Regulation: the challenge of reconciling growth and compliance

The investment management industry will have to adopt a host of regulatory legislation and new laws in the next few years. While working to meet client needs and growth goals, the industry must also address the impact that these regulatory changes will have on business, operational and compliance requirements. This article presents some views on the challenges and solutions with regard to aligning compliance and growth strategies.

By Michael Metcalfe, Co-Editor of the Journal of Applied IT and Investment Management

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Across the globe, a sweeping wave of regulatory reform and change is redrawing the contours of the financial landscape. Over the next three to five years, a loose and often arbitrary set of new legal provisions, standards and regulations will impact a wide spectrum of the financial services sector, its ancillary and auxiliary services, intermediaries and third-party suppliers and providers, as well as the combined range of financial instruments and products they manufacture, process and market. The impact will be varied, with some areas hardly feeling the pinch at all while others will be significantly squeezed.

For the investment management industry, by and large, the regulatory and compliance challenges in the years ahead will be unprecedented. Among the manifold changes to be taken into account at the strategic, tactical, systemic and operational levels are the new regulatory framework and demands of the landmark Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in the USA, AIFMD, MiFID conduct of business, PRIPs, Solvency II and UCITS IV in the EU, as well as on an international level the new tax rules and standards primarily embodied in IFRS 9. Comments Michael T. Dolan, a Partner at Ernst & Young in Washington D.C.:

“The combined ramifications of legislative and regulatory reform include the advice investment managers offer clients, the way they handle transactions, how they market the business, the disclosures they provide, and ultimately the manner in which they will have to reconfigure and retool existing operational and investment management systems.”

Ensuring effective implementation of the new regulations will be daunting enough for any investment management enterprise. The years ahead promise even more pressing challenges – with accelerated rulemaking becoming the norm as regulators implement financial reform and fine-tune the lawmaking. At the same time, the expectations of investment management organisations and their clients have never been higher. Argues Dushyant Shahrawat, Senior
Research Director at TowerGroup in the Securities and Investments practice in Boston:

“Key industry stakeholders including investors, clients and prospective clients are clamouring for greater transparency and disclosure, as well as more assurance that the individual manager has strong compliance and internal controls with the necessary investment management software to back these up.”

Many investment organisations have learned from the financial crisis and market upheaval that spawned the latest wave of regulatory reform. Demands for greater transparency, better reporting, lower risk tolerance and higher pressure on fees already have and will continue to increase substantially. However, these hard facts have not reduced client expectations regarding growth and returns – on the contrary.

THE RIGHT CHOICES

With unparalleled regulatory activity and more stringent client demands on investment managers, achieving growth will entail that companies make the right investment management system choices in the current environment. Sriram Venkataraman, an Executive at Ernst & Young’s Financial Services Risk Management practice in New York, takes the view:

“Regardless of whether investment managers pursue growth strategies of low-cost leadership, product differentiation, expansion into new markets and/or segments or a combination of these, it is imperative that the technical infrastructure is in place to support the desired growth strategy.”

Irrespective of the growth strategies employed by individual investment managers, there is one common challenge faced by all when delivering on the promises made to clients to provide attractive returns on their investments. If asset managers are forced to divert scarce and valuable resources to overcoming operational issues and deficiencies in their investment management system, then their prospects of achieving growth look bleak indeed.

PRESSURE POINTS

“There are five major components that make up the wave of financial reform which will impact the investment management industry ,” explains Mr. Venkataraman (see overview below). Of these five key areas of legislation, the Dodd-Frank Act is probably the most comprehensive and all-encompassing in terms of the impact it will have on financial services in general and the investment management industry in particular. The provisions are to be implemented over an 18–24 month period, but many aspects of the legislation have yet to be defined.

In addition to a host of other measures, the Dodd-Frank Act significantly enhances the powers and capability of the Securities and E xchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and the Federal Reserve and creates a new agency called the Consumer Financial Protection Bureau (CFPB). Notes Mr. Shahrawat:

“Dodd-Frank clarifies the roles and responsibilities of regulators, which is of special significance in areas such as derivatives, whose regulation historically was split among different regulatory bodies.”

