There’s a certain tidal quality to the ebb and flow of financial regulation. Some years the tide comes in and there’s a surge of implementations. In other years, the tide goes out as implementations recede and policymakers work on potential new rules that will arrive with the next regulatory high tide.
With more regulatory consultations on the horizon than implementations at the moment, the industry could be dealing with a receding regulatory tide this year. As policymakers focus on drafting new rules, three key themes may drive the global regulatory agenda: the impact of COVID-19, adjusting to a post-Brexit world, and Environmental, Social, and Corporate Governance (ESG) regulation going global.
Understanding the driving forces behind the regulatory agenda can help the industry better react and prepare for what may come.
Policymakers Perform a COVID Postmortem
With the worst of the pandemic hopefully behind us, policymakers have started to assess what changes to the regulatory framework might be needed to address issues raised by the COVID-19 experience. While it’s not expected that this postmortem will lead to a major framework overhaul, there is potential for some targeted policy changes that could create significant challenges.
Rebooting Money Market Fund Rules (Again)
For the second time in a little over a decade, the US government stepped in to backstop money market funds during the volatility experienced during March and April. While no direct intervention was required in Europe, the French regulator, the Autorité des Marchés Financiers, has said that several European money market funds did come close to requiring a bailout. As a result, regulators on both sides of the Atlantic have indicated that they are going to revisit the regulatory framework for money market funds.
In the US, policymakers may consider revising the rule that requires automatic fee triggers if certain liquidity thresholds are breached. Under the current rules, money market funds must impose a liquidity fee of 1% if weekly liquid assets fall below 10% of total assets and a 2% fee if liquid assets fall below 30% of total assets. The industry has argued that these triggers may be counterproductive and actually exacerbate a liquidity issue because they could hasten redemptions as funds near the thresholds. In Europe, one area of targeted reform may be loosening the rules that prohibit fund sponsors from providing support to money market funds. The concern is that this prohibition may be overly restrictive and that sponsor support may be a better outcome for investors.
More holistically, policymakers may revisit the idea that money market funds should be subject to stricter, more bank-like supervision. The proposals could include requirements for money market funds to maintain capital buffers to deal with redemption risk, which was suggested in previous money market fund reform efforts.
As regulators start their work on potentially revising the money market fund frameworks, it will be interesting to see how coordinated the US and EU are in their efforts. Though the markets are different, applying a common approach could help to address some of the issues that arise with the cross-border nature of asset management.
Revisiting Fund Liquidity
While there were no widespread fund liquidity issues encountered during the COVID-19 volatility, pockets of funds did have to suspend redemptions. Mostly, the issues experienced were not liquidity issues but valuation issues, where some funds had trouble pricing some holdings. While this is a critical detail from a systemic risk perspective, it is a distinction without a difference for investors who were unable to redeem their investments. Given the impact on investors, it is likely regulators will look at both liquidity and valuation issues in their investigations.
Regulators have already taken some action on this issue. In the UK, the Financial Conduct Authority (FCA) has signaled that it might prohibit open-ended property funds. Unique to the UK, these funds offer daily liquidity while investing in physical real estate. This liquidity mismatch between the fund and the underlying investments has made the funds more susceptible to redemption runs. Over the last few years, many open-ended property funds have had to suspend redemptions at some point. As a result, the FCA has proposed a redemption notice period of 90-180 days for property funds. The rules are expected to be finalized early this year and could bring an end to daily dealing for the open-ended property funds.
As part of its work on the Alternative Investment Fund Managers Directive (AIFMD) the European Securities and Markets Authority (ESMA) has proposed improvements to fund liquidity reporting. These include providing realistic estimates for portfolios’ liquidity. Conceptually, this is similar to the liquidity bucket reporting for funds in the US. ESMA has also suggested tightening the valuation rules for funds to make sure they work in times of market stress. The final proposals are expected in the first half of the year. Although the proposals are for AIFMD, it’s wildly expected they will be applied to the Undertakings for Collective Investment in Transferable Securities (UCITS) rules as well.
The fund liquidly issue is part of the larger concern that asset management may pose a systemic risk to the financial system and the industry should be prepared to face another round of regulatory investigation into its potential systemic risk.
In the US, there’s been renewed interest in swing pricing, which was introduced in the Securities and Exchange Commission’s (SEC) 2018 fund liquidity rules. A common feature in European funds, swing pricing allows managers to adjust the price of a fund to mitigate the impact of large shareholder activity on other investors. Despite the industry’s interest in swing pricing, logistical challenges of the US market, such as tight dealing times and high-volume of smaller trades, have prevented anyone from implementing swing pricing for US funds. However, the COVID-19 experience has led many in the industry to call upon the SEC to see how it could encourage the adoption of swing pricing.
