UK/EU Investment Management Update

The UK’s access to EU financial markets will not form part of the upcoming trade talks. As for equivalence for financial services (e.g., under MiFID II), on February 25, 2020, the commission updated its Q&A on the Future EU-UK Partnership; the Q&A states, bluntly:

The granting (or not granting) of equivalence is a unilateral measure by the EU. Equivalence can be withdrawn at any time. Decisions should be reciprocal.

By contrast, the UK is seeking a legally binding equivalence framework.

The commission aims to complete the equivalence assessment for the UK by June 2020, as set out in the UK/EU Withdrawal Agreement. In the meantime, the EU and UK will continue to discuss areas that are covered by the trade talks such as goods, security, movement of citizens and fisheries.

UK FCA – considerations for UK firms

On February 18, 2020, the FCA updated its web page Considerations for UK firms after the transition period, which sets out questions for firms to assess the impact that the end of the transition period (December 31, 2020) may have on their business. The FCA, however, provided additional commentary on the following considerations:

• Engaging with non-UK regulators: Firms should be prepared to discuss their plans with European regulators to ensure that they are ready and able to continue servicing European Economic Area (EEA) customers after the transition period ends. In turn, firms should also be prepared for European regulators making direct contact with them about their intentions. Firms should act lawfully and respond appropriately and in a timely manner with European regulators as they would with the FCA.
• Servicing EEA customers: Firms should be prepared for the possibility that not all of their activities may be covered by the arrangements agreed between the UK and the EU on January 1, 2020. The FCA reminds that decision-making should be guided by achieving the right outcome for customers, which involves treating them fairly irrespective of where they are located. In particular, choosing to stop servicing the consumer may cause significant consumer harm.
• Outsourcing: Firms will need a clear understanding of their dependencies on outsourcing or third-party service providers in order to assess whether the firm will be able to continue accessing such services after the transition period.

ECB’s Brexit preparation warning

On February 12, 2020, the European Central Bank (ECB) published a supervisory review, which noted that some UK banks still needed to take “substantial action” to implement their post-Brexit operating models. While the review is targeted at banks, the ECB’s message presents similar considerations to investment firms.

The ECB set out a few concerns for banks looking to revise their business models, which may also be relevant for investment funds by analogy:

• Branches in countries outside of the EU (e.g., the UK post-Brexit) should be used to meet local needs and not to perform critical functions or provide services to EU-based customers.
• Undue complexities in cross-border business models should be avoided (e.g., splitting a trading desk across multiple legal entities according to specific product characteristic would not be an acceptable practice).
• A qualitative approach to compliance should be taken (e.g., a firm should not merely transfer a certain number of staff but also employees with appropriate levels of seniority and skills).

The above, along with the European Securities and Markets Authority’s (ESMA) previous Opinions on firms’ relocations post-Brexit, makes clear that, for example, an Irish or Luxembourg MiFID firm or alternative investment fund manager (AIFM) will generally not be able to establish a small entity in Ireland/Luxembourg and then have people working in a branch in the UK, from which UK staff will deal with EU27 clients/investors.

The figures reinforce the FCA’s previous observations (e.g., in this speech) that the number of fixed-income STORs is very small compared with equities STORs; in any given month, there were on average 10 times as many equities STORs as fixed-income STORs.

FCA’s strategic approach

On February 6, 2020, Mark Edward, the FCA’s executive director for enforcement and market oversight, delivered a speech on the FCA’s strategic approach to market abuse. The key takeaways are as follows:

• International investigations. The FCA is taking a collaborative approach with U.S. and EU authorities to investigate several market abuse investigations involving trading across the countries.
• Abusive share-trading. The FCA has been investigating substantial and abusive share-trading, which has supported tax-avoidance schemes. It will soon issue its decisions.
• Market cleanliness. The 2019 figure for the FCA’s internal market cleanliness metric is at its lowest score of 10 % (compared with 2008, when it found that 30 % of takeovers showed abnormal price movements in the days prior to an announcement).
• Improved market enforcement efforts. The FCA has been putting more effort into its market integrity efforts, which involve primary and secondary oversight, surveillance and wholesale supervision.
• Market manipulation. The FCA is also prepared to tackle market manipulation cases, which are often more complex and difficult to investigate than insider dealing. There are two significant ongoing cases in which false and misleading statements had contributed to the destruction of considerable shareholder value.