Mr. Shahrawat goes on to explain that the Dodd-Frank Act accords much greater power to all regulatory agencies (especially the SEC, CFTC and the Federal Reserve), while creating new agencies: the CFPB, the Office of Financial R esearch (OFR), and the Office of Financial Stability. New powers to the SEC include oversight of the credit-ratings business and the ability to examine and fine nationally recognised statistical rating agencies.

In response to the new regulatory powers, greater resources, and a stricter mandate granted to regulatory agencies by the new law, investment management companies will need to enhance their compliance departments, add staff to deal with more regulatory examinations and implementractice compliance software (for surveillance of employees out of insider trading, data security and privacy considerations). “They will also need to conduct staff training and development and enhance preparedness for audits and examinations to deal with potential investigations of issues like market abuse and insider trading,” adds Mr. Shahrawat.

CAPITAL POOLS

Changes to private pools of capital (mainly in the form of alternative funds and private equity funds) are one of the aspects of the Dodd-Frank Act that will have the greatest impact on the industry. Dodd-Frank requires alternative funds and private equity funds to register with the SEC as investment advisers, which means they will need to report investment performance, client assets, financial records and other pertinent information on a regular basis. It also provides greater powers to supervise smaller alternative funds and implement special rules governing such funds.

“Collectively, all this means dramatic changes for this sector affecting operating costs, profitability, and the competitive structure of this business,” observes Mr. Shahrawat. Large hedge funds that already have established mature compliance, reporting, and client service departments will find these changes relatively manageable and will thereby gain an advantage over funds that do not, which will be hit with new costs and distractions.

NEW EUROPEAN RULES

In Europe, the range of new regulations will primarily affect investment funds – mutual and alternative alike – and significantly change the way in which they are operated, marketed and distributed. The various industry links making up the distribution value chain will need to modify the way they operate and interact, both with investors, regulators and one another.

The new UCITS IV Directive, MiFID conduct of business, an EU Directive on Packaged Retail Investment Products (PRIPs), and new UK-based regulations from the Retail Distribution Review (RDR) all share a number of common overarching objectives, the key being to restore and enhance investor confidence in financial products and improve industry efficiency.

This will be achieved by improving transparency and comparability across a range of financial products, not just UCITS funds; eliminating real and perceived conflicts of interest and harmonising rules surrounding investor information and the conduct of business across the entire investment fund value chain. All these changes will alter the processes by which funds are distributed across Europe by impacting the complex relationship between the fund manufacturer, distributor and investor.

Having been approved by the European Parliament, Council and Commission, AIFMD will go ahead in its present form in mid-2011. During 2011 AIFMD will proceed through Level 2 negotiations where substance is added to the proposals as agreed. The EU’s 27 member states then have two years to transpose AIFMD into national law, with AIFMD projected to enter into force in mid-2013.

Also affected by this directive on a national level is Switzerland, insofar as a European fund manager may be headquartered in Switzerland, just as a fund manager headquartered in Switzerland may offer both Swiss and European funds for sale in the EU. Comments Dr. Matthäus Den Otter, CEO of the Swiss Funds Association (SFA): “From the Swiss perspective, it is crucial that European fund managers are able to delegate certain business activities to Swiss financial services providers on the one hand, and that Swiss funds and fund managers receive the relevant ‘EU passport’ on the other.”

RELOCATION OR LOCATION?

When considering whether AIFMD will actually help boost the establishment and relocation of alternative funds in European jurisdictions like Luxembourg, a number of factors have to be taken into account. According to Camille Thommes, Director General of the Association of the Luxembourg Fund Industry (ALFI):

“Relocation is one question, location another. What seems to be clear from the current version of AIFMD is that it will be easier if you want to distribute your funds in Europe to have European funds in a European management company.”

If an alternative fund manager wishes to sell non-European funds in Europe or sell funds that are managed by a non-European company, there are specific provisions that have to be complied with in regard to the regulator of the country where these funds or managers are domiciled. “So what we believe is that if you want to sell funds to European investors, the easiest solution is to have your asset management company in Europe,” adds Mr. Thommes.

