It may not be highest priority for many asset managers but post-trade regulation can have broad implications for the industry and should not be ignored.
In his book, “Plumbers and Visionaries,” Peter Norman observed that the funny thing about what happens in stock exchanges is that no stocks are exchanged. Actual “exchange” (settlement) happens in a post-trade environment, which financial regulators and policy-makers considered with renewed urgency amidst the fallout of the 2008 financial crisis.
After a trade, a globally interconnected network of post-trade infrastructure providers and intermediaries – the “plumbing” of the global financial system – finalize the process through clearing and settlement. The post-trade process is not typically an asset managers’ highest priority. Historically, it was seen as a custodian’s role to sort it out so managers could focus on their primary investment management goals. However, following the crisis, managers quickly learned that regulators viewed looking out for the safety of transfer and disposition of customer assets to be their ultimate responsibility. Moreover, the tsunami of new regulation in the post-trade space over the last decade brought home the simple truth that pursuit of desired investment management strategies and objectives depend on whether post-trade structures and regulation of those structures contemplated or permitted them.
Banks and asset managers must remain attentive to the impact of post-trade considerations on trading strategies. Impacts of regulation in this space are not confined to service providers: the buy-side, sell-side and post-trade industries must collaborate and engage with public authorities to ensure reform measures operate in the interests of investors whilst simultaneously reducing systemic risk. It pays to anticipate the developments in this area that may affect investors’ interests.
Here we focus on the four post trade issues that are currently most relevant to asset managers:
Books and Records
Contrary to popular belief, the AIFMD and UCITS V directive continue to develop. Key areas still under discussion include how an AIF or UCITS trustee/depositary is expected to maintain “books and records” of financial instruments belonging to the investment fund and whether elements of market infrastructure such as certain central securities depositories (CSDs) providing commercial services should be held to the same standards and requirements as any “traditional” custodian. Both issues raise questions about access to post-trade infrastructure, how assets should be held and protected, and whether strategies such as collateral management, repo, hedge and exposure to certain geographic markets can operate with minimum cost and maximum efficiency.
To comply with the books and records requirements, the depositary industry adopted an approach to ensure managers could continue to operate as before but with greater attention to how investment fund assets are maintained at third-party providers, such as collateral agents or affiliated custodians. Whether and how depositaries are obliged to more intrusively supervise certain CSDs as “delegates” has also raised questions.
Regulators’ views are not entirely consistent and market practice has varied across member states. ESMA sought to redress these inconsistencies in an opinion last summer. ESMA’s goal was to provide an EU framework for “strong client asset protection, especially in insolvency, for the safe-keeping of assets which are required to be held in custody.” The opinion acknowledged views emphasizing the imperative of maintaining “omnibus accounts” in order to give effect to clients’ goals (since asset protection would be preserved more effectively), but did not resolve questions surrounding books and records and CSD requirements. The industry has engaged with authorities to provide assurances that they already satisfy books and records requirements and protect investor interests across all major models. On the CSD point, the industry is engaging with market infrastructure providers to ensure that managers fulfill regulatory and client expectations. It is important that asset managers work closely with their service providers to ensure that regulators pursue the most sensible outcomes.
Corporate Governance and Stewardship
ESMA’s Shareholder Rights Directive II (SRD II) may be the most impactful regulatory change you haven’t yet heard about this year. When it goes live in 2019, SRD II will cover more than 8,000 listed EU companies representing about €8 trillion in market share. SRD II’s goals are ambitious to say the least. They include:
- Increasing the quality of engagement of asset owners and asset managers with their investee companies
- Creating a better link between pay and performance of company directors (requiring approval of remuneration policies at AGMs)
- Enhancing transparency and shareholder oversight on related-party transactions
- Ensuring the reliability and quality of advice of proxy advisors
- Facilitating the transmission of cross-border information (including voting and corporate actions) across the entire custody chain
Public authorities believe ensuring the empowerment of institutional investors and asset managers to exercise shareholder rights (thereby denying any excuse to sit passively on shares) will enhance the long-term stability of investee companies. Indeed, to further long-term investment goals, regulators will require asset managers and institutional investors to develop and disclose policies covering how they intend to engage with investee companies, including with respect to how they integrate shareholder engagement into their strategies. Regulators also expect asset managers to provide enough information to institutional investors so the latter can assess whether the managers have been acting in their long-term interests.
As for the post-trade industry specifically, SRD II requires intermediaries to ensure they process information up and down the chain of custody as necessary. Timing considerations pose particularly thorny challenges: regulators expect that communications among issuers, intermediaries throughout the chain, and the final investor occur by close of business on the day of issuance, which becomes particularly difficult if applied across different time zones and conflicting legal frameworks. The post-trade industry is encouraging authorities to adopt market standards for timing and deadline requirements.
Another post-trade development that should be on asset managers’ radar is the Central Securities Depositary Regulation (CSDR) and in particular ESMA’s report on so-called internalized settlement. This practice occurs when a custodial intermediary moves securities on client instruction “internally,” without notifying the CSD. Such transactions commonly occur to facilitate collateral management services, transfers of securities between accounts, in specie transfers and other services necessary to support asset management post-trade requirements. CSDR will require such transactions to be reported to authorities starting 12 July 2019, yet questions remain regarding scope, who should report and circumstances under which reportable “internalization” occurs – even potentially outside the EU. Whilst the industry is providing views to authorities to address open points, asset managers can expect to feel the impact of internalization reporting requirements – along with the imposition of separate new buy-in requirements in the event of failed settlements – in some way.
Bank Recovery and Resolution Impacts
Finally, the moratoria proposals under the Bank Recovery and Resolution Directive II (BRRD II) are likely to have significant impact on trading with EU banks and risks relating to settlement involving EU securities. Industry associations acting for the buy-side have engaged with authorities extensively on preventing or minimizing disruption to counterparty trading arrangements involving EU banks, but it is important to also note the knock-on impacts of any moratoria on settlement and securities-related cash movements through the chain of custody. Significant discussion is under way among policy-makers and the industry to understand the implications of imposing a moratorium on satisfaction of payment obligations that may relate to securities custody so that any disruption to the normal function of securities settlement and securities-related cash flows is minimized in the event an EU bank who acts as an intermediary gets into trouble.
The Post-Trade Story Continues
While the examples above provide a snapshot of some of the most important ongoing post-trade developments in the EU, they are only a part of a story that reinforces two inescapable themes: 1) global policymakers are seeking to ensure investor protection by imposing more intrusive requirements on market infrastructure and other post-trade service providers, and 2) the same bodies are insisting on more investor transparency to improve shareholder involvement in companies in which they invest and, on an entirely separate front, to ensure investors are identified by intermediaries and subjected to proper AML and sanctions screening requirements.
This post-trade story is far from finished, and asset managers can play a critical role in scripting its ending by actively engaging in these debates and paying attention to the “plumbing.”