After a relatively calm year for asset management in 2021, the industry is expected to face a regulatory storm surge this year. The surge is driven by the confluence of an increase in new rules going live and the finalization of several important new regulations. This increase in activity will require firms to focus on the near-term requirements of meeting regulatory deadlines, while ensuring they engage in policy discussions that could have a substantial impact on the future of the industry.
Understanding the scope of the regulatory storm surge can help firms better prepare for the challenging year ahead.
The Implementation Waves Roll-In
The industry faces an increase in implementations this year, in part due to the normal ebb and flow of regulation. However, the surge in implementations is strengthened because several regulations that were delayed due to the initial onset of Covid are coming due this year. The key regulation going live this year are:
CSDR Settlement Discipline Regime
After several delays, the Central Securities Depositories Regulation (CSDR) Settlement Discipline Regime (SDR) goes live in February, with a catch. The controversial mandatory buy-in rules for failed trades have been delayed until further notice, to give the European Commission a chance to address concerns that they may cause further instability and potential systemic risk in times of market stress. Despite the welcome delay in the buy-ins, firms still need to comply with the other elements of the SDR, including the enhanced reporting and cash penalties in the event of a failed trade settlement.
US Derivatives Rule
In August the Securities and Exchange Commission (SEC) Derivatives Rule goes live. The rule is an outgrowth from policymakers’ concerns about the potential systemic risk posed by aspects of asset management and limits the amount of imbedded leverage in mutual funds and Exchange-Traded Funds (ETFs).
Under the Derivatives Rule, funds are subject to a leverage limit of 200%, based on Value at Risk (VaR) calculations of a designated benchmark or 20% of the fund’s net assets using an absolute VaR test. As a result, previously approved 300% leveraged ETFs have been grandfathered, and any future leveraged ETF will need to comply with the 200% limit. Funds that limit their derivatives use to 10% of their net assets are exempt from the VaR test limits. Additionally, there are exemptions for currency and interest-rate hedging.
As often occurs with new regulations, the Derivatives Rule comes with additional reporting requirements. Firms will have to establish a written derivatives risk management program that includes risk guidelines, stress and back testing, internal reporting and program review procedures. Fund boards will have to approve a derivatives risk manager that will be responsible for administering the program. In addition, fund N-PORT, N-CEN, and N-LIQUID (renamed N-RN) reporting will have to be updated with information regarding its derivatives use. In broad strokes, the new derivatives risk management requirements are similar in design to the liquidity risk management requirements that were introduced in 2018.
For asset managers with European funds much of this will be familiar because the Derivatives Rule is comparable to the derivatives reporting requirements for Undertakings for Collective Investment in Transferable Securities (UCITS) funds. These firms may look to leverage their existing UCITS derivatives programs for their US funds.
Initial Margin Rules Wave 6
The impending final wave of the global Initial Margin (IM) Rules for un-cleared derivatives goes live in September, when the in-scope threshold from $50 billion in uncleared derivatives (or local market equivalent) to $8 billion (or local market equivalent). The final wave of the IM rules will have a significant impact on the asset management industry. It’s expected that 775 entities, primarily asset managers, will come into scope of the IM rules in September, according to the International Swaps and Derivatives Association. This will be a significant event across the financial industry because the IM rules impact the whole ecosystem, including counterparties such as broker dealers, custodians, and market infrastructure.
Firms caught in the final wave will need to implement major changes to their existing operational processes and custodial relationships. Firms will have to post initial margin for their un-cleared derivatives, a process that will be new for most asset managers. As a result, impacted firms may need to invest in technology or look for outsourced solutions to ensure they can calculate the daily margin amounts. In either case, development of new expertise to oversee the process will be required. The IM Rules also mandate that the initial margin must be held in pledge accounts at an unaffiliated custodian for each counterparty relationship. In addition to the custodial arrangements, a bilateral Credit Support Annex, which governs the collateral arrangements between the trading counterparties, needs to be put in place for each counterparty relationship.
Getting everything in place to comply with the IM rules is a time-consuming process. The sooner firms begin to prepare the better as the consequences of being unprepared are dramatic; firms that are not ready by the deadline won’t be able to trade un-cleared derivatives.
EU ESG Rules
This year, firms will have to implement three interrelated components of Europe’s Environmental, Social, and Governance (ESG) regulations.
