UCITS and AIFMD: What does the future hold?

The European Commission published its consultation on the review of the Alternative Investment Fund Managers Directive (AIFMD) in October 2020. The consultation contains 102 questions which touch on several topics. It is split into seven sections:

• General review of the AIFMD
• Investor protection 
• International relations
• Financial stability
• Investing in private companies
• Sustainability and ESG
• Miscellaneous

The consultation reflects the contents of a letter issued by the European Securities and Markets Authority (ESMA) in August 2020. This set out its recommendations for potential amendments to the AIFMD. Some of the more meaningful questions relate to the area of delegation to third countries and the introduction of further restrictions on delegation by AIFMs as recommended by ESMA. These questions are of particular relevance to firms whose Brexit models rely on delegation models. They are also very timely, with the recent release of the CBI’s ‘Dear Chair’ letter following the completion of its CP86 review.

Other questions considered  the possibility of greater harmonisation between the AIFMD and UCITS frameworks and granting of additional powers to ESMA. This could be viewed as a step closer to supervisory convergence, which has been an ESMA supervisory priority for a number of years now. The ultimate goal is consistent implementation and application of EU rules and regulations and to avoid gold plating and supervisory divergence by national competent authorities (NCAs). ESMA are clearly starting to exercise the additional powers previously granted to them to directly supervise the EU markets. They are doing this in the form of EU-wide market assessments and Common Supervisory Actions (CSAs), with the most recent CSA focussing on fund liquidity.

The area of investor protection raises questions in relation to client classification, the possibility of a depositary passport, mandatory disclosures under AIFMD and rules relating to conflicts of interest and valuation. More generally, the underlying driver and ultimate objective of any new regulation or changes to regulation is investor protection. This is borne out in ESMA’s supervisory framework of costs of UCITS and AIFs and the ESMA performance fee guidelines for UCITS and certain AIFs issued earlier this year.

From a financial stability perspective, the consultation refers to issues such as the use of liquidity risk management tools, possible enhancements to Annex IV reporting and loan originating AIFs. There are numerous suggestions relating to harmonisation as follows:

• Harmonisation of UCITS funds to AIFs - supervisory reporting and leverage calculation methods
• Harmonisation of reporting formats and definitions with EMIR and SFTR
• Availability of liquidity risk management tools across the EU

These suggestions for improvement and harmonisation form part of a wider agenda for financial stability at an EU level. There is a long-term focus on liquidity risk management and stress testing, the importance of which was emphasised even more so during the COVID-19 crisis.

The AIFMD review is just one of many regulatory issues that asset managers and particularly their legal and compliance functions must consider, interpret, implement and monitor on a daily basis.

The ongoing cost of regulatory compliance is only going in one direction. Asset managers ultimately want to avoid passing this cost onto investors. Where compliance failures are experienced, they often arise as a result of compliance being treated as an obligatory cost of doing business, versus an opportunity to instill trust in stakeholders and improve competitive advantage.

The rapidly changing risk and compliance landscape is challenging the effectiveness of firms’ compliance activities and the digital infrastructure supporting them. Many firms are being faced with revisiting how they manage compliance, not only to increase their effectiveness and reduce cost but to redefine what is possible for compliance while doing more with less.

The new normal will result in unprecedented change and opportunity - fit for future, technology-enabled and efficient compliance functions will no longer be optional, but a requirement to remain not only competitive but operational and positioned for future success.

Five key actions for asset managers

AIFMD review

The AIFMD consultation closes on 29 January 2021. Given the significance of this review process as well as its potential impact on the UCITS framework, firms should take the current opportunity to participate in the consultation process. The European Commission will use the responses received to inform their decision on the proposed amendments to the current framework. Firms need to consider the potential impact of this process on their business, particularly with regard to delegation to third countries, extension of the directive to third country firms and a push towards harmonisation of the UCITS and AIFMD frameworks. These issues are also very important from a Brexit perspective, as the UK will become a third country from 1 January 2021.

Substance

The question of regulatory substance and boots on the ground has been a burning issue, at both a European and national level for some time now. This focus on substance has intensified during the Brexit transition period. The AIFMD consultation further re-emphasises the need to avoid the creation of letterbox entities. From a business perspective, firms want to ensure investors have access to the best investment and administrative resources and expertise for their products, regardless of their location. They also need the appropriate level of supervision and oversight conducted by a local regulated firm.

In the short to medium term, a large number of Irish regulated funds and management companies must consider staffing up in order to meet ESMA’s and therefore the CBI’s  minimum criteria of three full-time employees for the smallest and simplest of firms. On top of that, the AIFMD consultation asks whether the delegation rules should be complemented with quantitative criteria and a list of core or critical functions that should always be performed internally and may not be delegated to third parties.

Supervisory convergence and harmonisation

ESMA continues on its trajectory towards supervisory convergence. It has identified this as one of its supervisory priorities for 2021. The aim is to build a common risk-based and outcome-focused supervisory culture across the EU. This has specific focus areas including fund liquidity risk and liquidity management tools, retail investment product costs and performance, and quality and usability of data. The AIFMD consultation raises the prospect of even greater powers being granted to ESMA as well as a single EU rulebook for the UCITS and AIFMD regulatory frameworks.

There is also the suggestion that AIFMD reporting be centralised with ESMA rather than submitted to NCAs. It is also suggested that ESMA are given powers to take action against individual AIFMs and AIFs where their activities threaten the integrity of the EU financial market or stability of the financial system. Asset managers must try to incorporate this path to supervisory convergence into their compliance monitoring programmes.

Fund costs

The recent ESMA supervisory framework of costs of UCITS and AIFs puts the issue of fund costs and value for money for investors at the top of the agenda for asset managers. This follows the implementation of the value for money assessment by the FCA in the UK last year. Management companies are required to develop and periodically review a Structured Pricing Process, addressing ten defined questions. ESMA will cooperate with NCAs to implement this process and firms must be prepared to respond to data requests from regulators at any stage of the fund’s lifecycle, from authorisation to any stage of the ongoing supervision process.

Proactive approach to regulation 

The importance of compliance activities in response to a range of risk and regulatory areas is becoming even more pronounced. By approaching compliance in a more risk-focussed way that is aligned with key strategies, uses technology and human centred design and the data and predictive capabilities that result, will drive down the cost of compliance. It will also allow firms to do more with less while increasing its effectiveness. The culmination of a number of factors, namely a high volume and diverse range of regulatory requirements, data proliferation and sharper and more sophisticated techniques employed by regulators is resulting in a more data driven compliance function, whereby new data integration and visualisation tools are enabling more thorough testing, better identification of trends and dynamic reporting.

We are here to help you

The regulatory landscape continues to present the asset and wealth management industry with evolving, complex challenges. Firms must maintain continuous compliance with their regulatory requirements while ensuring that investors are getting value for money. In order for firms to thrive in an efficient and cost effective manner, they must adopt a proactive approach to regulatory compliance and leverage the technological and digital assets available to them. We are here to help you on this journey. Contact us today.