Regulation of asset management in the European Union: what the future may bring

Author: | Published: 18 Mar 2015
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Gabriela Diezhandino and Vincent Ingham of the European Fund and Asset Management Association (EFAMA) examine the outlook for European regulation, and resulting implications for the Asset Management industry

With a new European Commission (EC) and European Parliament (EP) recently installed, in 2014, and in the process of defining their work programme for the next five years, we thought it would be an appropriate time to take a prospective look at what this new legislature is expected to bring in terms of regulation of our industry. In our review we make a few observations and recommendations. This chapter does not mean to pre-empt what the EU policymakers will, in the end, decide to propose in terms of new regulation. However, based on what we know today, it seems relatively safe to assume that the regulatory agenda for the investment management industry over the next five years will essentially be driven by two elements: (1) the ambitious agenda of the Juncker's Commission to restore growth and create jobs in Europe, which encompasses what may be a myriad of initiatives, some of them quite far-fetching; and (2) the important – and sometimes underestimated – work that remains to be done to complete and effectively implement the regulatory reforms adopted under the previous Commission.

Taking stock of recent achievements – time for a regulatory pause

Before looking into what may fill the European agenda in the coming months and years, it is worth briefly taking stock of the considerable improvements to the regulatory environment that have been achieved over the last few years. It has often been said, under the previous Parliament's legislature, financial market participants in Europe have been the subjects of exceptionally intense regulatory activity, primarily as a result of the implementation of the G-20 agenda. The objective being to improve the resilience and stability of financial markets worldwide. Even though asset managers – and the products they manage – were not at the root causes of the latest financial crisis, they have been not been excepted, and have been directly and indirectly affected by a wave of regulatory reforms. A number of these reforms still have to be completed, such as the regulation on Money Market Funds.


"The asset management industry is among the most transparent of all financial markets players… The Ucits Key Investor Information Document is often cited as an example in this respect"


We believe that the global net effect of the regulatory changes will be positive for our clients, the end-investors. This gives us good reasons to be reasonably optimistic for the future development of our industry. However, it should also be remembered that adapting to this new regulatory environment remains painful, frustrating and burdensome and our industry has duly taken efforts to adapt, and will continue to do so for a number of years.

In 2013, we celebrated the 25th anniversary of the first registration of an Undertakings in Collective Investment for Transferable Securities (Ucits) fund back in 1988. Since then, much water has flowed under the bridge and the Ucits framework has developed into a true European success story we can be proud of. According to EFAMA statistics, there are approximately 36,000 Ucits operating, accounting for more than €7.8 trillion assets under management, in addition to a worldwide recognised quality label and state of the art regulatory standard for investor protection and international distribution of investment funds. To a large extent, this success is the result of a cleverly designed legal framework that has been regularly updated over time, to reflect the evolutions of the financial markets and of investors' needs, while not compromising on aspects of investor protection. Most recently, the Ucits V review in July 2014, adopted by the European co-legislators, and due to come into effect in March 2016 (after adoption of the implementing acts), marks a new important step in this respect. Drawing on the lessons of the financial crisis, notably the Madoff scandal and the Lehman default, and building on best industry practices, it further clarifies the functions and responsibilities of the depositary in the safekeeping and oversight of Ucits assets, and strengthens the liability standards in case of loss of those assets.

Another major evolution for our industry is the adoption in 2011 of the Alternative Investment Funds Directive (AIFMD). Sometimes erroneously depicted as a hedge fund regulation, it actually covers a much broader variety of investment funds through the regulation of their management companies. Although we are still missing some hindsight at the time of writing (the directive only came into effect in July 2013, and is yet to be implemented in some member states), the AIFMD will undeniably contribute to a greater transparency and a better understanding of a number of investment fund activities that were previously not always sufficiently well regulated. This, in turn, should significantly alleviate regulators' concerns as to the potential systemic relevance of some of those activities, which was one of the key objectives of the Directive.

Such fundamental changes to the regulatory environment under which asset managers are operating take time to be put in place. They should first be properly implemented and their actual impact should be carefully evaluated in practice over a certain period of time before new changes to those overarching regulations can be envisaged. This is why we strongly welcome the call made by many EU-officials and stakeholders representatives for a regulatory pause, as well as the inclusion of better regulation principles at the heart of the new Commission's agenda. A stable and predictable regulatory environment is not only essential to maintain the competitiveness of EU market participants. It is also a must if Ucits are to remain the vehicle of choice for the cross-border distribution of investment funds in Asia and in other parts of the world.

Capital markets union and long-term financing of the economy – asset managers are part of the solution

Let us now turn to the new Commission's plans for the near future. Reflections have begun on what the future outlook for the EU regulatory agenda may look like. Although it is still a concept under construction, there is already a phrase for it: capital markets union.

Europe is facing a big challenge, which may also be a unique opportunity for asset managers. In order to counteract the effects of bank de-leveraging, Europe needs to encourage the financing of its real economy via the capital markets, by increasing their size, putting in place the necessary incentives and making them open to the widest possible range of investors. Market-based financing is indeed one of the key solutions that will enable Europe to get back on track on the road towards growth recovery.