In answer to the question whether the regulatory challenge can be turned into a benefit or competitive advantage for investment management companies, Charles Muller, the Deputy Director General of ALFI, responds: “One has to consider that some of the regulatory impulses come from the lessons learned from the financial crisis, like AIFMD to start with; but we are also talking now about the process of UCITS V, about MiFID, about PRIPs. So as a point of principle to look at these elements, it’s certainly a good thing.”

IFRS 9 DOUBTS

IFRS 9 may be seen as the accounting world’s answer to the financial crisis, but there are doubts that the standard is enough to prevent another crisis. Many experts argue that this requires vigilance from all stakeholders – from accountants to investors and regulators. All in all, it points to improved fiscal transparency and convergence.

The next phase of the IAS 39 replacement will focus on liabilities and impairment, and is due to be completed later in 2011. Here the implications will be wider for financial institutions, many of which have been setting aside millions of dollars as provisions for bad debt. The larger financial institutions have the technology to help them capture the necessary data and calculate credit risk. But smaller companies may have to invest in more investment management system resources.

“In our experience, data makes up 70% of an IFRS project. It is a key component to the work being done,” estimates John Foulley, the Hong Kong risk management practice head for SAS Institute Asia Pacific. Moreover, accountants need to be more attuned to risk management that has typically been handled by a separate department.

FATCA IMPACT

Another tax regulation that could have a far-reaching impact all over the world is the new US legislation embodied in the US Foreign Account Tax Compliance Act (FATCA). Passed by the US Congress in March 2010, it is designed to ensure the identification of (and reporting on) US persons with banking relationships outside the USA.

The US legislation envisages the imposition of a withholding tax amounting to 30% on specific payments from US sources (particularly investment income and capital gains) paid to any foreign financial intermediary for either its own account or that of a client. The foreign financial intermediary can avoid this procedure only by concluding an agreement directly with the US tax authority IRS.

Given its significant international activity, particularly with the USA, Switzerland is highly affected by FATCA. Comments Dr. Den Otter: “If non-US financial intermediaries wish to invest in the US capital market and look after US clients once FATCA enters into force, they will have to conclude the corresponding agreement with the US tax authorities. Any affected financial intermediaries would have to be prepared to take on a comparatively high administrative burden in order to comply with this agreement.”

But Luxembourg too is likely to feel the repercussions of FATCA. Comments Mr. Thommes: “Depending on how that will end up in detail – we in Luxembourg and also through our European association EFAMA are still in discussions with the US tax authorities as to how exactly FATCA should be interpreted – this could have an outstandingly important impact in terms of investment management system applications and could prove extremely costly to implement.”

WINNING WAYS

Heightened regulatory expectations will place additional pressures on the investment management industry at large. In the words of Mr. Dolan:

“Investment management firms have dealt with changing regulations, accounting policies and risk trends. But this time it’s different. Complying with emerging rules will require fundamental changes in business models and strategies. The impact will be enterprise-wide. We recommend that firms leverage their compliance investments into a growth agenda by streamlining and enhancing systems portfolios, improving data governance and management, and enhancing customer management.”

The changes are at the strategic level, they are not at the business unit level anymore or at the product level. Whereas in the past, the approach was more tactical in orientation, the present circumstances call for more of a strategic re-appraisal to take account of not only one aspect of regulatory change, if Dodd-Frank is taken as an example, but a whole host of regulatory measures (i.e. AIFMD, MiFID, Solvency II, UCITS IV, etc.).

As a consequence, and in view of this all encompassing and wide-ranging change, regulators expect to see, and indeed demand, a comprehensive, custom-built and sophisticated compliance programme with full testing, use of technological tools and software system expertise. The consequences of non-compliance are not worth thinking about, and a compliance failure can prove terminal to a business operation.

A sound system of compliance controls – backed up with the necessary IT architecture – is essential in protecting the organisation from business, regulatory and reputational risks. A strong compliance function will also become a factor of increasing competitive importance, which will define and set an organisation apart from its competitors. In the end, the winning way will prevail.

Michael Metcalfe is Co-Editor of the Journal of Applied IT and Investment Management. A financial journalist by profession, he has worked for such publications as The Economist, Financial Times and International Herald Tribune. Based in Germany, he also worked in the Luxembourg financial sector for 10 years, including tenures with Nordea Investment Funds S.A. and Lombard International Assurance S.A.