2019 was dominated by uncertainty around Brexit and wider geopolitical instability. Looking ahead, INDOS Financial shares its insights about some of the key developments that may impact the asset management industry in 2020.
Early signs of a new liquidity regime
Barely six months after the financial services industry was shocked by the gating of investors within Neil Woodford’s daily dealing flagship fund, M&G suspended dealing in one of its open-ended property funds following a wave of redemptions precipitated by tough retail conditions. Both incidents will have consequences for the industry.
Regulators including the UK’s Financial Conduct Authority (FCA) and the Central Bank of Ireland are already circling, having warned the industry that its liquidity risk management practices require improvement. It is possible regulators could introduce rule-changes stipulating that fund liquidity terms be more aligned with the assets in managers’ portfolios. While the European Securities and Markets Authority (ESMA) has tacitly cautioned against making changes to the current UCITS’ regime, the regulator is imposing additional liquidity stress testing obligations on UCITS and AIFs (alternative investment funds), which will take effect from September 2020.
Moreover, the new rules will also require depositaries to affirm that managers have well-documented liquidity risk management processes in place. Simultaneously, investors are likely to sharpen up their operational due diligence procedures for UCITS amid concerns that some institutions may have been less than thorough in their initial manager reviews.
ESG: Pressures continue to increase
So seriously are regulators taking ESG (environmental, social, governance) that the Bank of England is requiring major lenders to perform climate risk stress tests. The funds’ industry is under similar pressure, both from institutional investors and market regulators. In the case of the latter, the EU is looking to put an end to greenwashing by developing an ESG taxonomy and detailed reporting framework for institutional investors, which will be phased in incrementally over the next few years.
Others believe the passage of the Shareholder Rights Directive II (SRD II) in 2020 will also put pressure on managers to demonstrate their ESG credentials as the regulations demand investors report on their shareholder engagement policies, including ESG. Some major institutional investors are beginning to take decisive action. The Children’s Investment Fund (TCIF) recently announced it would vote against company directors at organisations that fail to disclose their carbon emissions and reduction targets, and others are likely to follow suit.
Independence of the depositary
There is growing support – particularly among investors – for the independent depositary model as concerns grow about the lack of engagement applied by depositaries affiliated to banks and administrators. In addition, some investors have expressed scepticism about whether depositaries would adequately call out or report issues at their fund administration arms if it were to have adverse consequences for the group-wide company as a whole. As competition for institutional assets becomes even greater, managers will continue to transition towards an independent depositary model, especially if such a move helps them win mandates from more risk-conscious allocators.
The push towards independent depositaries has also been given a boost by governance reforms in the UK. Just as the existing accountancy model is facing change as regulators consider separation of providers’ lucrative consultancy services from their audit businesses, similar changes could unfold at depositaries.
In light of rule-changes such as the Senior Managers & Certification Regime (SMCR) now imposing heightened accountability requirements on fund managers in the UK, engaging with an effective independent depositary is one way in which firms can demonstrate they have effective oversight over their core operations.
Extension of the depositary model beyond Europe
The new Cayman Islands Private Funds Bill, 2020 (published on 8th January 2020) will require large numbers of previously unregulated private equity funds to register with the Cayman Islands regulator and become subject to new rules around valuation, asset verification and cash flow monitoring, requirements that borrow heavily from the European AIFMD depositary oversight model.
AML (anti-money laundering) features extensively as regulators inside the EU and Cayman Islands push ahead with new rules to mitigate the problem. The EU’s fifth AML Directive imposes stricter client due diligence measures and greater transparency around beneficial ownership disclosure, and this is something fund managers will need to come to grips with. Having unveiled its own strengthened AML provisions, the Cayman Islands is also likely to start taking action against fund managers deemed to be non-compliant.
While still niche, interest in digital assets, and in particular asset tokenisation, could pick up at asset managers as the industry searches for new sources of alpha. Tokenisation – which takes place on a distributed ledger – can support fractionalisation allowing investors to access hard to hold or illiquid assets through part ownership structures. Not only will this create new investment opportunities, but it could generate greater liquidity in historically illiquid instruments and asset classes such as private equity.
However, institutions are still apprehensive about some of the custody products used for tokenised securities along with the ease at which these instruments can be reconciled with the underlying assets. Custodian banks are quietly sounding out to their clients about whether there is much appetite for digital custody solutions although a handful of smaller technology companies have launched their own crypto-custody offerings. Just as independent depositaries enhance fund governance processes by validating that assets are appropriately safe kept and verified, it is probable this business model will evolve to cater for digital assets as well.