European regulators are spending a lot of time scrutinising the liquidity risk management practices at investment firms following a number of high-profile fund suspensions last year. That such liquidity issues were allowed to happen raises questions about the effectiveness of fund governance practices as a whole. If asset managers are to retain the trust of investors, higher standards of governance are required within areas of the funds’ industry.
FCA is pushing up standards
The UK’s Financial Conduct Authority (FCA) is taking a lead on governance, having introduced the Senior Managers & Certification Regime (SMCR) in December 2019, which imposed heightened accountability criteria on asset managers. The importance of SMCR and robust fund governance were the central messages in two “Dear CEO” letters sent by the FCA to both retail and alternative asset managers at the beginning of 2020.
In the letters, the FCA said SMCR was not to be treated as a “discrete compliance project” but “as an opportunity to deliver high standards of governance.” The FCA’s message was clear: “Overall standards of governance, particularly at the level of the regulated entity, generally fall below our expectations”. The FCA has told firms it wants them to have “refreshed [their] approach to governance and taken the necessary steps to improve it”.
The letters were also clear in stating the FCA will be actively examining the retail asset management and alternatives sectors during 2020, so firms should expect increased scrutiny. As a result, managers have been put on notice meaning they will need to demonstrate how they have adapted their governance frameworks as a result of SMCR.
Building blocks of strong fund governance
SMCR focuses mostly on culture, conduct and accountability at asset managers. However, effective fund governance, which ensures a fund is operated in the best interests of its investors, requires a broader system of checks and balances. These are performed collectively by the fund board, the depositary and auditor, and must be done to a high standard. These three functions are essentially the building blocks of good fund governance. However, they are often treated as a box ticking exercise or worse they are vulnerable to conflicts of interest. This can result in subpar service much to the detriment of investors.
Examples of such deficiencies include fund directors not being genuinely independent of the asset manager, or depositaries overseeing fund administrators which they are affiliated with. In these circumstances, depositary is not seen as a core business but one born out of a need to enable clients to comply with a regulatory requirement. As such, there is little incentive for these depositaries to shine a spotlight on poor performance or errors made by the parent fund administration group.
Independence, independence, independence
Truly effective fund governance requires independent and conflict free oversight, which always places the interests of investors first. As a consequence of SMCR and the follow up Dear CEO messages, more managers are expected to review the effectiveness of their fund governance arrangements. They will assess all aspects of their operations and recognise that independent, conflict free services represent a stronger governance model.
Tick the box approaches towards compliance should no longer be tolerated. Managers must review conflicted service models and demonstrate that fund directors and depositaries are subjecting them (or their affiliates) to appropriate challenge. Managers will benefit from being able to demonstrate to their clients that they have embraced effective fund governance and depositary oversight.
Where do we go next?
As the end of the Brexit transitional period looms and calls from the industry grow for the UK to adopt its own unique, internationally accepted fund structure, the case for more effective fund governance is becoming stronger.
If the UK is to preserve its reputation as a leading asset management hub, regulators need to ensure that governance is robust. The role of the fund depositary is likely to grow in importance and this could be an excellent opportunity for the UK to lead the way on insisting that depositary oversight be strengthened and become more independent.
This INDOS Financial article was first published by HFM Week and can be read here.