The fund liquidly issue is part of the larger concern about the potential for asset management to pose a systemic risk to the financial system. This long simmering debate has been on the back burner for the last few years but COVID-19 has brought some of the issues to the fore. In addition, a change in leadership in the US means that the debate may likely have renewed focus from the new administration. Under the previous administration, the Financial Stability Oversight Council (FSOC) largely abandoned its work on the potential systemic risk of asset managers. With Former Federal Reserve Chair Janet Yellen expected to take over the US Treasury, the FSOC may reinvigorate its work in this area. Overall, it seems as if the industry should be prepared to face another round of regulatory investigation into its potential systemic risk.
Rethinking CSDR and IMR
Two major pieces of regulation were delayed last year because of COVID-19 and policymakers may use these delays to consider tweaks to the rules.
The first was the delay of the fifth and sixth phases of the Global Initial Margin rules (IMR) for uncleared derivative transactions to September 2021 and 2022, respectively. The fifth phase requires firms with more than $50 billion in uncleared derivatives to start posting initial margin and the sixth phase lowers the threshold to $8 billion in uncleared derivatives. All told, at least 1,000 entities and over 9,000 trading relationships will be captured by the final two waves of the IMR, according to the International Swaps and Derivatives Association (ISDA). Given the strain that COVID-19 put on the market, policymakers may reassess the final two phases. It’s possible that regulators may reconsider whether it is worth having smaller firms post collateral for uncleared derivatives. This could lead to a reassessment of the sixth phase and possibly raising the threshold for the fifth phase. The industry would likely welcome such a move, as it has long argued the lowest thresholds should be raised to $100 billion. Nonetheless, firms should continue to prepare for the fifth phase to go live in September as scheduled.
The second was the delay of the next phase of the Europe’s Central Securities Depositories Regulation (CSDR) that ushers in mandatory buy-ins and cash penalties in the event a trade settlement fails, until February 2022. There were always concerns in the industry that it could lead to reduced bond market liquidity by pushing trading and settlement of global bonds to non-EU markets. The large spike in settlement fails, caused by the market volatility during the initial stages of the pandemic, led to further worries that had the mandatory buy-in regime been in place during this tumultuous period, it could have created further instability and potential systemic risk. Given these concerns, the European Commission launched a consultation on amending the settlement discipline rules. This will be closely watched by the industry and it will be interesting to see how the Commission balances the desire to improve the post-trade infrastructure in the EU, without causing any unintended consequences.
Everyone Adjusts to Life After Brexit
With the end of the transition period, Brexit has officially arrived. However, this is just the beginning for the asset management industry and it will now need to start navigating the new normal of a post-Brexit world. As the industry begins this journey there are a few key items for it to tackle this year.
Making the Temporary Permeant
In the run up to Brexit, policymakers took a number of steps to cushion the short-term impact on asset management. Starting this year, policymakers will begin to make the temporary agreements permanent. A key item for asset managers is the UK finalizing its Offshore Fund Regime (OFR), which will replace the current Temporary Permissions Regime. The OFR creates a fund passport for UCITS funds that will allow, more or less, the status quo to remain for firms selling UCITS into the UK. This year the FCA will draft the specific rules for the regime. One area to watch is whether the FCA will require UCITS funds sold into the UK to produce an Assessment of Value (AoV). Currently, only UK-domiciled funds produce the AoV, which requires managers to assess the value proposition for each fund, take corrective action if the fund does not offer value, and publish an annual AoV statement. It is possible that the FCA will seek to level the playing field and extend the AoV to non-UK funds. For asset managers this could add another layer of complexity to their European cross-border distribution, but if it’s the cost of admission to the UK market, many in the industry will likely find it is worth the effort.
Tightening Delegation Rules
Driven in part by Brexit, the European Commission is reviewing the delegation and third-country rules for UCITS funds. At a minimum, the Commission will seek to harmonize the delegation rules for AIFMD and UCITS funds, which means creating a third-country framework for UCITS. Unlike the rules for alternative funds, which are governed by AIFMD, under the UCITS framework there are no delegation rules. Instead, local regulators determine the appropriate level of governance, local substance and oversight for the UCITS funds they authorize. In and of itself, this probably wouldn’t be too disruptive to asset managers’ existing delegation arrangements. The major fund domiciles, Ireland and Luxembourg, have both increased their local substance requirements in recent years so meeting the new level of AIFMD delegation rules shouldn’t be an issue. The potentially bigger issue is whether the European Commission will also look to tighten the delegation requirements for UCITS funds.
