In previous editions we have considered the different factors that gave rise to and are influencing the EU debate on delegation. This month we look at the recommendations in the US Treasury (UST) paper on asset management and insurance and ask what they might mean for the global asset management model, especially for European-headquartered firms.
The UST paper is one in a series of four prepared for President Trump in response to Executive Order 17332, which set out seven Core Principles. The report identifies “significant opportunities for reform” consistent with four of the Core Principles:
- Ensuring appropriate evaluation of systemic risk and solvency;
- Promoting efficient regulation and rationalizing the regulatory framework to decrease regulatory burdens and maximise product and service offerings;
- Rationalising US engagement in international forums to promote the US asset management and insurance industries, and encourage firm competitiveness; and
- Enhancing consumer access to a variety of relevant products and services.
The UST notes that the asset management sector has seen a median increase in compliance costs of about 20% over the past five years. Costs of asset management are expected to increase further to 2022, with one of the most important drivers being the cost of complying with an increased regulatory burden since the financial crisis. Implementation of compliance regimes under the current regulatory framework has put continued pressure on margins, has favoured the largest asset managers by disproportionately affecting smaller asset managers, and has reduced the ability of asset managers to reinvest for innovation and long-term growth.
Against that backdrop, the industry has broadly welcomed the UST's recommendations. One key area is the question of systemic risk. The UST's position is that entity-based evaluations of systemic risk are generally not the best approach for mitigating risks arising in the asset management industry. It broadly supports shifting to an activities-based framework and establishing an appropriate regulatory framework to address elevated engagement in those activities.
In particular, it recognises the fundamental differences in business and legal structures between banking, asset management and insurance: “The performance of the asset management industry during periods of financial stress demonstrates that the types of industry-wide “runs” that occur in the banking industry during a systemic crisis have not materialized in the asset management industry outside of money market mutual funds.” Since the turn of the century, including through the financial crisis, “aggregate net flows into equity and debt funds have rarely exceeded more than 1% and 2% of total assets under management on a monthly basis, respectively”.
Specifically, the UST rejects the need for stress testing of asset management firms (as introduced by the Dodd-Frank Act) and believes that a strong liquidity risk manageframework is a more effective approach to addressing the concern of increased liquidity risk due to fund redemptions. It therefore supports the 15% limitation on illiquid assets in mutual funds, but it rejects an overly prescriptive regulatory approach to liquidity risk management, such as the bucketing requirement, which should be postponed, in its view.
As regards the use of derivatives in investment funds, the UST recommends that the SEC should consider a derivatives risk management program and an asset segregation requirement, but reconsider what, if any, portfolio limits should be part of the rule. Other recommendations include removing the need to obtain individualexemptive relief from the SEC for “plain vanilla” ETFs, modernising fund disclosure material through electronic delivery of shareholder material, and harmonising and rationalising the fund reporting requirements to eliminate overlapping and duplicative requirements. It also recommends removing the dual SEC/CFTC registration requirement for certain advisers and funds.
We must wait to see whether and how quickly these recommendations are implemented given that some require legislative amendment, but a number of impending rules have already been postponed or withdrawn. Taken as a package, the recommendations point to a material deregulatory agenda for the asset management industry, mainly for investment funds.
On the face of it, this will be welcomed by an industry experiencing persistently increasing compliance costs. But it also points to a growing divergence between the future US regulatory regime and the direction of travel elsewhere, in particular in the EU. In relation to liquidity risk management, for example, the UST approach reads very differently to the recent European Systemic Risk Board's recommendations. The ESBR seeks expansion of provisions in the UCITS Directive and AIFMD to include additional liquidity management tools, measures to limit the extent of liquidity mismatch in open-ended funds, and requirements for UCITS to report to national regulators on liquidity risk and leverage, and increased guidance from ESMA.
This divergence points to a bigger question: how far can the US and EU regulatory regimes diverge before the industry's model of delegation of portfolio management services is restricted? It is common practice among all sizes and types of asset management firms to utilise portfolio management expertise from other countries and jurisdictions in order to provide investors (whether in collective funds or via separately-managed accounts) with the best chance of good outcomes. The delegation debate has reared its head in the EU in the context of the Brexit negotiations, even though there is no indication that UK regulators are minded to make any material changes to relevant rules in the UK for the foreseeable future. Does the increasing divergence between US and EU rules signal a more serious threat to the global delegation model?
Look out for our Evolving Asset Management Report to be launched in June, which will consider this question further. In the meantime, read about the main regulatory trends and stay tuned in to this monthly series of regulatory insights.
Key questions for firms:
- Do we have a full set of consolidated information on what portfolio management activities we delegate within and outside the group? To where, via which contractual routes and for which clients or funds?
- How much optionality do we have, given our existing entities and strategies, if our current delegation model and practices became restricted due to divergent regulatory agendas?
- Are we keeping abreast of the debate?
- Are we effectively and efficiently monitoring the regulatory direction of travel?