The first component is changes to the Markets In Financial Instruments Directive (MiFID) that clarifies how firms should incorporate ESG considerations into their organization, risk management, and product governance arrangements. Additionally, there is a requirement to consider investors’ sustainability preference when selling financial products, which adds another layer in the pre-sale process. Importantly, these rules apply to all firms and not just those who are pursuing an ESG strategy. These changes will come into effect in August and November.
The second component is the Sustainable Finance Disclosure Regulation (SFDR), which requires asset managers to produce ESG disclosures at an entity and product level. The SFDR went live in March 2021 despite the omission of the final detailed rulings. This was a break from normal procedure, as the Commission felt that high-level requirements were substantively clear enough for firms to comply.
Currently, asset managers must label their EU-domiciled funds in one of three categories:
- Article 6: Funds that do not pursue an ESG strategy
- Article 8: Funds that promote ESG values but don’t have them as explicit objectives
- Article 9: Funds that explicitly have sustainability as a core objective
The final rules from the Commission will introduce standards on how asset managers justify their funds’ categorization. Additionally, Article 8 and 9 funds will have to disclose their level of alignment with the EU’s incoming ESG Taxonomy.
The ESG Taxonomy is the third component of the EU’s ESG regulation. The taxonomy is supposed to create a standard definition of what constitutes green, based around six environmental considerations, to allow investors to better assess ESG funds and reduce greenwashing.
Part of the challenge with the EU ESG regulations is that rather than being an omnibus piece of regulation like MiFID, it is a combination of new regulations and amendments to a number of existing regulations. This means that the implementation timeline for the various elements can vary, despite the fact that there are often interdependencies between them.
The other issue for the industry is that some of the rules, such as the SFDR guideline and Taxonomy, aren’t finished yet. This makes it challenging for firms to get started on implementation, especially since they may need to rely on new service providers or data sources to confirm. Nonetheless, both the SFDR and Taxonomy are scheduled to go live in January 2023 and Europe seems committed to making the current deadlines, so firms will face a tight deadline to comply.
The UCITS PRIIPS Conversion
One of the longest running sagas in European FinReg looks likely to come to an end this year when UCITS funds adopt the Packaged Retail and Insurance-based Investment Products (PRIIPs) Key Information Document (KID) on 31 December. The PRIIPs KID is designed to be a standardized document that allows retail investors to easily compare investment products from asset managers, banks, or insurers. The implementation comes nearly four years after the initial live date.
The biggest sticking point has been how performance should be presented. In the UCITS KID, managers provide past performance. Under the PRIIPs rules, managers are required to present four potential future performance scenarios, ranging from stressed to favorable, based off past performance calculations derived using a prescriptive model. The Commission has moved to address these concerns with updated proposals that would require UCITS funds to display past performance. In addition, the Commission also proposed changes to the methodologies for the calculation of performance scenarios and certain costs, which were also a concern to asset managers.
While these proposals have been welcomed by the industry, there remains concerns about the sheer size of the project to covert UCITS funds to the PRIIPs KID. The KIDs need to be provided at the share class level, and it’ not uncommon for a UCITS fund to have dozens of share classes. This means that managers may need to create hundreds, if not thousands, of new KIDs. This will put tremendous stress on the shoulders of firms’ legal, compliance and product teams. It will also put pressure on the larger ecosystem, as managers may have to rely on outside counsel and service providers to help implement the PRIIPs KID.
Before the new PRIIPs proposals can be finalized, agreement is needed from the European Parliament and the Council. The Commission will also need to publish the detailed requirements for the revised rules. Neither of these steps are expected to be completed before the second quarter, at the earliest. This will create a tight turnaround for firms and they cannot bank on a further delay. Firms should continue to keep a watchful eye out for the final PRIIPs revisions, while getting their teams ready to manage the implementation of the new KID requirements for their UCITS funds.
Finalization of New Regulations
This year will likely see the finalization of changes to several pieces of key asset management regulations. These changes will create the next wave in regulatory implementations as well as potentially impact firms’ business and product strategies.
Money Market Reform
As part of the Covid post-mortem, policymakers on both sides of the Atlantic have been reviewing the regulatory framework for money market funds.
At the close of last year, the SEC released its’ proposal for US money market fund reform. There are four key elements to the proposal:
- Increasing the required amount of assets with daily liquidity from 10% to 25% of a fund’s portfolio and weekly liquidity from 30% to 50%.