• Priorities and milestones. The FCA has recently published guidance on LIBOR transition planning targets in 2020, which apply to asset managers and may be useful for transition plans. It notes the following milestones for asset managers in particular:
  • Now: Firms with LIBOR exposures or dependencies (e.g., LIBOR-referencing instruments or systems used for valuation measurement) that do not have a transition place should act now.
  • ASAP: Firms should consider switching from LIBOR swaps to sterling overnight index average (SONIA) swaps for new positions where possible.
  • End of Q3 2020: Firms should consider not making any new investments in GBP LIBOR-based cash products maturing beyond 2021 by this point.
  • End of Q3 2020: Firms may wish to cease launching new products with benchmarks or performance fees linked to LIBOR by this point

• Products and services. Firms should consider whether any existing LIBOR-exposed products or services will continue to meet the needs of clients, perform adequately or comply with product governance rules after 2021. For example, the FCA suggests that firms should engage with issuers and counterparties to convert any LIBOR-referencing instruments and pursue instruments that reference alternative rates or have fallback provisions.
• Governance and planning. Firms should establish a proportionate transition plan that is supervised by its governing board in addition to second and third lines of defense. There should be clear lines of accountability as well as statements of responsibility.
  
  

In relation to the investment management sector, the FCA noted that harm to the sector mainly comes from six areas:

1. pricing and quality of investment management products
2. operational resilience
3. disorderly markets
4. market abuse
5. pricing and quality of institutional intermediary services
6. pricing and quality of custody and investment administration services

The FCA says that it is most concerned with the first two areas of harm. We have set out a summary of the FCA’s key findings on those two areas:

• Pricing and quality of investment products: It observed that many drivers (e.g., poor governance practices in firms) resulted in investors’ making poor investments that diverged from their objectives or overpaying for such investments. In addition, their Asset Management Market Study observed that there was weak price competition in parts of the industry, no clear relationship between fees and performance and a lack of transparency on pricing. However, FCA hopes that recent regulations will continue to reduce this harm.
• Operational resilience: In 2019, 50 technology and cyber incidents were reported to the FCA within the investment management sector compared with 26 in 2018. The FCA highlighted that poor operational resilience against technological disruptions or cybercrime could lead to widespread market disruption, which prevents firms from investing, or limits investors access to their capital. It cautioned against poor governance and management of outsourced functions, use of legacy IT systems with poor cybersecurity and a lack of contingency plans for disruptions. 

In relation to market abuse, the FCA notes:

One issue in this sector is that a high proportion of asset management firms’ income and individual employees’ remuneration comes from performance fees. These fees can be significant and can create incentives to commit market abuse.

Risks of algorithmic and AI-based trading

The Sector Views 2020 report also took particular interest in the risks arising from the increased use of artificial intelligence (AI) and algorithmic-based trading, warning that it could lead to systemic market failures. It observed that an increasing number of fund managers are looking to increase spending on such technologies to automate certain parts of their operations and gain efficiencies. However, the FCA cautioned that firms using the same technologies may inadvertently follow “herd behavior” and make similar trading decisions across the market. In addition, an overreliance on such technologies could expose the market to potential flash crashes caused by an algorithm fail or technology outages (the FCA saw a 7% increase in outages in 2019 compared with 2018). While the FCA praised AI innovations in managing regulatory compliance, it noted that the industry will need to do “significantly more” to deal with cyberthreats.

One of such problematic misalignments involves the treatment of financial counterparties (FCs) that have low derivatives activity and are seen to pose a relatively insignificant risk to financial stability. EMIR REFIT introduced a new class of entity for parties in such a position: “FC-”. FC-s would be able to choose to not centrally clear their over-the-counter derivative transactions, provided that they exchange collateral on a bilateral basis. However, this new exemption created a mismatch between EMIR and MiFID requirements. While FC-s are now exempt from the central clearing obligation by virtue of EMIR REFIT, they are still subject to the MiFID II derivatives trading obligation (DTO), that is, the obligation to execute mandated derivatives transactions on regulated trading venues.

ESMA’s Final Report now recommends that the scope of MiFID II’s DTO be brought in line with the scope of the clearing obligation under EMIR such that FC- are also exempt from the DTO. The Final Report has been submitted to the European Commission and is expected to feed into the report that the commission will prepare for the European Parliament and the council on the need of aligning the trading and clearing obligations on derivatives under MiFIR and EMIR (as amended by EMIR REFIT). The commission’s report is expected to be delivered by December 18, 2020.

