Regulatory Review Financial Directives 2010s

Business Operating Model Redesign - Call of Decade

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Survive. Sustain.

Faced with the new regulatory environment, a secular trend impacting margin compression and the potential of big data. Entrepreneurs and Investors will emerge to survive from the current restructuring process for competitive advantages in efficiency and flexibility and to sustain with a higher cost for compliance degree.

The challenges brought on by a nearly significant increase in registered investment advisers since the implementation of the Dodd-Frank Act required the Office of Compliance Inspections and Examinations (OCIE) to consider both tactical and strategic opportunities to examine higher-risk registrants and, within those examinations, focus on high-risk compliance areas.

Going forward, it is clear that more and more private fund advisers will receive greater examination scrutiny. But the consequent potential for decreased systemic risk and increased confidence on the part of investors and counterparties will be a significant benefit for the industry as a whole.

regulatory review within the CRS and tax avoidance frameworks 2018-2020:

BEPS

The OECD’s project on base erosion and profit shifting (BEPS) may have been originally intended to tackle real and perceived tax avoidance by multinational companies, but its effects have rippled through to the real estate fund management industry.

The risk for any international business, including real estate firms, is that different approaches by individual countries create a highly complex and constantly evolving tax landscape. Even where legislative changes are not made, it is fair to assume that governments, under pressure to increase their tax bases, will tighten up the enforcement of their existing rules.

07 June 2017, Paris:  Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (the MLI).

19 February 2018, Paris:  Preventing Abuse of Residence by Investment Schemes to Circumvent the CRS (the CBI).

FATCA

The FATCA was enacted into US law as a provision of the Hiring Incentives to Restore Employment Act (U.S. HIRE) in 2010.

FATCA is intended to counter offshore tax avoidance by U.S. persons by strengthening the information reporting by third-party payers, typically financial institutions. Within the US, US investment funds are classified as withholding agents. Outside the US, FATCA affects all foreign financial institutions (FFIs), US withholding agents and their customers worldwide. The definition of FFI is extremely broad and would likely include all managed funds. Any non-US entity that would be called an “investment fund,” “hedge fund” or any similar classification would most likely be categorized as an FFI. All of an FFI’s global-affiliated financial institutions will, therefore, fall within the category of either an FFI or a US withholding agent.

For non-US entities, FATCA is an extraordinarily far-reaching piece of national legislation, yet another that will affect firms far beyond their home jurisdiction.

Most major firms categorized as FFIs likely will enter into an agreement with the Internal Revenue Service (IRS). If not, they are classified as “nonparticipating FFIs.” Such nonparticipating FFIs, as well as US persons who do not permit their FFI to disclose account details to the IRS, will face 30% withholding on certain US-source payments.

Financial Transactions Tax (FTT) Directive

The concept of an FTT was initially supported by 11 EU participating Member States (PMS) and was approved in the European Parliament in December 2012 and then by the Council of the European Union in January 2013. A lengthy drafting process coordinated across the EU was designed, in theory at least, to avoid fragmentation of the single financial services market in Europe to ensure that the financial sector makes a contribution to public finances, and to discourage transactions that do not contribute to the efficiency of the financial markets. Under the current draft directive, not only would the asset management industry (including collective investment schemes) operating within the PMS be exposed to FTT on its financial transactions, but non-PMS counterparties conducting transactions with PMS-based entities potentially would be as well. So far, the proposed minimum charges are 1 basis point of the notional underlying Principal of derivative transactions and 10 basis points on secondary market transactions of financial securities. For electronic transactions, FTT would be payable when the tax becomes chargeable. Exemptions permitted in the current draft of the directive are much narrower in scope than other preexisting corresponding transaction taxes, such as the UK stamp duty regime. Except in limited circumstances, FTT would likely apply to every financial institution that is party to an in-scope financial transaction, with no provisions for netting permitted.

Continued uncertainty around the exact final shape of the proposed FTT Directive makes planning for changes in operational infrastructure difficult. Already, the initial January 2014 proposed deadline has passed, and internal debate within the EU continues.

Nonetheless, in one form or another, the PMS authorities most likely will implement an FTT. The major remaining questions are related to the timeline for implementation and the exact shape of the final regulation. One important outstanding question, particularly for the asset management industry, is whether transactions in the units or shares of collective investment schemes could be within the scope of any final FTT Directive. With a final directive, however, watered down it may be from the initial draft directive issued in February 2013, asset managers will be required to review and adapt their business model to ensure that they have an FTT-efficient structure and the necessary systems to capture and record the FTT that is due. Further, depending upon the scope of the FTT, certain product areas may prove uneconomic and eventually be eliminated. Key questions also remain as to which collection and reporting systems will be needed in the asset management value chain.

FTT has already been introduced under national regimes in France and Italy and has been discussed for introduction in other countries, such as Portugal and Spain. The FTT is a classic example of an ostensibly local regulation having an extraterritorial global effect far beyond the jurisdictions in which it has been enacted.