In order to achieve this ambitious but necessary objective, the project for a capital markets union should lead to integrated capital markets in the EU that would unlock capital to invest in businesses, in particular small and medium sized-enterprises (SMEs) and infrastructure in Europe, and reduce the cost of investment funds and pensions savings for investors. Building an effective capital markets union will mean bringing down existing regulatory, or other, barriers to the single capital market in order to allow a better flow of capital within the EU, as this would increase competition and reduce costs to both issuers and investors.

A key initiative in this respect is the European Long-Term Investments Funds (ELTIFs) Regulation, which was adopted by the EU co-legislators at the end of 2014 and should be fully operational in 2016, after adoption of the implementing acts. It aims to set up a legal framework to ensure that investment of patient capital would be encouraged and directed towards infrastructure projects and SMEs that often face difficulties in raising funds in the stock markets, or to secure banking loans. Importantly, the ELTIF initiative also demonstrated a change in attitude towards the asset management industry, as EU policymakers are embracing the opportunities that the asset management industry offers, in terms of supporting sustainable economic growth and recovery.

European asset managers encouraged this initiative and welcomed the agreement between the EU institutions on a regulatory framework for ELTIF. Even though the final text is the result of political compromises and may be lacking the required flexibility in certain aspects – notably in terms of restrictions in the access to retail investors – we see this as a concrete step forward towards meeting Europe's pressing needs for growth and long-term financing. The asset management industry can be part of the solution to long-term financing as it has the potential to broaden its products towards a greater range of investment opportunities, covering asset classes in which households are currently unable to invest directly.

With this new EU regulation, funds that want to benefit from the ELTIF label will have to meet a number of requirements both at the level of their management company, which will be subject to the AIFMD regime, and at the level of the fund itself (ie., eligible assets, diversification rules, product lifetime, redemption rights, etc.). Subject to those strict conditions, asset managers will be able to market the ELTIFs across all EU member states, once they will be approved in their country of domicile.

For ELTIFs to become a market success however, it will be necessary to ensure that the interests and needs of different types of investors are met and that the right incentives are in place. In addition, the implementing measures of the ELTIF framework will be put in place in the coming months of 2015. It will be important to make sure that they are carefully designed so that they do not become unnecessarily restrictive or burdensome.

We also wish to underline here the important link between promoting long-term savings and the development of a capital markets union. We encourage EU policymakers to promote and enhance retirement savings, as our industry does. This would, in turn, increase the amount of capital that would be readily available to be channeled towards long-term investment in the EU economy, ie., businesses, SMEs, infrastructure investments, and so on.

Completing and implementing the regulatory reforms – the devil is in the details

As already mentioned in the introduction, a significant part of the work programme of the new Commission – at least for the first part of its mandate – will consist of completing the regulatory reforms of financial services that were adopted under the previous legislature so that they can be effectively implemented in each member state. A considerable number of Level 1 regulations and directives have been voted or revised over the last years (such as Markets in Financial Instruments Directive (MiFID II), Emir, Ucits V or PRIIPs, to name but a few) but still have to be further detailed by implementing acts before they become fully effective. The importance of this technical work, which has already started with the involvement of the European Supervisory Authorities (Esma, EBA and EIOPA), cannot be underestimated. Important choices remain to be made in this context that will ultimately condition the success of the reforms that have been engaged. Great care should be taken in particular not to undermine, through the implementing measures, the political choices that were made when the Level 1 texts were negotiated.

We cannot discuss here the details of all the implementing measures that still need to be adopted. But, from an asset managers' perspective, we would like to highlight two concerns that these implementing acts could help to address: (1) the perceived lack of transparency of our industry; and (2) the need for a level playing field between comparable investment products.

Transparency

Arguably, the asset management industry is among the most transparent of all financial markets players, certainly when it comes to retail products. The Key Investor Information Document (KIID), which each Ucits produces, is often cited as an example in this respect and more detailed information can be found in the funds' prospectus, its annual reports, and on the website of the management company. Alternative Investment Funds are also subject to specific disclosure obligations towards their investors. In spite of this wealth of available information on the products it manages, our industry needs to recognise that there is often insufficient knowledge about the nature of its business model, among peer financial sectors, consumers and policymakers. This inevitably leads to a number of misconceptions (for instance, on the costs and charges of our products) and may also explain a certain lack of trust from investors. We know we need to do more to explain better what we do and address those negative perceptions.


"When products are similar, as are fund and insurance-based investment products, they should be subject to the same rules. … retail investors must receive the same high level of protection"


Against this background, we strongly welcomed the adoption in 2014 of the EU Regulation on Packaged Retail and Insurance-based Investment Products (PRIIPs) that aims to provide enhanced protection to retail investors with clear and consumer-friendly pre-sales disclosures.

Provided that its details are properly designed, PRIIPs will help in promoting and enhancing transparency and comparability of investment products, and will increase the protection of retail investors. European supervisory authorities have started to work on the details of the implementing measures of this regulation, in particular on a PRIIPs Key Information Document (KID). The asset management industry will actively contribute to this work stream and we will gladly share our experience with the Ucits KIID, which we believe is a successful benchmark. In this exercise, the focus should be on making sure that the PRIIPs KIID exclusively contains information that is necessary for retail clients to make an informed investment decision, bearing in mind that too much information may also be extremely confusing for the average investor. Inconsistent or overlapping requirements should also be avoided, as may be the case with conflicting cost disclosures between MiFID II and PRIIPs, for instance.