Common supervisory action on suitability rules

ESMA will be launching a common supervisory action (CSA) with national regulators on the application of MiFID II suitability rules over the course of 2020. We note, however, that this will primarily affect investment firms that deal with retail clients rather than professional clients. The CSA’s focus will be on how MiFID II’s requirements on suitability assessments are applied (e.g., how investment firms take investment product costs into account when recommending a product to clients). The intention behind this initiative is to ensure consistent implementation and application of the rules and develop the supervisory approaches of national regulators in line with ESMA objectives.

It is worth noting that on February 5, 2020, the European Systemic Risk Board (ESRB) had published a separate letter to the European Commission on the shortcomings of the AIFMD framework. The ESRB identified the following key areas for improvement in AIFMD reporting (referring to AIFMD Annex IV reporting):

• Availability of unique fund identifiers: More funds should have a legal entity identifier (LEI). The ESRB noted that around half of funds reporting under AIFMD do not report or possess a LEI.
• Fund classification: There should be a better classification system for fund net asset values rather than relying on using the “other” category.
• Information on funds’ interconnectedness: Regulators should receive a more complete breakdown of portfolio holdings from fund managers (rather than on an aggregate level) and geographical exposures.
• Information on leverage: Funds should revise current metrics and reporting of leverage.
• Information on liquidity risks: Regulators should receive more information on liquidity management tools that are available to fund managers and more guidelines on how asset managers should determine the liquidity profile of portfolios.
• Aligning reporting frameworks: Regulators should ensure that frameworks across member states are aligned on reporting frequencies and have access to all relevant data.

The ESRB also noted that the need to operationalize existing macroprudential policy instruments and made reference to the ongoing development of the macroprudential policy framework “beyond banking.” For investment funds in particular, the letter recommends that there be an appropriate alignment between portfolio assets and redemption terms. In addition, it proposed that funds should not be managed in such a way that the investment strategy relies on additional liquidity management measures such as suspensions.

There is no immediate effect of the Cayman Islands’ being placed on the Non-Cooperative List, and it is entirely possible that the Cayman Islands will be removed from the list when it is next updated around October 2020. The Cayman Islands has adopted various pieces of legislation to address the EU’s concerns, the latest being the Private Funds Law and the Mutual Funds (Amendment) Law, enacted on February 7, 2020, both of which address the EU’s concerns for collective investment vehicles.

As a technical matter, being placed on the Non-Cooperative List means that three types of EU “defensive measures” become applicable:

• Non-tax defensive measures: Broadly, these preclude access to EU funding from the European Fund for Sustainable Development or the European Fund for Strategic Investments. These measures are not expected to be relevant to investment managers.
• Administrative tax defensive measures: EU member states have agreed to implement at least one of these measures that, broadly, amount to increased monitoring and audit risk of structures involving a jurisdiction on the Non-Cooperative List.
• Legislative tax defensive measures: The potential measures consist of (i) denying tax deductions for payments made to entities in jurisdictions on the Non-Cooperative List, (ii) amendments to controlled foreign company (CFC) rules (an anti-avoidance regime that all EU member states are now required to have in place) to ensure that such rules better catch CFCs in listed jurisdictions or impose a higher rate of tax if so caught, (iii) either applying higher withholding tax rates or imposing a new specific withholding tax on payments made to entities in listed jurisdictions and (iv) denying participation exemptions on distributions on profits from entities in listed jurisdictions. Importantly, no member state has yet adopted such measures, but the EU has encouraged member states to implement at least one of them by January 1, 2021.

The inclusion of the Cayman Islands on the Non-Cooperative List should not cause any particular issues for Cayman funds under the AIFMD from a marketing perspective, as the AIFMD refers to managers/funds not being on the Financial Action Task Force on Money Laundering (FATF) list (which relates to money laundering and financial crime) rather than the Non-Cooperative List. However, managers will need to check whether they have side letters that refer to the Non-Cooperative List or whether any EU member state into which they market their funds somehow prohibits the marketing of funds that are domiciled in a country on the Non-Cooperative List. It is also possible that certain EU investors may decide against investing in Cayman funds on the basis of internal controls and policies. Finally, managers of Cayman funds will also need to consider whether it would be appropriate to draft risk factors for their disclosure documents to address the Non-Cooperative List.