by Sophia Bantanidis (Head of EMEA Regulatory Developments at Northern Trust)

The UK financial services industry is regulated by both the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). There have been wide-ranging regulatory changes across Europe that have impacted the investment management sector and there are more to come, with particular impact for firms that, like us, trade in fixed income instruments and derivatives.

This article provides an overview of existing regulation that impacts the investment management sector and some insight into recent and impending regulatory changes.

The investment management industry is under increased regulatory scrutiny

The success of the investment management industry has put the sector into the heart of global capital flows. On the one hand this creates opportunities for investment managers and on the other hand it means increased scrutiny from regulators and more rules with which to comply.

In Europe, the existing body of rules for the investment management industry which was drafted in the pre-crisis era focused on making markets more efficient and on investor protection. For example, the Undertakings for Collective Investment in Transferable Securities Directive (UCITS IV) which was transposed into national law in July 2011 contains various rules supporting market efficiency. UCITS IV allows cross-border and domestic mergers of UCITS funds, which gives managers new opportunities to consolidate their operations and to increase significantly the size and assets of a single UCITS fund. UCITS IV also introduced the use of master feeder structures (which was previously prohibited under the UCITS III Directive) allowing a feeder UCITS vehicle to invest 85% or more of its assets in shares or units of a master UCITS. This development creates another framework for managers to pool assets and to lower overall expense ratios. Finally UCITS IV also introduced a full management company passport whereby a management company authorised in its home Member State can provide services not only to a UCITS established in its home Member State but also to a UCITS established in other Member States.

The ’original’ Markets in Financial Instrument Directive (MiFID) which was transposed into national law in November 2007  contains various measures which aimed to strengthen investor protection in  the investment management sector. For example, MiFID introduced rules governing investment firm’s execution of client orders. These “best execution” requirements (which at the time of writing are in the process of further revision under MiFID II) require firms  to take all reasonable steps to achieve the best possible result for clients taking into account price, cost, speed, likelihood of execution, settlement size and any other relevant order execution consideration. Investment firms also have to obtain client consent to the execution policy and must be able to demonstrate that they have executed the clients order in compliance with their execution policy.

In the UK, one of the most recent investment management regulatory developments that seeks to protect investors are the rules on dealing commissions. These rules stipulate what investment managers can (and cannot) pay for using client dealing commission. These rules  (which are not new but which the Financial Conduct Authority (FCA) further clarified in a consultation paper and accompanying policy statement) prevent investment managers using dealing commission to pay for access to senior staff at firms they invest in.

Recent regulatory changes have wide-ranging implications for the investment management industry

Recent regulatory changes impacting the investment management industry highlight certain key trends. This paper will review three of these trends.

Firstly, investor protection remains at the forefront of policy making. To this end, various directives and regulations are being revised with investor protection in mind.

The second iteration of the Markets in Financial Instruments Directive (MiFID II) is the prime example of this now that the level 1 text of the directive and regulation (which together make up the MiFID II package) has been finalised[1]. Certain clients (such as municipalities and local authorities) who had previously been categorised as professional clients are being re-categorised as retail clients, which means that investment managers will have to assess carefully the categories of clients that they do business with and which rules apply to any newly categorised clients. Certain products are also being re- categorised as complex products, which will no longer be able to be sold on an execution only basis. Certain UCITS products will fall into the complex category and investment managers will be obliged to assess the appropriateness of the UCITS product as part of the sales process.

MiFID II also bans third party remuneration for independent investment advice (a diluted version of the UK’s in force rules that came from the Retail Distribution Review) and extends this ban to third party remuneration for portfolio management, which will be a new requirement for the investment management sector. Distributors who have been receiving commission or fees from investment managers in exchange for product distribution will no longer be able to accept such fees.

Secondly, policymakers are getting their hands on previously unregulated market areas as a reaction to the crisis and other events.

On the back of the Madoff fraud in 2008 policymakers proposed a directive (the so called Alternative Investment Fund Managers Directive (AIFMD)) regulating the management of alternative investment funds and the marketing of these funds to professional investors in the EU. This directive regulates the manager rather than the funds managed by the manager so that the directive does not regulate or restrict the investment strategies that a fund can pursue. However, the directive does require in-scope managers to obtain authorisation from their regulator, to ensure that they meet on-going operating conditions and to comply with new transparency, reporting and remuneration rules.

Another significant new requirement for alternative investment fund managers is the requirement to appoint a depositary. This imposes new rules not only for the manager but also for the appointed depositary, especially around depositary liability. This will have a knock on effect for investment managers as the increased liability measures will make the depositary business a more expensive business to operate. This trend will continue and AIFMD has set the tone for depositary rules which are now enshrined in the next iteration of the UCITS directive, UCITS V. UCITS V further increases the duties and liabilities of depositaries and introduces new remuneration requirements for investment managers (these are closely aligned to the provisions within AIFMD but with some subtle differences). The UCITS V directive is already in force but Member States have until the 18 th of March 2016 to transpose it into national law.

Thirdly, policymakers have moved away from addressing market efficiency to addressing market transparency and thereby promoting continuously functioning markets (i.e. markets that can function even in stressed conditions).