To say the least, there has been considerable debate and pockets of opposition throughout the PMS. For example, the UK has led a number of other countries staunchly opposed to the FTT. In April 2013, the UK’s Chancellor of the Exchequer filed a challenge to the implementation of the FTT with the Luxembourg-based European Court of Justice. Further, perhaps as an indication of deep-seated, underlying ideological differences, serious discussion about such a transaction tax has not occurred in the US.

MARKET INFRASTRUCTURE

The Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the Dodd-Frank Act, seeks to promote financial stability by reducing systemic risk in the economy and enhancing investor protections. For the US financial services industry, the 2,100-page piece of legislation is arguably the most complex law affecting the financial services industry. The act restructured the US financial regulatory regime by requiring enhanced reporting to regulators and increased transparency to investors, fundamentally changing the permitted investment activities of banks, and demanding additional market infrastructure and consumer protections. The Dodd-Frank Act and the surrounding debate over the complex rule-making process will continue to drive change across the industry, including how firms structure and operate themselves and their investments, how they interact with counterparties, their ability to take a risk and how they interact with customers.

FSOC and Key regulatory changes and impacts:

  • Title (I) covers the promotion of financial stability through the creation of the Financial Stability Oversight Council (FSOC), composed of senior members of US regulatory agencies. FSOC has broad powers to address systemic risk to the economy, including the ability to enhance the monitoring and governance of certain institutions by designating them as systemically important financial institutions (SIFIs).
  • Title (IV) requires the registration of advisers to private investment vehicles. In addition, these types of advisers are now subject to specific reporting requirements related to the private funds being managed (Form PF).
  • Title (V) institutes the monitoring of the insurance industry by the Federal Insurance Office in the US Treasury.
  • Title (VI) “The Volcker Rule” attempts to allay systemic risk by limiting banks and their affiliates’ risk-taking capabilities through several steps: a prohibition on proprietary trading, limitations on a bank’s ability to invest in funds, an expanded application of “Super 23A” prohibitions and the implementation of a Volcker Rule compliance program.
  • Title (VII) drives for transparency and accountability on Wall Street through regulation in OTC derivatives markets, including centralized clearing and settlement.

Capital Requirements Directive: CRD IV

CRD IV is a package of prudential requirements that apply to many asset management firms with effect from 1 January 2014, subject to some transitional provisions. Based on Basel III, CRD IV applies to banks and a broad range of other financial institutions across all of the EEA. Most asset management firms likely fall within the scope of CRD IV. Where there is a group of companies, the existence of a CRD IV-covered firm within the group can bring the group within the jurisdiction on a consolidated basis.

Some key areas of impact:

  • Calculation of regulatory capital resources is potentially tougher with the new requirement to deduct deferred tax assets and effectively account for pension fund deficits.
  • Increased quality of capital is required. Upper Tier 2 and Tier 3 capital categories are removed. The ratio of common equity Tier 1 and Tier 1 capital is now significantly higher.
  • In calculating regulatory capital resources, one favourable change for asset managers is that their own holdings in open-ended funds are no longer subject to deduction. This is particularly helpful for asset management firms that hold seed capital.
  • Credit risk calculation is administratively more burdensome because the standardized approach must be followed since the previously available simplified approach is no longer available.
  • Increased common reporting Integrated Common Reporting (COREP) requirements now include capital adequacy reporting for all firms and increased financial reporting (FINREP) requirements for some groups. Both of these require reporting through eXtensible Business Reporting Language (XBRL). There is also increased tax reporting with a potential impact on firms operating in different countries.

The European Commission has committed to review the prudential regime for investment firms in 2015 as an acknowledgement that these banking-based CRD IV requirements may not be the most appropriate for investment firms. Thus, there may be a new prudential regime for asset managers beginning around 2018.

EMIR

The EMIR, like the Dodd-Frank Act, will mandate central clearing for standardized contracts and impose risk mitigation standards for non-centrally cleared contracts. There will also be wide reporting requirements. The clearing obligation will apply to both financial counterparties and nonfinancial counterparties that exceed certain thresholds, and it will apply broadly to most OTC derivatives.

EMIR’s key regulatory changes:

  • There are increased reporting, process and people requirements — transaction reporting by February 2014 and exposure and collateral reporting by August 2014.
  • All standardized OTC and exchange-traded derivatives will be required to be cleared through a central clearing party (CCP); initial and variation margin treatments will be finalized for an effective date of December 2015.
  • There are increased trade confirmation, portfolio compression and reconciliation arrangements effective September 2013. Risk weights for non-centrally cleared instruments will be announced.
  • The current six announced trade data repositories will be administered by the new European Securities and Markets Authority (ESMA).

MiFID II

The MiFID has been the cornerstone of capital markets regulation in Europe since its first implementation in 2007. With new amendments, MiFID II, the second version of the highly encompassing directive, was published by the European Commission in 2011 and has been progressing through the EU negotiation and decision-making processes since then.

