Though prompted by Brexit, the proposed review of the AIFMD legislation will also have implications for buy-side firms operating in Asia, says industry veteran Tony Freeman.
At first glance the recent publication of a letter about AIFMD from ESMA (European Securities and Markets Authority) to the European Commission doesn’t seem like big news. Isn’t AIFMD an obscure piece of European legislation that isn’t applicable to Asia-Pacific? It’s a tempting thought – but its quite wrong. Here’s why.
Investment funds in Europe which can be sold to retail and institutional investors are classified either as UCITS, retail funds with high levels of investor protection, or Alternative Investment Funds sold to institutional investors and sophisticated private clients. The local trade association EFAMA (European Fund and Asset Management Association) says the two sectors have 61,000 funds managed by 4,500 buy-side firms. The value under management is EUR 16.3 trillion (USD 19.3 billion).
The concept of a “European fund” deserves unpacking. The segment is highly developed and has been evolving for many years. The UCITS brand is a trusted marque and known internationally – so these funds are sold to investors globally and cover almost every segment you can think of. The funds also invest globally and, perhaps surprisingly, are managed globally. A quick scan of the fund managers involved shows a large number of firms based in APAC. Many of the funds they manage are Asia themed: Japan Small Companies, China Tech, Taiwan semiconductor, etc. (One of the largest European tech funds is controlled by a portfolio manager located in Taipei.)
One of the reasons for this global reach is the flexible operating model that has evolved in Europe. This is known as “delegation”. Delegation is the practice of registering a fund in a single location inside the EU (typically Ireland or Luxembourg) enabling retail sales across the whole EU and outside. Many of the bigger investment managers are geographically very dispersed and typically little, or none, of the “front-office” tasks – asset allocation, stock picking, risk management – actually happen in Dublin or Luxembourg. The process of managing the fund frequently happens in London or Edinburgh but is just as likely to happen in Toronto or Tokyo. What happens in Luxembourg & Dublin is primarily “back-office” functions like fund accounting and shareholder record keeping. This model has worked fine – until Brexit happened and the issue became political.
The EU, very understandably, wants to avoid the Cayman Islands model where all real activity takes place outside the region. So-called “brass plate” shell companies are not acceptable. Regulators require a local entity to be properly staffed and resourced on the ground. The current UCITS and AIFMD legislation specifies what rules must be followed but, crucially, they do not define what is a core function versus a supporting function. The ESMA letter specifically refers to the opacity and confusion that surround these issues – even amongst the regulators themselves. It therefore proposes further definition of what activities should be classified as “core” versus “supporting” tasks.
This search for clarity is at the heart of the letter. ESMA is also now acknowledging differences between the sets of rules and is making clear that whatever revisions are agreed in relation to AIFMD will also apply to the UCITS segment. In effect the two separate pieces of legislation will not be combined but will be harmonised.
The political agenda, most evident in France, is that delegation is a problem. The ESMA letter links delegation to “operational and supervisory risks” but it isn’t specific and doesn’t provide any evidence or examples. But the tone is clear. And the obvious, and politically attractive, by-product of mandating that some core functions must be done within the EU is the growth of high-paying jobs in the local market.
The letter also connects differences between EU and non-EU regulatory standards to “circumvention” and “regulatory arbitrage”. This is quite a contentious opinion and could be seen as a somewhat politicised viewpoint. Regulators in Asia-Pacific are not likely to be in agreement but, yet again, the political influence is quite clear.
Regulatory clarity is always welcome, but the results could be uncomfortable. If the outcome is that core functions must be performed within the EU, which appears to be the political ambition, substantial organisational change is inevitable. And to make it more delicate this isn’t purely an EU-UK issue. The delegation model has a global impact because whatever new rules are defined surely have to apply equally to all non-EU countries.
The AIFMD review is not a technical exercise on an obscure piece of legislation. It’s a test-case of how EU financial services will be structured after Brexit. It will have global impact. Investment managers in Asia need to pay attention.