Developments and issues facing the investment management industry.
Capital markets union (CMU) has regained some momentum with the European Commission publishing its mid-term review consultation (see KPMG summary) and more recently a report on addressing national barriers to capital flows. True to its promise to look beyond pure regulatory measures, this latest report targets the barriers to investment from national approaches and measures. Stopping short of naming and shaming, the European Commission highlights that Member States need to do more on financial markets integration for capital markets activity to improve. However, the national barriers are often deep-rooted and change will be challenging.
Key areas of focus for the Commission are barriers before, during and at the end of investment, including:
CMU is a key initiative for Europe. Broadening financing options for business and increasing the opportunities for investment requires significant change across a range of complex interconnected issues, both regulatory and structural. So far, the Commission has tackled mainly the regulatory barriers, with specific proposals to help loosen the financial system, and also helping businesses to access capital markets. Critics of CMU have always argued that national self-interests are the greatest obstacle to Europe having more vibrant capital markets. Brexit makes the need for broader EU capital markets all the more important as the market access of European businesses and investors via the UK will likely be restricted.
The Commission has published the report ahead of developing a roadmap in the coming months. The areas of focus have been developed by an expert group and it is important that industry and other stakeholders engage in the process now.
ESMA’s investment management workstreams in 2017 are mainly aimed at continuation of the work started in 2016, or a follow-up of those activities.
In addition, ESMA will work on common approaches to UCITS eligible assets, the operation of home and host responsibilities under UCITS and AIFMD, a peer review on compliance with the guidelines on ‘ETFs and other UCITS issues’ and possible stress testing methodologies for funds.
A recent example of ESMA’s supervisory convergence work was its Opinion that hedged UCITS share classes (other than for currency) are effectively a different pool of assets and should not be allowed, but rather should be separate funds or sub-funds. Any such existing share classes should be closed for investment by new investors by the end of July 2017 and for additional investment by existing investors by July 2018.
On a European level, the responses by the national regulators, to this guidance, will be interesting. Will those countries that have allowed share classes that allow hedging other than for currency risk purposes now fall into line with ESMA’s opinion or choose not to follow it? And if they do not, might other national regulators prohibit the cross border distribution of those share classes into their countries?
It is widely expected that the Central Bank will adopt ESMA’s Opinion and that it will replace its current Guidance. The principles set out in the Opinion are broadly in line with the current regulatory treatment of share classes by the Central Bank. However, having said that, the Central Bank does permit interest rate hedging at share class level, a practice which is likely to become prohibited. If that is the case these share classes may have to close to new investment in accordance with the timelines set out above and, eventually, convert to separate funds or sub-funds.
The Central Bank has used powers, available to it under the Central Bank (Supervision and Enforcement) Act 2013, to consolidate and place existing requirements on a statutory footing. On 7 March 2017, the Central Bank (Supervision and Enforcement) Act 2013 (Section 48(1)) (Investment Firms) Regulations 2017 (“Investment Firm Regulations”) came into force. These new regulations apply to investment firms, certain investment business firms (excluding retail intermediaries) and fund administrators. They supplement existing legislative requirements, in particular the European Communities (Markets in Financial Instruments) Regulations 2007 and the Investment Intermediaries Act 1995.
In the main, the new regulations replace the various conditions and requirements which the Central Bank had imposed on a piecemeal basis on firms in the investment management sector, for example the Prudential Handbook for Investment Firms is now obsolete. However firms should take note as they do contain some new provisions and they have been supplemented by a new Central Bank Q&A on Investment Firms and new guidance on;
The biggest impact of the new regulations is on fund administrators, authorised under the Investment Intermediaries Act 1995. The regulations contain new provisions on directors, outsourcing and capital and replace Chapter 5 of the AIF Rulebook.
Previously fund administrators had to have a minimum of two Irish resident directors. Residency has been defined and now fund administrators must have a minimum of two directors present in the State for 110 working days in the year. This is aligned with the residency rule for directors of fund management companies.
In relation to outsourcing, the majority of the new regulations reflect the requirements in Chapter 5 in the AIF Rulebook. It is noteworthy that they confirm that the fund administrator must check and release the final NAV and the outsourcing service provider can only do so in circumstances determined by the Central Bank, as is already the case. There is a new requirement for fund administrators to submit an annual return template to the Central Bank concerning its outsourced activities. The Central Bank has also issued an industry letter which sets out its expectations in relation to the level of outsourced activity and recommendations on governance and oversight of the activities.
The capital rules for fund administrators aim to ensure that they are subject to capital requirements similar to those set out in the CRD framework. For example own funds are still the higher of €125,000 or the fund administrator’s expenditure requirement but the method of calculation of the expenditure requirement, particularly around the treatment of fixed expenses, is more prescriptive. Own funds have been redefined and Tier 2 capital is limited to one third of Tier 1 capital. All instruments need the prior written approval of the Central Bank for inclusion as own funds, with transitional arrangements in place for pre-existing instruments.
In addition a fund administrator must now develop a risk analysis and capital adequacy assessment process, including having written policies and procedures in place to identify, assess and manage risk. The regulations set out the following minimum risks, which must be considered - credit and counterparty risk, concentration risk, market risk, operational risk, liquidity risk, strategy or business model risk, group risk, environmental risk and governance risk. Larger and more complex fund administrators or those operating in a particularly dynamic environment will need to consider whether or not they should have a stress-testing framework in place to adequately manage liquidity and capital.
The Central Bank has had to update the UCITS and AIFMD Q&As and the AIF Rulebook to reflect these changes. These updates were made on 13 March 2017.
MiFID II introduces changes to the existing best execution regime. It strengthens the governance aspects of best execution, so instead of firms having to take “reasonable steps” to get the best possible results for their clients, taking into consideration factors such as cost and price, they will now have to take “all sufficient steps” which is a much higher bar. It places a specific obligation on firms to check the fairness of prices proposed to clients when executing orders or taking decisions to deal in OTC products and it also introduces other changes aimed at increasing the scope and transparency.
These changes reinforce the importance of best execution as a key component of investor protection. They will be challenging to implement as evidenced by a number of reviews, conducted by regulatory agencies across Europe, of best execution under the existing MiFID framework. The findings from these reviews is that the level of implementation and convergence of best execution practices is currently quite poor, even though there has been some improvement.
In 2015, ESMA performed a peer review of European regulators and found that there was a low level of supervisory activity devoted to monitoring best execution as well as a low level of understanding by investors. In the follow up report in January 2017, ESMA found a definite improvement in the level of attention being paid to best execution but highlighted the need for continued efforts to ensure compliance.
The Central Bank of Ireland conducted a themed inspection of best execution practices under MiFID in investment and stockbroking firms in 2012. That inspection raised many concerns about the adequacy of policies and the effectiveness of procedures.
The most extensive work in this area has been done by the Financial Conduct Authority (“FCA”), both in a thematic review in 2014 and in its recent asset management market study. Its overall assessment is that investment managers are still failing to ensure effective oversight of best execution and that the pace of change to ensure improved client outcomes is slow.
The FCA’s concerns included;
However the FCA has highlighted some good practices;
To ensure MiFID II readiness and future compliance, firms will need to improve current practices and this is borne out by the experience of regulators across Europe.