The regulators have tackled the opaque OTC derivatives market by forcing firms (including investment managers) to trade OTC derivatives on exchanges so that regulators have sight of transactions and exposures. These transactions are to be cleared via a central counterparty (to remove counterparty risk) and to be reported to a trade repository. These requirements are found in MiFID II and in the European Market Infrastructure Regulation EMIR (EMIR entered into force on 16 August 2012 but most of the provisions only apply after technical standards enter into force). To help supervisors monitor systemic risk a new global identification standard, the Legal Entity Identifier (LEI), has been established to act as a universal standard for uniquely identifying all entities related to a financial contract. The impact of these market infrastructure changes on the investment management sector range from large scale infrastructure changes and tactical decisions to comply with mandatory clearing  (for example, investment managers having to decide whether to become a clearing member of a central counterparty or a client of an entity which is a clearing member or an indirect client.

In the UK, ‘wholesale conduct’ was a clear focus of the FCA during the course of 2014. The FCA launched a range of thematic reviews to address wholesale conduct issues including conflicts of interest and market abuse controls in the investment management industry. Investment managers operating in wholesale markets have to pay close attention to the outputs of these reviews and will be expected to demonstrate to the regulator how they are delivering good consumer outcomes.

Impending regulatory changes provide challenges and opportunities for the investment management industry

In addition to the themes discussed above, another area that that has featured prominently on the agenda of the G20 and global regulatory bodies in the wake of the crisis is addressing systemic risk in the financial sector. This is intended to complement the existing regulatory framework, which addresses market efficiency, transparency and investor protection.

The banking sector was the initial target for global regulators which led to the creation of ‘G-SIFIs’ (Global Systemically Important Financial Institutions) and a shopping list of regulatory measures to make banks safe (for example, the requirement for banks to hold increased capital and higher quality capital under the Capital Requirements Directive, CRD IV) and to make banks safe to fail (for example the requirements for recovery and resolution plans under that Bank Recovery and Resolution Directive, BBRD). These issues have now moved beyond the banking sector and have filtered through to other sectors of the financial services industry including insurers and investment managers.

The Financial Stability Board (FSB) in consultation with the International Organization of Securities Commissions (IOSCO) has commenced work on a methodology to identify systemic entities with respect to investment funds. These developments are still work in progress so it is difficult to predict exactly what the level of impact will be for investment managers. However, if we draw a parallel with the equivalent reforms that are already in place for banks we can anticipate the likely impact. Any bank that has been earmarked as a G-SIFI has an extra layer of regulatory requirements imposed on it such as additional capital buffers, enhanced supervision and enhanced recovery and resolution plans.

Across the Atlantic, rules on money market funds have already come into force. To address sources of systemic risk the European Commission proposed a Regulation on Money Market Funds (MMFs) in September 2013. As the EU Regulation on Money Market Funds goes through the legislative process the jury is still out on whether the 3% capital buffer for constant NAV funds will find its way to the final version of the regulation. If the cash buffer is introduced unchanged it is likely going to mean an end of constant NAV cash funds as investment managers will find it very difficult (and expensive) to meet the requirements for the buffer.

The measures outlined above are already work in progress and with a new Commission and Parliament in Europe we are seeing another shift in the policy debate (now that financial stability is in the process of being tackled), focused on fostering economic growth.

There are various legislative and non-legislative measures that have been proposed to assess Europe’s long term financing needs and the role of non-bank financing is seen as being essential to this agenda. While banks will continue to play a significant role, the diversification of funding sources to include more capital markets-based financing will help the European economy to better withstand future crises. An example of legislative measures is the Regulation on European Long -Term Investment Funds (ELTIFs) which was proposed in June 2013. ELTIFs are designed to increase the amount of non-bank finance available for companies investing in the real economy of the European Union. It is an investment vehicle that will allow professional investors and individuals to invest for the long-term in European non-listed companies and in illiquid assets such as real estate and infrastructure projects. Making ELTIFs available to all types of investors across the European Union is seen as being vital to maximising the pool of capital available to European companies. Any investment manager complying with the rules of the AIFMD will be able to manage an ELTIF.

The diversification of funding sources and the move away from the bank based funding addiction is one of Lord Jonathan Hill’s[2]  top priorities. At the time of writing it is unclear exactly what policy measure a capital markets union will consist of, however, what is clear is that this is potentially exciting news for investment managers, as the sector is viewed as part of a solution that can help stimulate economic growth.

Apart from the regulatory changes outlined in the previous paragraphs(some of which still need to be fully finalised at an EU level and implemented locally) which will carry over into the years ahead, we expect to see an industry –wide drive to raise standards and to restore the trust between clients and investment managers. This direction of travel is unsurprising: the banking industry in the UK has already set the tone for the voluntary raising of standards by with the Banking Standards Review Council. In the investment management sector the raising of standards will be spearheaded by the Investment Association (formerly known as the Investment Management Association) which is due to publish a statement of investment principles during the course of 2015 which we understand will contain less than ten standards. These will not be binding regulations, however, it is expected that most investment management firms will comply with these principles voluntarily. We also understand that the association will ask that firms set up an internal independent panel or to report on compliance.

[1] Note that at the time of writing, the delegated acts and technical standards (the so called Level 2 text)  which will supplement MiFID II are not yet finalised.

[2] The new European Commissioner for financial stability, financial services and capital markets union since 1 November 2014.