Tailoring funds regulation following Brexit Consumer, political and regulatory opportunities in the funds sector

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Dinah McDonald
5 years ago
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The regulatory position for non-eu marketed products and services must also be a priority.

1 Consumer, political and regulatory opportunities in the funds sector The debate on the future of financial services regulation has focussed on the terms of access to the European Union (EU). The regulatory position for non-eu marketed products and services must also be a priority. While managing a smooth transition to a post-eu rulebook is likely to involve many EU regulations being carried over into the new environment, the new regulatory framework must nonetheless allow the UK to regulate its domestic market independently in the future. 80% of assets managed in the UK are managed on behalf of UK or overseas clients not in the EU. It should not be assumed that firms that do not sell goods or services into the EU must permanently comply with EU-derived rules. EU obligations should only apply where a provider takes a commercial decision to sell to EU customers: firms would then opt-in to EU regulations as required ( opt-in approach ). This framework will deliver substantial long-term benefits. UK policymakers will be able to maintain investor protection standards that achieve their own regulatory and political priorities. This offers the possibility of better targeted, proportionate regulation, lower compliance costs and keener product pricing. It will allow the UK to maximise the competitiveness of the funds sector. In turn this will help maintain and grow UK employment and Government tax receipts arising from fund management activities. Providers will be empowered to make a commercial decision to access EU markets and opt-in to EU rules. Many firms, particularly smaller businesses focussed on the UK, may conclude that cost of complying with EU rules does not provide compensating benefits. The opt-in approach will ensure the UK s regulatory framework matches costs with benefits and will make the market more competitive. Delivering these benefits represents a Brexit dividend for the UK and the funds sector. Allowing the UK to determine its own standards for funds not marketed into the EU is a politically realistic proposition. This opt-in approach is already embedded in the EU s rules. This proposal is consistent with seeking to maximise access to EU investors, whether this is on an equivalence or passported basis. The opportunity to reform the application of the Alternative Investment Fund Manager (AIFM) Directive demonstrates how the UK rulebook could be tailored to meet domestic consumer, regulatory and political objectives. Targeted reforms of the AIFM Directive, or even its abolition, could maintain regulatory standards and increase UK competitiveness. Taking steps to reform or remove the AIFM Directive would be a striking political statement of the UK s intention to deliver a Brexit dividend. 1

2 A better outcome for consumers Ensuring that UK policymakers can set rules for the non-eu funds market will mean that investor protection can be maintained according to domestic political and regulatory objectives. UK regulators will be able to make swift and targeted interventions as the need arises. This process will recognise the specific characteristics of UK product and investment markets. Traditionally EU rulemaking has favoured a narrow range of funds, particularly UCITS, and distribution via banks and insurers. Many UK retail investors hold a wider range of funds, including investment companies (closed-ended funds, structured as companies with their shares traded on public stock markets). They often purchase them via independent advisers or through other non-advised routes (such as fund platforms or brokers). This market has delivered high levels of competition, which has been further stimulated by recent reforms to distribution (introduced by the Retail Distribution Review). This environment offers the potential for competition in the consumer interest where individuals are able to acquire better products, more keenly priced. EU rulemaking is less able to accommodate the specific needs of UK consumers. This can be seen in the challenge of introducing Key Information Documents (KIDs) for all investment products for retail consumers. Clear and comparable pre-sale disclosure for investment products may be desirable but the KIDs framework will struggle to deliver the best outcome. It must cover products available in 27 countries as well as the UK. The rules prevent a major fund sector (UCITS) from making comparable disclosures until January Maintaining two disclosure regimes will mean consumers will receive standardised disclosures which may seem to provide comparable information but which, in reality, do not. Concerns about the Commission s proposed methodology for preparing KIDs have seen these requirements delayed. It remains unclear whether the final rules will provide suitable disclosures. Creating a UK-specific approach will allow policymakers to recognise the specific circumstances of the domestic market and deliver the best possible pre-sale consumer information. Under the proposed framework policymakers will be able to respond quickly to threats to the consumer interest. They will not be delayed by the need to bring together the European Commission, other Member States and the European Parliament to agree a response. Where regulatory intervention is required, objectives will be translated into rules using the substantial technical expertise and market insight of UK regulators. Rules will not be compromised by the need to recognise the priorities of other jurisdictions. The process can rely on established mechanisms to gather the views of all stakeholders. Rules will be clearer, and conform to UK legal norms, reducing regulatory uncertainty. Consumers will benefit as there will be less risk of unclear requirements and more effective supervision. Better targeted, proportionate regulation will reduce compliance costs and support keener product pricing. This could produce major long-term consumer benefits, particularly if investment returns are low or less certain. Competition can be increased by reducing barriers to entry. Investors will benefit as firms seek market share on the basis of higher quality products and delivering better returns. More regulatory flexibility can also enable innovation. The Financial Conduct Authority s Project Innovate seeks to remove regulatory barriers to The Association of Investment Companies is on the EU Transparency Register; registration number:

3 allow providers to reach customers in new ways. Interventions of this type can be more ambitious if the need to comply with EU rules is removed. Securing UK employment and tax revenues In 2014 the investment management industry represented around 1% of UK economic activity and contributed a similar proportion of tax revenues. At the end of 2015, 62% of assets managed in the UK were managed on behalf of UK clients. A further 17% were managed on behalf of non-eu clients. While access to EU clients is clearly important, it is not the most significant part of the funds and asset management market. Ensuring that UK policymakers can regulate non-eu activity following Brexit will create opportunities to support and bolster economic activity within the UK. Under the current arrangements UK fund managers have to comply with EU obligations whether or not they market into other Member States. The closed-ended, quoted investment company sector is 95% held by UK shareholders. Many individual investment companies have no non-uk investors. These funds are within scope of the AIFM Directive, which regulates the marketing and management of non-ucits funds within the EU. While AIFMs with small amounts of assets under management can secure a less onerous regulatory regime, the full rulebook is imposed, without any derogation, on most UK domiciled investment companies. This would be the case even where the AIFM, which may also have regulatory responsibilities for other types of fund, does not market them into other Member States. By way of contrast, non-eu funds (say American funds with American managers) can be marketed to UK investors without this compliance burden being imposed. The opt-in approach would make the UK funds sector more competitive. EU obligations would only be imposed if the provider marketed into the EU or if compliance was required to secure equivalent standards as a condition for providing services to EU clients or to operate a delegated mandate. The calculation of whether this would be a worthwhile price to pay would be made by the provider. This approach automatically meets any cost-benefit or regulatory impact assessment. The application of UK rules would not be optional. While these could be onerous in some aspects, we would anticipate that they would have a proper regulatory justification and would be proportionate and sympathetic to the specific circumstances of UK providers. Applying the AIFM Directive to UK providers after Brexit will mean that the UK manager of a non-eu, non-uk fund which is entirely held by non-eu investors, would potentially have to comply with the full EU rulebook. The justification for applying the rules in this way, rather than complying with the regulatory obligations imposed according to UK requirements and in the jurisdiction of the fund, is unclear. Many providers, particularly smaller, UK-focussed firms, may conclude that the cost of complying with EU rules does not provide sufficient benefits. The AIFM Directive passport, for example, provides no automatic right to sell to retail investors, a key source of demand for the investment company sector. Even for institutional fund sales the market is fragmented, with each Member State able to impose additional rules, regulatory fees, and administration arrangements. Other barriers arise because of local market structures and tax treatments of 3

4 funds. Similar issues arise for UCITS. While access to the EU may be of value to some UK providers, it is not for all. An opt-in model maximises the UK s potential to sustain mutually beneficial commercial relationships. A growing part of the investment company sector, for instance, is domiciled in the Channel Islands. These companies customarily employ asset managers and professional advisers based in the UK. Their shares are admitted to trading on UK markets and distributed by UK firms. A more sympathetic regulatory environment will allow UK providers to offer more attractive terms to overseas clients. In turn, those entities will be able offer a more attractive propositions to their investors. Increased UK competitiveness will sustain these mutually beneficial links and help retain key activities within the UK. It will support public policy in relation to sustaining employment and raising tax revenues. A realistic and achievable objective Achieving an opt-in approach is a politically realistic proposition. It is already allowed by EU s rules. It is the basis on which non-eu firms seek to actively market funds into EU markets under the AIFM Directive. This model for funds regulation removes the need to negotiate a special arrangement for the sector. It will allow the UK to prioritise other objectives for the funds sector. This might include, for example, securing grandfathering/transitional arrangements for UCITS managed by UK firms. The opt-in approach also fits with any ambitions the UK has to secure a sector-by-sector settlement. Banking, for example, may have other ambitions given the relative importance of EU markets to these providers. This proposal is consistent with seeking to maximise access to EU investors, whether this is on an equivalence or passported basis. UK providers will have systems in place to ensure compliance at the time the UK leaves the EU. If further regulatory requirements are created at an EU level in the future, these can be added to the opt-in rulebook as required. Following the UK s departure from the EU we would envisage a process of consultation and reform to refocus the rules that will apply where firms are not selling into the EU. This will not conflict with maintaining whatever standards are required for EU access. Maintaining the UK s position as a rule-maker will also ensure that domestic regulatory authorities remain influential in setting global standards for regulation. Practical considerations The opt-in approach will mean regulated entities have to take a view on how to take advantage of the flexibility that would be made available to them. This may create commercial dilemmas for some providers but creating choice should not be seen as a downside. Creating options avoids the greater risk that significant consumer benefits and competitive advantages would be forgone by implementing a one-size-fits all rulebook. The Association of Investment Companies is on the EU Transparency Register; registration number:

5 In any event, providers in the UK are already required to deal with myriad, complicated, regulatory obligations. Depending on the services/products they offer, a single commercial entity may have to comply with the AIFM Directive, UCITS and MiFID. Each item of regulation potentially creates the need for separate structures and compliance systems. In principle an opt-in model is no different, except that it offers the opportunity for a streamlined, more proportionate approach for providers not servicing EU investors. For those entities the model offers the potential for less regulatory complexity, not more. Under an opt-in approach UK regulators will have to develop a separate standard, and police the boundary, but this is a continuation of current regulatory practices. For example, the AIFM Directive allows different standards for non-eu AIFMs marketing into the UK. It has separate rules for small registered AIFMs. It imposes yet another set of obligations on AIFMs within the full scope of the Directive. The UK also applies different rules where shares are quoted on different public markets with different regulatory standards (including standard and premium listings and lower obligations imposed on the Alternative Investment Market). The opt-in model is, in its fundamental elements, no different. Opportunities to streamline regulation: focus on the AIFM Directive The immediate challenge of transitioning to a post-eu environment will see most existing EU requirements carried over into UK rules. Many of these measures deliver broad UK regulatory priorities in relation to consumer protection, maintaining orderly markets etc. This makes it unlikely that EU rules will be immediately disapplied on a wholesale basis. There are nonetheless opportunities to make the UK rules better targeted and more proportionate. The AIFM Directive offers a good example as it includes obligations which have no discernible regulatory value in a UK context (particularly not in an investment company context). The AIFM Directive s introduction reflected the political and regulatory concerns of other Member States. The UK did not share these concerns. Its own rulebook already regulated hedge fund and private equity managers, which were a primary target of the regime. A key UK priority when this legislation was being introduced was to manage the technical challenges and reduce the potential harm the proposals implied for UK financial services. Critically, in early discussions over the scope of the AIFM Directive, HM Treasury supported excluding investment companies from the scope of the legislation. It took up an AIC proposal that alternative investment funds with the capacity to govern their own activities, and whose shares were subject to an official listing on a regulated stock exchange situated or operating within a Member State, should not be included. This was justified as other legislation already regulated these entities. This meant that they did not pose the regulatory risks identified by the European Commission. These arguments were not accepted and, in the event, investment companies were not excluded from scope of the AIFM Directive. 5

6 The AIFM Directive is a clear candidate for review as part of the process of transition or immediately after the UK s withdrawal. Options for targeted reforms include (but are not limited to): abolishing the private equity requirements: The AIFM Directive imposes obligations on funds where they take over private companies. It is unclear why these measures have been included in rules seeking to manage regulatory risks arising from the fund sector. If UK policymakers think these obligations are appropriate for other public policy reasons, then they should be applied to all buyers of unlisted companies (such as other listed and unlisted businesses, sovereign wealth funds etc.) Otherwise, this compliance burden should be removed. depositories: The depositary requirement increases costs with no clear consumer value. The oversight function, for instance, is particularly difficult to justify in an investment company context where an independent board already has responsibilities to shareholders. At the very least the rules could be tailored to remove complexity regarding delegation of depository functions or to limit custody obligations to AIFs with traded securities. scope of exemptions: Smaller AIFMs are exempt from many obligations. The justification is that they are not systemically relevant and that they do not have permissions to market across EU borders. The size thresholds are very low ( 100m for AIFMs managing leveraged funds and 500m for unleveraged funds). These exemptions could be simplified and increased: for example, creating a single small AIFM threshold at, say, 5 billion and allowing for 100% leverage before the full obligations apply. There might be scope to increase this suggested threshold even further as asset managers considerably larger than this are unlikely to be considered systemically relevant. However, rather than making targeted changes, the AIC recommends a more ambitious approach. When considered as a whole, it is difficult to see that the AIFM Directive provides any material regulatory benefits. UK regulators do not consider that full AIFM Directive compliance is required to deliver domestic regulatory priorities. Non-EU AIFMs offering non- EU AIFs in the UK do not have the full obligations imposed. Smaller domestic AIFMs are similarly exempted from many of the obligations. There is no clear regulatory justification for imposing the full obligations imposed on larger UK AIFM simply because they breach a certain asset threshold. Their location in the UK would not be a factor which justifies imposing more obligations than on their non-eu competitors. The AIC recommends that consideration be given to abolishing the AIFM Directive in its entirety for providers not marketing funds into the EU. The UK would then be free to introduce specific, targeted measures, following consultation, if any were considered necessary. Radically reforming or abolishing the AIFM Directive would reduce unnecessary costs, help deliver keener product pricing for investors and increase the global competitiveness of the UK as a location for funds and asset management. It could also increase the competitiveness of funds marketed into the EU by UK AIFMs under the private placement rules. The Association of Investment Companies is on the EU Transparency Register; registration number:

7 Taking steps to abolish the AIFM Directive, in whole or in part, would also be a striking political signal of the UK s intention to deliver a Brexit dividend to financial services while still maintaining standards and enhancing the UK s competitiveness as a centre for funds and asset management. November 2016 To discuss the issues raised in this paper please contact: Guy Rainbird, Public Affairs Director guy.rainbird@theaic.co.uk,

Implementing measures on the Alternative Investment Fund Managers Directive: CESR call for evidence

Implementing measures on the Alternative Investment Fund Managers Directive: CESR call for evidence Initial submission by the Association of Investment Companies The Association of Investment Companies