Similarly, the asset management industry also embraced another crucial piece of EU legislation adopted in 2014 after long negotiations: the Markets in Financial Instruments Directive (also known as MiFID II, as it revised an earlier version). Its fundamental objective was to set high consumer protection standards for financial, including fund, products. For this Directive as well, the EU is currently working on the implementing measures. Without going into the details, the priority here should be to ensure that those measures will remain in line with the spirit and the letter of the Level 1 Directive.

Regulatory level playing field between comparable products

A point asset managers have stressed over the years is the need to ensure a regulatory level playing field among similar retail investment products. The PRIIPs regulation defines what those similar products are: it comprises all retail products with an investment component, and may take the form of investment funds, structured, insurance-based investment or similar products. Such offerings are comparable investment products and therefore in nature substitutable.

When products are similar, as are fund and insurance-based investment products, they should be subject to the same rules. Put differently, what is good for consumers and users of one financial sector is good for those of other sectors as well. Regardless of who provides the investment-type product, be it an insurance company, a fund company or any other entity, retail investors must receive the same high level of protection.

The problem we are facing here is that there is no single EU legislation dealing with investor protection issues on a horizontal basis. The EU legal framework for the conduct of business and investor protection rules, for products with an investment component, is somewhat confusing because two separate directives govern similar investment products. Those are MiFID II and the Insurance Mediation Directive (IMD II). But a sectorial approach should not be a reason to create an unlevel playing field for different type of PRIIPs.

In this context, we continue to see with concern that the EU is building parallel but inconsistent regimes. Consumers choosing insurance-based investment products (covered in IMD II) may end up having lower levels of investor protection compared to the protection that MiFID II offers to consumers buying fund products. This is worrying because whatever the regime, and whatever the distribution channel, retail consumers deserve to benefit from the same high level of investor protection standards for the investment-like products they wish to buy. This is the level playing field that EU legislators should agree to, in particular with regards to the rules governing inducements and conflicts of interest. And the way that the IMD II proposal is currently being re-written means that this may simply not be the case.

Are asset managers a source of systemic risk?

We cannot conclude this overview without briefly mentioning the ongoing debate on the potential systemic relevance of investment funds or asset managers.

The identification of sources and transmission of systemic risk in the broader financial ecosystem, beyond the banking and insurance sector, is an important step towards strengthening the stability and the resilience of the global financial system. It will improve the investment climate for the pensioners, and savings that the asset management industry serves. We therefore welcome the efforts undertaken by a number of international bodies, in particular the Financial Stability Board (FSB) and International Organisation of Securities Commissions (IOSCO), to identify financial entities that might cause financial instability should they fail.

Having said this, we strongly believe that asset managers cannot be regarded as a source of systemic risk for the simple reason that their business model requires them to act as agents for their clients and not trade on own account. Asset managers do not take any major risks on their own books when conducting their investment activities. Clients' assets are invariably segregated and placed with a custodian, which means they are not on the asset managers' balance sheet, thus are not affected by the asset management firm's insolvency.

We are also convinced that investment funds themselves are not systemically relevant either, except perhaps for those that are highly leveraged (as this is the only possible contagion factor we see). This excludes de facto all Ucits funds because of the leverage limits to which they are subject, as well as all AIFs that are not substantially leveraged.

A related point for the future agenda, in line with G20 discussions, is the issue of resolution mechanisms in case of failure. The EU institutions have begun in the last few years to talk about recovery and resolution mechanisms for banks. This is a welcomed initiative, as it aims to minimise the risk of systemic contagion and enhance the stability of financial markets. In Europe, this is achieved through strengthened supervisory cooperation on a cross-border basis, greater integration and harmonisation of EU rules on preparatory and preventative measures, early intervention, resolution tools and powers.

Authors

Gabriela Diezhandino
Director of Public Policy


Vincent Ingham
Director of Regulatory Policy

European Funds and Management Association (EFAMA)
47 Rue Montoyer
1000 Brussels, Belgium
T:+ + 32 2 513 39 69
F:+ 32 2 513 26 43
E: info@efama.org
W: www.efama.org

A regulatory regime on such recovery and resolution measures exists for the banks. It was one of the last key measures adopted by the European Parliament before it broke off for the European elections in 2014. The new European Commission will now resume discussions and will propose a similar regulatory framework for financial institutions other than banks. The Commission has already announced its first target will be Central Counterparties (CCPs).

Conclusion

Despite a number of calls for a pause in the regulatory agenda, the coming years are likely to remain pretty busy for lawyers interested in the developments of the regulation concerning the asset management industry. The plans that the new Commission is progressively unveiling – in particular in relation to the capital markets union and the long-term financing of the economy – are promising, and could help foster the expected growth of our industry. We are looking forward to actively and constructively take part in this debate.