The fund management industry and the financial crisis:
regulatory challenges and opportunities
The EU fund management industry faces challenges that are similar to other areas of the financial sector in the emerging post-crisis environment: a new regulatory wave and tighter supervision. This article gives a brief overview of the main elements of the changes to come and the related opportunities.
by Karel Lannoo
As in other sectors of the financial industry, the fund market can expect more and more detailed regulation and supervision in the years to come. Although the European regulated fund market has not been in the centre of attention of the financial crisis, it will have to cope with new rules and stricter enforcement. The latter will result from the creation of new authorities, essentially the European Securities Market Authority (ESMA), the former as a result of issues which have come up during the financial crisis, such as the role of depositaries and the definition of money market funds, and the implementation of UCITS IV, which was proposed just before the crisis erupted. But there is also more regulation to come for the non-regulated side of the industry in the Alternative Investment Fund Managers (AIFM) directive, which will level the playing field in terms of regulated funds.
2008 saw a massive outflow of funds in the regulated fund sector, as well on both sides of the Atlantic. Although the regulatory frameworks and issues differ considerably, it is remarkable that 1) both sectors have acquired similar sizes (see Figure 1 below); 2) both have seen a big drop in 2008, which has only been partially restored in 2009; 3) similar problems have arisen in the asset allocation of money market funds, although these were much more debated in the USA than in the EU. Assets managed by the EU and US regulated fund industries amount to 88% of the global fund management industry (according to ICI).
Figure 1. European and US total net fund assests compared
Data sources are the European Fund and Asset Management Association (EFAMA) and the US Investment Company Institute (ICI). European data include UCITS (about 75%) and regulated special funds (including a limited number of hedge funds). US data include primarily mutual funds (about 90%), closed-ended funds, exchange-traded funds and units of investment trusts, following the 1940 Investment Company Act.
The Lehman collapse and the Madoff fraud revealed an interesting regulatory difference between the EU and the USA in the segregation between asset safekeeping and fund management. This is an obligation in the EU according to the UCITS directive – although probably not always well-respected – but not in the USA. It is clear that this has become an important issue in the post-crisis debate, as the EU Commission has already indicated with the public consultation on UCITS depositaries.
TOWARDS UCITS IV
The new UCITS IV directive will allow for fund sector consolidation and rationalisation and give a new boost to the European fund sector. The directive further completes the UCITS framework, which started in 1985 with the first EU directive covering investments funds, the so-called Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS IV must be implemented by July 2011 at the latest.
The UCITS IV rules follow for the first time in the sector the ‘Lamfalussy’ approach, meaning that not only primary but also secondary legislation is largely harmonised at European level. These so-called implementing measures, which were published by the European Commission in July 2010, are another 100 pages plus of rules, detailing the core new elements of directive. It concerns:
• detailed conduct of business rules for fund managers, covering conflicts of interest, governance and the relationship with depositaries;
• the content of the key investor information document (KID) and the use of electronic media for dissemination. The regulation specifies methodologies on calculating a fund's level of risk and charges;
• fund mergers and master-feeder structures. The measures detail certain investor protection measures in relation to asset pooling techniques, and establish a common approach to the sharing of information between master and feeder UCITS. It also covers detailed rules on the liquidation, merger or division of a master UCITS;
• supervisory issues and notification procedure, such as the form and contents of standardised notification and attestation letters, procedures for on-the-spot verifications and investigations, and the exchange of information between competent authorities.
The upshot of the new rules should not necessarily be negative, on the contrary. More harmonised rules should ease the operational conditions for large fund managers in the EU’s single market, which is what is expected to emerge from UCITS IV.
The new UCITS will for the first time allow for the separation between authorisation of fund registration and fund management in the ‘management company passport’, which fund managers are busily preparing for. To date, the member states could require fund management to happen in the same state as the registration of funds, which was an advantage for countries such as Ireland and Luxembourg. Now that this obligation is lifted, fund management can be expected to reap scale economies and converge in a few financial centres, which will benefit large well-organised players.
A related change is the facilitation of fund mergers across borders, which should reduce the sub-optimal size of the fund sector in Europe, and again facilitate scale enlargement. These changes can be expected to unleash further dynamic processes, with more investment in technology to cope with the new rules, but also to gain strategic advantage as was the case with the Markets in Financial Instruments Directive (MiFID), covering broker dealers and exchanges.1
THE RELATIONSHIP WITH AIFM AND MIFID
At the other end of the spectrum is the much more debated hedge funds directive, or Alternative Investment Fund Managers (AIFM) directive. Although the final form of the directive is not yet known, it is clear that legislation of this largely unregulated part of the fund industry is now definitely coming.
This changes two facts for the regulated fund sector: 1) it levels the playing field, and will probably dampen the strong growth which the alternative investment fund sector had seen over the last years, and 2) it opens the way for well-established fund managers to also offer funds using alternative investment techniques to their regular outlets, with a single licence for the whole of the EU, and with grosso modo the same rules for investor information and reporting to the authorities.
The big outstanding issues for the sector remain fund distribution rules and taxation. Although fund distribution falls largely under the EU’s MiFID directive, with rules covering suitability and appropriateness, tackling conflicts of interest (including retrocession fees) and price/fee transparency, the rules seem to have been badly implemented so far,2 and cover only fund products distributed by banks or investment firms, not insurance companies, for example. The expected reduction in size of the banking sector following the crisis may lead to a re-emergence of independent intermediaries, reducing the market power of the bank’s retail networks, but this will take a long time. More tax harmonisation, on the other hand, is not on the agenda. Tax avoidance has been tackled in the EU’s savings tax directive, but tax rates and deductions remain an entre national competence and very divergent.
The creation of the European Securities Market Authority (ESMA) by the end of 2010 should ensure that the regulatory framework will be effectively the same all over Europe, but also that supervision can be streamlined in a global industry such as fund management.
ESMA will have the facility to mediate between EU member states supervisory authorities, and to delegate supervisory tasks between them. ESMA will participate in the supervisory collegiates of international fund managers and act to comply supervisory databases.
CONCLUSION
In a period of 25 years, the fund industry has seen a huge development, from an essentially nationally-based industry to a largely European-wide organised sector. EU regulation, primarily the UCITS directive, has been a huge contributor to this process, to the degree that it is seen as one of the most successful EU directives in the area of financial markets. UCITS IV should give a new boost to the permanence of the UCITS brand, leading to further internationalisation, but at a cost of further rules and complexity. The challenge for the industry is to turn this into a benefit.
Karel Lannoo has been Chief Executive Officer of the Centre for European Policy Studies (CEPS) since 2000 and senior research fellow since 1997. Karel Lannoo has published books and numerous articles in specialised magazines and journals on general European policy, and specifically financial regulation and supervision matters. He is a regular speaker at international gatherings and in executive programmes. Karel Lannoo holds a baccalaureate in philosophy, an M.A. in history from the University of Leuven in Belgium (1985) and obtained a postgraduate in European studies (CEE) from the University of Nancy in France (1986).
