Adjusting to Life After Brexit
With the end of the transition period, Brexit has officially arrived. However, this is just the beginning for the asset management industry and it will now need to start navigating the new normal of a post-Brexit world. As the industry begins this journey there are a few key items for it to tackle this year.
Making the Temporary Permanent
In the run up to Brexit, policymakers took a number of steps to cushion the short-term impact on asset management. Starting this year, policymakers will begin to make the temporary agreements permanent. A key item for asset managers is the UK finalizing its Offshore Fund Regime (OFR), which will replace the current Temporary Permissions Regime. The OFR creates a fund passport for Undertakings for Collective Investment in Transferable Securities (UCITS) funds that will allow, more or less, the status quo to remain for firms selling UCITS into the UK. This year the Financial Conduct Authority (FCA) will draft the specific rules for the regime. One area to watch is whether the FCA will require UCITS funds sold into the UK to produce an Assessment of Value (AoV). Currently, only UK-domiciled funds produce the AoV, which requires managers to assess the value proposition for each fund, take corrective action if the fund does not offer value, and publish an annual AoV statement. It is possible that the FCA will seek to level the playing field and extend the AoV to non-UK funds. For asset managers this could add another layer of complexity to their European cross-border distribution, but if it’s the cost of admission to the UK market, many in the industry will likely find it is worth the effort.
Tightening Delegation Rules
Driven in part by Brexit, the European Commission is reviewing the delegation and third-country rules for UCITS funds. At a minimum, the Commission will seek to harmonize the delegation rules for AIFMD and UCITS funds, which means creating a third-country framework for UCITS. Unlike the rules for alternative funds, which are governed by AIFMD, under the UCITS framework there are no delegation rules. Instead, local regulators determine the appropriate level of governance, local substance and oversight for the UCITS funds they authorize. In and of itself, this probably wouldn’t be too disruptive to asset managers’ existing delegation arrangements. The major fund domiciles, Ireland and Luxembourg, have both increased their local substance requirements in recent years so meeting the new level of AIFMD delegation rules shouldn’t be an issue. The potentially bigger issue is whether the European Commission will also look to tighten the delegation requirements for UCITS funds.
One of the big unknowns is ESMA’s suggestion to create a quantitative criteria to assess the appropriate amount of delegation. The industry has expressed concern that creating a formulaic approach to assessing delegation could lead to an overly prescriptive approach. The details of the quantitative criteria still need to be set, however, one possible outcome is that as funds get bigger, more local substance could be required. While Brexit is the catalyst for reviewing the delegation rules, the potential impact goes beyond the UK. UCITS funds are truly global and are just as likely to be managed in New York as they are in London. The concern is that the creation of rules that require more activity to be done within the EU could lead to inefficiency and additional cost that would ultimately be borne by investors. If the rules get too prescriptive, other domiciles could follow suit with similar rules, which could cause dislocation across the industry. Nonetheless, there is potential that the status-quo will not remain and that asset managers are going to need to have more substance in the EU. The issue now is really a matter of how much.
Managing Regulatory Divergence
Now outside of the EU, the UK is no longer bound to adopt European regulations and can instead plot its own course. The UK has already begun to diverge from the EU’s regulatory framework with the UK Treasury’s announcement that it won’t be adopting the Central Securities Depositories Regulation mandatory buy-in regime and that it will create its own prudential regime for UK investment managers that is largely aligned to the EU’s Investment Firm Directive and Regulation but tailored to the UK market. The UK has also announced its intent to create its own ESG taxonomy, separate from the EU’s ongoing efforts. Overall, divergence between the UK and EU was inevitable but it will likely be a slow drift, rather than a big bang. As the two jurisdictions continue to grow apart, firms will have to figure out how to track, implement, and reconcile the different regulatory approaches. To do so, firms will need to develop a mechanism to assess how rules in the EU impact their UK business and vice versa. In addition, firms will now have to engage more with the UK regulatory consultations, on top of managing EU consultations. Invariably a divergence in rules will lead to differing approaches to regulatory reporting, which highlights the importance of having a strong data management and regulatory reporting strategy.
The Beginning, Not the End
The post-Brexit landscape will continue to evolve and it will take a few years for a new normal to emerge. This year, the industry will face a number regulatory consultations that will have implications for what the new normal might look like. Given this, it is important that the industry engage with policymakers to help ensure their voice is heard during this critical juncture.
This piece originally appeared in the Citi Securities Services 2021 FinReg Outlook
Sean Tuffy, Head of Market & Regulatory Intelligence, Citi Securities Services