The European Commission says Asian regulators or industry voices have not played a role in how Brussels drafts its funds regulations, but that this should change. As the EU looks to introduce stricter rules on Ucit funds, Asian fund managers and regulators should take up this offer.
Speaking at the Asian Financial Forum in Hong Kong in a panel session moderated by this writer, Tilman says views from Asia would be welcome but that no one had made the effort during the EU’s consultation period over revamping rules for Ucits and alternative investment products.
He also argues that the credit rating of government debt has no bearing on a Ucit fund domiciled there, implying that some investors or fund managers have questioned the safety of funds based in eurozone countries.
These issues matter to the industry in Asia because Asian countries now constitute the second largest consumer group of Ucit funds; rules on alternatives impact Asian funds’ asset gathering in Europe; and more Asia-based fund managers are setting up Ucit fund ranges.
European regulators are now writing the detailed implementation rules of the Alternative Investment Fund Manager’s Directive (AIFMC) and reforms of the Ucit rules for retail funds.
The European Securities & Markets Authority (Esma) is now filling in the details of over 100 provisions that mark Europe’s response to the 2008 financial crisis, which in turn will be implemented by the European Commission, with some discretion.
Three important changes relate to calculating thresholds in AUM terms that dictate when rules apply to a fund manager; to defining and calculating ‘leverage’; and to new liabilities being forced upon custodian banks.
New rules will apply to funds with €500 million or more in assets, or if using leverage, €100 million. Leverage is defined by Esma as the market value of all underlying and derivative exposures.
Calculating leverage means a fund’s total exposure, including instruments that incur debt and all derivative positions. This means many funds with nominal AUM of below €500 million but using derivative strategies will probably hit that threshold, which means more reports and stricter rules about potential conflicts of interest.
Meanwhile, in order to prevent the sort of chaos surrounding lost assets when Lehman Brothers collapsed, Esma will now require all alternative investment funds to appoint a single custodian bank (depositaries, in EU lingo) to vouchsafe assets.
This applies to non-European funds raising assets in the EU, or to European funds investing in other markets.
Safekeeping is new in scope, and requires the custodian to divide a fund’s instruments into two buckets, one for stocks and bonds, and the other for derivatives, and both are subject to greater recordkeeping. The idea is to have traditional assets held in case derivative positions are lost in a bankruptcy. The kicker is that the custodian is fully liable for those traditional assets, except under extreme cases where force majeure can be applied.
This is also the case for operations in third countries where a custodian appoints a sub-custodian – the master depositary remains fully liable. It is also the case if a Bernie Madoff-like manager commits fraud; the custodian remains on the hook.
I asked Tilman if this would make it difficult to invest in particular markets where local regulation or financial market institutions are weak. If a custodian is going to be liable for shenanigans that occur in portfolios in certain markets, perhaps they won’t want to do business in that country or for that fund. Tilman didn’t directly answer this but says global custodians should already have secure networks.
The European Commission’s overriding goal regarding retail funds is to ensure they remain a trusted brand. Tilman notes that controversial products in areas such as exchange-traded funds and money-market funds may or may not comply with Ucit rules, such as controls on risk diversification and collateral management.
Ucit rules must not only apply to the fund, but in the case of indexed products, to the index as well (for example, by avoiding concentration risk).
This means domicile is irrelevant; what counts is whether the fund and its underlying exposure meet Ucits rules. Tilman emphasises that this makes irrelevant the sovereign credit rating for the country where a Ucit fund is domiciled. He says a Ucit fund chooses a certain domicile for tax or local regulatory reasons.
I raised the point that some of the bigger EU members, notably France and Germany, have argued that Ireland should raise its tax rates to generate revenue and pay down its debts. The Irish have fiercely resisted such moves, but surely European sovereign debt woes could, in theory, touch the Ucits brand?
Tilman says no, for the simple reason that there is no such thing as a pan-European tax code, and Ireland or any other country could veto such a move. But this begs the question why some market forces are obviously challenging the EU on this point.
The EU is working on several changes to the Ucits code. First, it is going to make Ucits compliance stricter, to harmonise it with the new rules on alternative investment funds. That means the same requirements as to reporting, risk management, and a custodian’s safekeeping of assets.
Tilman says his unit will have a concrete proposal out by March or April.
Secondly, the EU is looking to what Tilman calls a “wider package” on derivatives and money-market funds, for both Ucit and non-Ucit products.
These represent an effort to reform Europe’s shadow-banking system. It recognises that money-market funds, for example, promise bank deposit-like features but may experience volatile NAVs.
Finally, the EU is creating new rules for venture capital. Tilman says regulation is not just about throwing up hurdles and rules, but fostering growth. The EU has recently ruled that venture capital should be treated differently from private equity, because its managers are too small to handle the onerous regulation of the AIMFD. The EU wants to create a Ucit-like pan-European funds passport and brand for VC investors.