Natalie Westerbarkey, Director, Client Executive at Citigroup Securities and Fund Services discusses how through understanding the new regulatory landscape and intersection (or interaction) of rules, asset managers can better assess the impact these new rules will have on their costs, risk management and operations
To better understand the multiple regulatory changes, asset managers must grasp the complexity and interconnectedness of the various regulations and the implications they will have on the buy-side from a cost, risk and operational perspective. There is a tremendous amount of interrelation between the different regulations so asset managers cannot just look at specific regulation in isolation.* For instance, one can no longer separate The Markets in Financial Instruments Directive (MiFID) from Undertakings For The Collective Investment Of Transferable Securities (UCITS) because structured UCITS funds will be classified as complex products under MiFID II changing the transparency and sales process requirements to investors. This is just one of many examples of the interrelationship among various regulations.
In addition to the volume of regulatory changes, the dynamic of the regulation landscape is very different today compared to what the financial industry experienced five years ago.
Before the financial crisis of 2008, the focus of regulation was more on enabling regulation focusing to foster greater competition, efficiency and harmonisation of markets. Today, and for the past four years, the focus of regulation has shifted imposing rules to support greater protection, liability, oversight, safety and soundness in response also to the advocacy demands of investors for improved transparency and financial market security. Whilst these objectives are valid, the new regulatory requirements will greatly impact the asset management industry’s business growth and to some extent create uncertainty as to how these new rules apply. .
Cost, Risk and Operations – Three Areas of Impact
Cost
There is no doubt that complying with the various new regulatory requirements will increase costs for asset managers and asset servicers. However, costs will be passed on throughout the chain and to the end investor as well.
With European Market Infrastructure Regulation (EMIR) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the biggest cost relates to the move to clear most Over-the-Counter (OTC) derivatives via a central counterparty (CCP) because financial institutions will have to post increased amounts of collateral (initial and variation margin) to clear centrally.
On a related capital front, Basel III requires higher capitalization for asset management companies and service providers and these increased capital requirements will limit revenue generation, which in turn is a cost for investment managers.
One of the main cost burdens associated with the Alternative Investment Fund Managers (AIFM) Directive and UCITS relates to depository liability. The regulations are scoped in a way that imposes the burden of proof onto the depositories. This means that depositories in the future will be held liable for any loss of financial instrument, and it must restitute the equivalent amount without undue delay and then prove the procedures were in place to prevent this loss afterwards to recuperate the value. This new dynamic burden of proof fundamentally changes the business risk profile of the depository function at financial institutions. It is expected that depositories will have to factor in this additional risk and cost related to exposure to larger claims which they will need to mitigate. as a result. So, this increased liability has a direct cost to the depository business.
Risk
The push to centrally clear OTC derivatives under Dodd-Frank and EMIR introduces additional risks to financial institutions by virtue of concentrating the counterparty risk to CCPs. Transparency is improved with central clearing but the counterparty risk exposure to a single entity rather than several counterparties in a bilateral environment is unknown for this asset class’ market size and therefore the systemic impact would be far more significant if something were to go wrong within a CCP environment.
Also, the capital cost of clearing via the increased collateral requirements means that some of the OTC contracts will be closed out before the regulation comes into place, reducing the size of the OTC market and that may have also been the expectation behind the change.
For the asset managers in particular, there is also a risk introduced through legal uncertainty for example regarding the sales and transparency rules of structured UCITS under MiFID as complex products. Whilst there is a legal definition of structured and unstructured UCITS funds, these may naturally be subject to interpretation leading to uncertainty in practice. Another example of legal uncertainty are the recent discussions at technical level regarding the AIFMD Level 2 measures, for example, what constitutes a loss of a financial instrument and how to prove that the event was beyond the depositaries’ reasonable control or unavoidable.
Operations
The middle and back-office operations will become more complex as firms adapt processing systems and employ knowledgeable staff to comply with new regulation, however, the most important operational change lies in the firm’s ability to understand the regulations and how the business strategy must be developed to cope in the long-term. For example, a firm will have to review the operational and business strategies as they pertain to the changes in collateral and liquidity requirements. Also, firms will have to determine which products will be the most demanded by clients and have a higher potential of guaranteed success. This is a crucial question as asset managers weigh up trading OTCs on exchange, off exchange and clear bilaterally or via a CCP as it pertains to investment strategies and the balance of cost with returns.
With regards to UCITS, asset managers need to categorize if a UCITS fund is structured or not and consequently distributed under the MiFID II rules or not. If so, the MiFID II marketing rules need to be applied for UCITS-structured funds.
Getting started – dealing with uncertainty
Despite the complexities of the regulatory landscape and operational responses, there is an opportunity for asset managers who are nimble and can very quickly adapt and establish new systems and reporting procedures to gain a competitive advantage.
Many firms are keen to understand how to operationally prepare for new regulation but in some instances there aren’t sufficient details of the new rules available yet to really start the implementation for example with FATCA, so the focus now is more on awareness and understanding the regulation and getting prepared doing the analysis. An additional complication is the differing speeds in which each region is implementing new regulation when they address same objectives for example the US Dodd-Frank Act and in Europe EMIR for the central clearing of OTC derivatives, which is a global market. Naturally, it would be advantageous if there was one hard date and specific requirements and everyone prepares accordingly but that’s not the case, so the industry have to prepare for increased complexity and the different timelines.
Getting a better understanding of regulation is the first step followed by a gap analysis of the regulation and the impact on a firm’s individual business and – most importantly – future business and client strategy.
For this to happen it is more required than reviewing systems and operational changes. It is essential to ensure that internal staff fully understand the regulation and how the new requirements will impact the organization and its clients as a whole.
* Full visual regulatory mind map available via link below:
http://www.citibank.com/transactionservices/home/sa/b1/spotlight/mind_map.jsp
Citigroup developed this regulatory mind map to offer a look at regulatory changes through the lens of the asset managers and their key stakeholders and to specifically convey the complexity and interconnectivity of the various regulations impacting their asset management clients. The ecosystem in the centre shows the relationship of the stakeholders, eg the expectation of underlying investor clients as enforced by the regulators, the impact on asset managers and what they will deliver to respond to these requirements. This chart also shows how the service providers, such as Citigroup, will respond to the new needs of their asset management clients. This flow chart highlights some of the key requirements of various regulations globally but is not comprehensive.
