New (Super) Powers for ESMA?

The European Commission recently proposed substantial changes to the cross-border finance supervisory model. Here’s what UCITS and AIFMD managers need to know.

The European Commission has published new proposals suggesting significant revisions to the supervisory model in place for cross-border finance. The revisions could curtail the ability of UCITS and AIFMD managers to delegate and outsource services to non-EU countries, if it’s approved.

The proposals, released on 20 September, would enhance the powers and funding of the three EU Supervisory Authorities – European Securities and Markets Authority (ESMA), European Banking Authority (EBA), and European Insurance and Occupational Pensions Authority (EIOPA). They aim to reduce regulatory arbitrage and foster greater supervisor convergence across the EU.

Casting a Wide Net

The proposal suggests giving ESMA direct power to oversee asset management companies’ use of delegation. Now, many firms set up the required management company, board, and legal framework in Luxembourg or Dublin and then delegate portfolio management to another country within or outside the EU. Under the proposal, national regulators would have to notify ESMA every time they receive a request for authorization by a firm that proposes to delegate to a country outside the EU.

If ESMA considers a firm’s organizational construct breaches delegation rules, it would have the power to instruct the national regulator to seek amendments to the application or even reject it.

Powers that already reside with ESMA include:

  • Oversight of central counterparty clearing houses including third-country Central Clearing Counterparties under European Market Infrastructure Regulation
  • Direct authorization and ongoing supervision of European Venture Capital Fund regulations, European Long-Term Investment Funds, and European Social Entrepreneurship Funds
  • Approval of closed-end funds’ prospectuses

Other powers that could shift to ESMA include:

  • MiFID 2 provides ESMA with direct product intervention power, which may be applied to UCITS and AIFMD managers directly marketing shares in their funds
  • Stress-testing power akin to that of the European Banking Authority
  • Direct supervision over significant benchmarks and non-EU administrators whose benchmarks are used in the EU

Avoiding Letterbox Entities

The extent to which the European Commission’s proposals demand the centralization and harmonization of regulatory oversight has not been witnessed in Europe before. But it’s not a complete surprise, particularly when it comes to delegation and outsourcing.

In July, ESMA said in a non-binding opinion that regulators should apply extra scrutiny when activities are delegated to third-countries, which will include the UK when it leaves the EU in 2019. ESMA is concerned about expertise – and a significant amount of profit – going to countries beyond the EU.

Some national regulators have been said to take a lighter touch to the delegation rules than others, so the only way to ensure harmonization is for ESMA to take control. The proposed changes are part of the EU’s drive to ensure any firm that benefits from passporting has appropriate “substance” within the EU, rather than simply an EU-based letterbox. Harmonization is far easier with centralization of assessment compared to having 27 different overseers.

Feeling the Impact

If these proposals are approved by the EU Council and Parliament, they will have a far-reaching impact, because most asset managers operate on a global basis. Global managers access the best expertise available, leverage economies of scale, and benefit from globally situated operational infrastructure. To lock them into EU-only resources would be detrimental to the industry.

The largest impact would be felt in the US because many UCITS have US-based asset managers or advisers attached. Under the proposals, UCITS need to house more expertise, infrastructure, and capabilities within the EU rather than leveraging those of their home country. The issue of delegation is likely to form a significant part of the omnibus review into UCITS and AIFMD, planned for 2018.

If this comes to pass, it will be critical for the industry to agree how the term portfolio management is defined in the context of delegation. What will primarily count: Where the mind and management resides or where the work is conducted?

Planning Ahead

Before we get ahead of ourselves, there is a lot that needs to happen before these proposals become regulation. There is likely to be backlash from national regulators, policymakers, and market participants because the changes may disrupt the UCITS infrastructure. Most of the UCITS industry believes they already comply with delegation and outsourcing principles.

Either way, it’s important that asset managers plan for a potential short-term disruption to their organizational structure by creating an inventory of their delegation model – and then analyzing what it would mean if they couldn’t access third-country delegates as they do now.

On top of possible disruption, the industry will have to pay for ESMA’s expansion. Investment management firms will have to cover a percentage of ESMA’s budget, which will be an unwelcome addition to asset managers’ already stretched budgets. There is a risk once this levy is enshrined, it could be the thin end of a funding wedge, and that the cost will increase in the future.

Whether the proposals are ultimately passed or not, they represent another signal of ESMA’s intent to expand its oversight and control of EU markets following Brexit. Stay tuned…