EU Fund Management: The Changing Regulatory Landscape
Sarah Jane Leake | Bloomberg Law
In a recent speech given at the annual Terrapin Hedge conference, Sheila Nicoll, Director of Conduct Policy at the Financial Services Authority (FSA), discussed the changing regulatory landscape for the EU fund management sector and sought to reassure stakeholders that regulatory intervention is not unnecessary “interference,” but part of an agenda to better protect investors and maintain financial stability.
In view of the volume of regulatory developments that have emerged over the past two years, Nicoll is not surprised that those in the sector feel over-regulated by what they perceive to be unnecessarily burdensome requirements and are, arguably, hostile to further change.
Alternative Investment Fund Managers Directive
While the Alternative Investment Fund Managers Directive1 (AIFM Directive) was adopted over 30 months ago, much of the detail still needs to be finalised. The European Securities and Markets Authority (ESMA), notes Nicoll, is currently working on content of the AIFM Directive’s implementing measures, following extensive consultation over the summer,2 and is due to present its advice to the Commission by 16 November. Recognising that the legislation was negotiated and adopted in a highly charged political environment, Nicoll acknowledges that regulators, industry and consumer representatives in all 27 Member States are unlikely to unanimously agree on all issues all of the time.
Depositary liability3 has proven the most controversial aspect of the new AIFM regime. Under the Directive, depositary liability will arise in the event of failure, negligence, or loss of a financial instrument held in custody by a depositary or a sub-custodian. Nicoll notes that depositary liability in the event of loss “remains a sensitive issue for ESMA” and confirms that “ESMA has been treading carefully” in this regard. Over the past few months, ESMA has been working on defining “acts or omissions” by the depositary, with a view to providing further advice to the Commission on this issue. Its focus in the next few months will be on how such acts or omissions will apply in cases of insolvency and fraud. Nicoll stresses the importance of developing a balanced piece of advice – while stakeholder input is important, the principles agreed to during the initial negotiation stage must also be respected.
Equally as contentious are the AIFM Directive’s provisions on leverage.4 AIFMs will be required to set limits for the use of leverage, and regulators will, in certain circumstances, be able to step in and impose prescribed limits where considered necessary to maintain market stability.5 While the concept of leverage ratios and backstops will be all too familiar to those in the banking sector, Nicoll appreciates that those in the fund management sector have not to date been subject to regulation in this area. Clarity is therefore key. Nicoll stresses that “neither the industry nor the FSA will benefit from a poorly defined framework.” To avoid any ambiguity in this area, one option that is looking increasingly favourable given the time constraints is for ESMA to develop further guidelines at a later date, providing more detailed definitions and calculations with regard to leverage.
The treatment of third country AIFs and AIFMs under the Directive has also sparked significant controversy.6 Particular concern has arisen with regard to the scope of the equivalence assessment for the delegation of functions and the appointment of depositaries outside the EU. In this regard, ESMA, in developing its advice, has had to ensure consistency with international standards, especially, for example, the co-operation agreements in place between regulators. Nicoll reaffirms the FSA’s continued support for an approach that acknowledges the global nature of the alternative investment sector. To her mind, this includes “fully embracing” international standards developed by the International Organization of Securities Commissions and other international standard-setters, but “not doing so in a discriminatory or protectionist way.”
Nicoll urges her audience to remember that “ESMA’s advice is by no means the end of the process.” It is inevitable that there will, at some stage, be changes to ESMA’s proposals before they are formally adopted – whether by the European Council of Ministers, the European Parliament, or the Commission itself.
MiFID II,7 published only weeks ago, will overhaul the way in which Europe’s markets operate and investment services are provided.
In addition to covering market issues, MiFID II will also deal with the way in which conduct of business standards are regulated, including a number of issues that the FSA has recently been tackling through its Retail Distribution Review (RDR)8(e.g., investment adviser independence). Nicoll is pleased to note many crossovers and compatibilities between the two. For example, while MiFID II would, if adopted, ban commissions set by firms operating on an “independent” basis, the RDR will already have banned inducements for all firms that give advice by the time MiFID II comes into force. In Nicoll’s view, the concerns that led the FSA to develop the RDR “remain valid” and anticipates that other Member States may similarly impose super-equivalent provisions in due course.
The main impetus for change, explains Nicoll, was that MiFID failed to keep pace with market developments. MiFID II therefore proposes extending the scope of the regime to capture a wider range of instruments and types of trading systems. The FSA, in particular, lends its support to the Commission’s effort to bring algorithmic trading within the scope of the MiFID regime, considering it “vital” to the efficiency, orderly functioning and resilience of today’s markets.
Today, a significant amount of trading, particularly over-the-counter (OTC) takes place outside of MiFID venues on alternative platforms (e.g., broker crossing networks). To address this problem, MiFID II would introduce a new category of platform – the organised trading facility (OTF). While the OTF category will purposely be defined in a very broad fashion, intended to capture all forms of organised trading, Nicoll expresses concern that the category will be too broad in scope. “There is a significant risk,” she opines, “that it will capture forms of trading that are not truly ‘organised’ or venue-like.”
Given the volume and nature of the proposals, Nicoll anticipates that MiFID II is unlikely to come into force before 2016. Although this may seem like an age away, she stresses that it is important to be “collectively and constructively involved and engaged in the debate from the start.”
Despite the disparity of views on regulatory reform, at both European and national level, Nicoll considers it remains important that “together we have a constructive engagement and aim to build a stronger relationship.” Without it, the UK’s reputation as one of the world’s leading financial centres is at risk.
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