MiFID II likely will be finalized in the form of a single legal effect regulation (called MiFIR) and a directive form (MiFID II) to take effect by the end of 2016 at the earliest, and it will be introduced to coincide with other overlapping regulations likely to impact asset management firms, such as MAD II, PRIPs and IMD II. Some of the many areas that are addressed include the following:

  • Trading operations: order routing and client-order handling will need to be reconfigured, as will quote-driven markets such as fixed income and OTC-traded instruments, including interest rate, credit default and FX swaps.
  • Widely encompassing product coverage: the pre- and post-trade transparency regime under MiFID I will be extended to a very wide range of products, such as exchange-traded funds (ETFs), Global Depository Receipts (GDRs) and most OTC derivative and commodity instruments, including emissions trading.
  • Market structure: a new category of the venue called the Organized Trading Facility (OTF) will be introduced for non-equity trading and may cover single- and perhaps inter-dealer platforms. The OTF category will be in addition to the extent regulated market, multilateral trading facilities (MTFs) and systematic internalizer (SI) categories of venue.
  • Position limits and trading restrictions: MiFID II implement trade restrictions and position limits set by the ESMA, with the potential for deferral for certain economically structural commodities, such as oil and coal.
  • Algorithmic trading: although still permitted, a more restrictive regime covering high-frequency and algorithmic trading will be introduced with the greater focus on disclosure and on risk management considerations (such as margin requirements and leverage).
  • Investor protection: rules are expanded, new asset classes are included and investor categories are modified; there are also likely to be rules and limitations on “inducements” paid between product providers and distributors.

ASSET MANAGEMENT-FOCUSED PROVISIONS:

AIFMD

The AIFMD is one major element of the EU’s response to the GFC. It covers management, administration and marketing of alternative investment funds (AIFs) and focuses on regulating the Alternative Investment Fund Manager (AIFM) rather than the alternative fund itself.

AIFMD establishes an EU-wide, harmonized framework for monitoring and supervising risks posed by AIFMs and the AIFs they manage, as well as for strengthening the European market in alternative funds. Driving factors for AIFMD include more transparency; more disclosure; more filing requirements; and, in theory at least, more investor protection. EU-based managers can apply for an AIFMD passport for operations and marketing activities that fall within AIFMD’s jurisdiction. The UCITS passport will allow them to operate across borders around the EU. In the long run, AIFMD  - along with the UCITS regime - is part of the effort to strengthen the market for EU asset management firms to compete both within the EU as well as globally.

Form PF

While the EU was negotiating and implementing AIFMD, in the US, the Dodd-Frank Act introduced the new Form PF reporting requirement under its Title IV. This provision applies to managers of alternative funds. The coverage of Form PF and risk-related reporting requirements are somewhat similar to the broad jurisdiction and reporting requirements of AIFMD. Form PF reports received by the SEC and AIFMD reports received by EU regulators will be scrutinized both at national and global levels. In particular, among G-20 regulators, the Financial Stability Board and the International Organization of Securities Commissions (IOSCO) will use reported data to determine whether asset management activities can present systemic risk, as well as how to measure the risk created and which measures should be taken to mitigate that risk. While the regulatory debate on asset managers impacting systemic risk is ongoing, new regulatory initiatives targeted at fund managers with the intention to control risk could be significant, particularly for larger managers.

DISTRIBUTION: RDR

A domestic UK regulatory initiative, the wide-ranging RDR was first developed by the Financial Services Authority (FSA) and is now being implemented by the FSA’s successor regulatory body, the Financial Conduct Authority (FCA). The new law came into effect in January 2013. The RDR seeks to improve the quality of investment advice available to UK investors by improving the clarity with which firms giving investment advice describe their services, restructuring remuneration practices to eliminate conflicts of interest and raising professional standards. In addition to banning commission payments from asset management firms to client investment advisors, the RDR also covers the remuneration of investment platforms, banning payments by product providers to such platforms.

Key provisions:

  • Retail client advisors banned from receiving payments from product providers: the cost of advice must be fully disclosed and agreed upon in advance with the client.
  • Description of services: advice is to be classified as either “independent,” in which case it must cover the whole of the market for investment products, or “restricted.”
  • Professional standards: advisors must be more highly qualified than previously and undertake continuing professional development.

Impact on asset managers UK distributors must restructure their business models and remuneration policies. The FCA has clamped down on attempts to “get round” RDR, insisting on the spirit that no payments in any form should be permitted between product providers and distributors. There is considerable interest in other parts of the globe in developments in the UK’s RDR. RDR-like provisions may be incorporated into MiFID as part of an EU inducement ban on payments to advisors — as a ban has already been implemented in the Netherlands. Australia is implementing a similar initiative, and a number of other national regulators, such as South Korea, have also announced an intention to ban commissions paid to distributors.

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

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