There is potential the status-quo will not remain and that asset managers are going to need to have more substance in the EU. The issue now is really a matter of how much.
One of the big unknowns is ESMA’s suggestion to create a quantitative criteria to assess the appropriate amount of delegation. The industry has expressed concern that creating a formulaic approach to assessing delegation could lead to an overly prescriptive approach. The details of the quantitative criteria still need to be set, however, one possible outcome is that as funds get bigger, more local substance could be required. While Brexit is the catalyst for reviewing the delegation rules, the potential impact goes beyond the UK. UCITS funds are truly global and are just as likely to be managed in New York as they are in London. The concern is that the creation of rules that require more activity to be done within the EU could lead to inefficiency and additional cost that would ultimately be borne by investors. If the rules get too prescriptive, other domiciles could follow suit with similar rules, which could cause dislocation across the industry. Nonetheless, there is potential that the status-quo will not remain and that asset managers are going to need to have more substance in the EU. The issue now is really a matter of how much.
Managing Regulatory Divergence
Now outside of the EU, the UK is no longer bound to adopt European regulations and can instead plot its own course. The UK has already begun to diverge from the EU’s regulatory framework with the UK Treasury’s announcement that it won’t be adopting the CSDR mandatory buy-in regime and that it will create its own prudential regime for UK investment managers that is largely aligned to the EU’s Investment Firm Directive and Regulation but tailored to the UK market. The UK has also announced its intent to create its own ESG taxonomy, separate from the EU’s ongoing efforts. Overall, divergence between the UK and EU was inevitable but it will likely be a slow drift, rather than a big bang. As the two jurisdictions continue to grow apart, firms will have to figure out how to track, implement, and reconcile the different regulatory approaches. To do so, firms will need to develop a mechanism to assess how rules in the EU impact their UK business and vice versa. In addition, firms will now have to engage more with the UK regulatory consultations, on top of managing EU consultations. Invariably a divergence in rules will lead to differing approaches to regulatory reporting, which highlights the importance of having a strong data management and regulatory reporting strategy.
ESG Regulation Goes Global
As ESG investing continues to grow in popularity, it has been moving up the regulators’ agenda and this year it is expected by some to be at the top of their list. The EU has taken the global lead to create an ESG framework for all asset managers, even if they don’t have an ESG strategy. Many of these elements have extraterritorial elements so, the EU has been considered as setting the defacto global standard. However, that may be about to change as more jurisdictions begin to draft their own rules.
Asset managers are in for challenging period of trying to navigate varying approaches to ESG regulation that are coming at different speeds and sometimes have conflicting requirements.
As part of its Green Finance Strategy project, the UK will not adopt the EU’s ESG taxonomy and disclosure rules and instead will create its own versions. Meanwhile, in the US the change of leadership could mean a renewed focus on ESG. To date, the SEC has largely focused on the outcomes for investors and the possibility of greenwashing. However, under Democratic leadership, the SEC could take an expanded look at ESG rules. This could include increased disclosures for companies and funds, stricter rules around the ESG label and even possibly a more formal definition of ESG. Furthermore, both Hong Kong and Australia have both published ESG roadmaps that include their own disclosure requirements. Over the next few years, it’s possible that almost every country will install some level of an ESG regulatory framework.
Absent international cooperation, asset managers could be in for a challenging period of trying to navigate varying approaches by regulators that are coming at different speeds and sometimes have conflicting requirements. Firms may have to address the rules in isolation which could put strain on their resources as they look to create policies and reporting solutions that meet all the varying requirements.
ESG is becoming a permanent feature of the asset management industry and hopefully in time a consensus on a global regulatory approach will emerge, though for now that’s probably wishful thinking.
Preparing for the Next High Tide
Financial regulation is often a hostage to fortune and is frequently forced to react to changing circumstances. For firms the challenge is that there is a lag time between when the change in direction translates into action. This year regulators are looking to make adjustments that might not be felt by the industry for a few years. Asset managers should have a two-pronged approach to regulatory change. A tactical response, to deal with incoming regulation implementations and a strategic response that looks at the potential long-term impact open policy debates. If done correctly, the latter helps inform the former and makes firms better prepared to cope with regulatory change. This year, the focus should be on the strategic response and preparing for the next regulatory high tide.