- Removing the automatic liquidity fee triggers if certain liquidity thresholds are breached.
- Requiring institutional prime and tax-exempt money market funds to implement swing pricing.
- Enhancements to certain reporting requirements on Forms N-MFP and N-CR to improve the availability of money market fund information.
The proposals have been broadly welcomed by the industry. In particular, the removal of the liquidity fee triggers that require funds to impose a liquidity fee of 1% if weekly liquid assets fall below 10% of total assets and a 2% fee if liquid assets fall below 30%. The industry has long argued that this was counterproductive because they could hasten redemptions as funds near the thresholds. However, there is concern about the mandating of swing pricing because the current structure of the US market makes it hard to implement. The ability to utilize swing pricing has existed in the US since 2017, when it was introduced in the SEC’s Fund Liquidity rules. However, to date, no one has implemented it because of the practical challenges.
With the US proposals published, attention now shifts to Europe. It’s expected that the final European proposals will be published in the first half of the year. One area of targeted reform that may be considered is loosening the rules that prohibit fund sponsors from providing support to money market funds. The concern is that this prohibition may be overly restrictive, and that sponsor support may be a better outcome for investors.
Overall, we should know what the next iteration of money market fund frameworks will look like by the end of the year.
European Fund Delegations Rules
This year should see the finalization of the new delegation rules for European Funds, which will apply to both Alternative Investment Fund Managers Directive (AIFMD) and UCITS Funds. Under the Commission’s proposals, firms will need to have at least two full-time staff within the EU to perform a list of core functions that cannot be delegated outside the EU. Despite earlier concerns that the proposals could be a major issue for the industry, this shouldn’t be too disruptive. The major European fund domiciles, Ireland, and Luxembourg, have increased their local substance requirements in recent years which meet, if not exceeded, the Commission’s proposed requirements. The other major proposal is that firms submit an annual report to the European Securities and Markets Authority (ESMA) on their delegation arrangements and notify ESMA when more portfolio or risk management activity is delegated outside the EU than is retained in the EU.
In order for these changes to become official, the AIFMD and UCITS directives will have to be amended. Updating the directives requires the full European legislative process that involves the negotiations with the European Parliament, Council, and Commission. While the threat level has lowered, it’s possible that the Council and Parliament may propose stricter delegation rules. In addition, any time the directives are open for negotiation there’s always the chance for unexpected surprises. Given this, it’s important that firms pay close attention to developments and engage in consultations.
UK Offshore Fund Regime
Even with the first year of Brexit now on the books, the post-Brexit landscape is still evolving. One of the key pieces of post-Brexit regulations is the UK’s Offshore Fund Regime (OFR), which is expected to be finalized this year. The OFR will replace the current Temporary Permissions Regime and create a fund passport for UCITS funds that will allow the status quo to remain for firms selling UCITS into the UK.
This year the FCA will draft the specific rules for the regime. For asset managers, there are two key areas to track. The first is what will be the final mechanism for determining equivalence for non-UK funds looking to access the OFR passport. While it’s expected that UCITS funds will broadly be deemed equivalent, the devil will be in the details. The other area to watch is if 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. However, if it’s the cost of admission to the UK market, most will likely find it worth the effort. In fact, according to our recent Changing European Funds Landscape paper, more than half of asset mangers are not considering launching UK-specific funds in reaction to Brexit – which indicated that most managers are confident that the OFR will meet their needs for cross-border distribution.
Weathering the Surge
This surge in implementations will stretch firms’ teams because resources, such as legal and compliance, will need be used to cover multiple projects concurrently. There will also be bottlenecks in the industry, as many of the incoming regulations will require the use of outside advisors. In order to weather this surge firms need to proactively prepare for the implementations, in some cases this may mean starting work before the rules are completely finalized. Tight coordination between the various project streams will be key, to help ensure that there there is no resouce crunch. This coordination also will help understand the iterdependencies between projects, which should aid in minimizing duplication of effort.
However, given the number of important regulations likely to be finalized this year, firms cannot afford to focus solely on the pressing implementation efforts. Firms should not lose sight of developing, potential new regulations as they will lead to tomorrow’s implementations and could have a profound impact on their business.
Once firms have weathered the this regulatory surge, they can begin the process of assessing its impact on their business and the industry.
