, ESG standards are a mess, mainly because so many bodies and associations (albeit good-intentioned) have developed their own, customised standards. In addition, different regulators are pursuing their own ESG regimes, further complicating the process.  All of these conflicting rules are going to prove incredibly confusing for global investors. 

A failure to develop harmonised, sensible and easy to understand standards will undermine regulatory efforts to stamp out green-washing and ESG mis-selling, an issue which is likely to become more prevalent moving forward. It is vital that regulators and industry bodies communicate with each to create common standards to preserve the integrity of the rapidly-growing ESG market.