2018 Financial Regulatory Review: A Flurry of Activity

Despite a lack of mega-regulation, between Brexit, new ETF rules, and increasing investor protections, 2018 had plenty of action for global asset managers.

Brexit

We always knew it was going to be complicated to extricate the UK from the EU after the vote in favor of Brexit in 2016, but the political machinations surrounding the negotiations have thus far proved even more turbulent than first imagined. As we round off the year, it remains up in the air whether any Brexit deal will be achieved by March 29, 2019, the agreed date for leaving the EU. From a regulatory standpoint, however, one thing became clear: post-Brexit the UK would no longer be eligible for the financial passport that allows banks, insurance firms, and asset managers to sell their services in each of the other 26 EU countries. Most UK-based asset managers didn’t waste time waiting around for clarity, using 2018 to relocate their management offices to Ireland, Luxembourg, or other EU financial centers so they would still be officially domiciled in an EU country. This includes UK-based managers of UCITS as well as managers of funds covered by the Alternative Investment Fund Managers Directive (AIFMD).

Investor Protections

After Brexit, another key regulatory storyline in 2018 was the implementation of General Data Protection Regulation (GDPR). Although it is an EU regulation, the rules apply to anyone (including asset managers and banks) involved in the processing of data relating to EU citizens, regardless of whether the processor is domiciled inside or outside the EU, so it is, in effect, a global regulation. One estimate suggested that US firms spent nearly $8 billion trying to comply. Businesses that hold personal data had to adopt safeguards such as anonymization to protect privacy and ensure that data was not available to others without express informed consent of the individual involved. Firms had to appoint a data protection officer and the regulation also gave individuals a limited right of data erasure. GDPR put a focus on financial institutions’ data and how it’s held and secured. Data is frequently seen as an asset, but it’s also a liability if not adequately protected. There’s a regulatory and reputational risk now that didn’t exist to this extent in the past.

Cyber security was an important focus for global financial regulators in 2018, especially following the implementation of the Network Information Systems Directive (NISD) in the EU in November. NISD was initially conceived to mandate protection of essential utility services like water and electricity supplies, but financial services are also covered by the directive. The directive requires firms to take precautions against hackers and lays out a reporting requirement in case of a cyber security event. In the US, the New York State Department of Financial Services adopted similar cyber rules in March 2017. Because New York represents one of the greatest centers of global finance, the state law’s requirements for reporting security breaches are likely to influence developing Federal US regulation and, along with GDPR, play a part in defining an evolving global cyber security standard.

The aspect of privacy and compliance stool which came into sharper focus in 2018 in both Europe and the US entails more thorough requirements on Know Your Customer (KYC) verifications and rules to fight money laundering and terrorist financing. The EU’s Fourth Anti-Money Laundering Directive (AMLD4) was implemented across Europe, while the European Commission added both the Fifth and Sixth Directives to their regulatory agenda. This is a fast paced and ever evolving area of financial regulation across the world. AMLD5, introduces a number of measures to enhance verification of customer identity, as well as establishing new types of assets that require reporting, such as electronic wallets, which are used in cryptocurrency transactions, prepaid debit cards, and other digital monetary transaction tools.

ETF Uplift

ETF inflows continued at a steady clip in 2018, although somewhat behind the record amounts recorded in 2017. Not surprisingly, the continued rapid expansion of ETF assets brought ETFs into the purview of regulators across the globe. The US Securities and Exchange Commission (SEC) responded to the increase in investor interest in ETFs by publishing new proposals that would allow a firm to bring certain types of ETFs to market without first obtaining an exemptive order from the SEC, as previously required under the Investment Act of 1940. In addition, the SEC proposed changes to liquidity risk management rules, no longer requiring public disclosure of aggregate risk and only requiring a “narrative” discussion of the firm’s risk management process in its annual reports. In its reporting requirements, the SEC also reduced the number of liquidity buckets each investment falls into from four to three, based on the number of days it would take to convert the asset to cash. Those changes took place after consultation with the asset management industry and shows that there is a good dialogue going on between the agency and the industry.

The Central Bank of Ireland (CBI) also weighed in on ETFs when they published their “Feedback Statement” in September. In a move sought by the industry, they indicated they intends to revise a policy to allow co-mingling of listed (ETFs) and unlisted (mutual funds) share classes in a single fund structure. The CBI did not change their stance on portfolio transparency – the requirement for sponsors to publicly disclose details of the portfolio holdings daily. ETF sponsors raised concerns that these disclosures could lead to front running and release of intellectual property. This crucial debate will continue in 2019.

And earlier this month, Hong Kong’s financial regulator, the Securities and Futures Commission (SFC), provided clarity on a few important topics pertaining to mutual funds and ETFs. The changes to the Code on Unit Trusts and Mutual Funds (UT Code) aim to update the rules to bolster market development, increase investor protection in Hong Kong, and align with international standards. Key changes include allowing for active ETFs and the co-mingling of listed and unlisted share classes.

Investors’ Best Interests

Another important 2018 SEC decision was its Regulation Best Interest. Recall that the US Department of Labor (DoL) had previously issued a controversial Fiduciary Rule for anyone advising on retirement assets. The rule was eventually thrown out by the courts, but the SEC stepped in with its own rule, which it rebranded as Regulation Best Interest. The SEC proposal has a much wider scope than the DoL’s Fiduciary Rule as it covers all retail investment accounts. The DoL, due to its regulatory remit, was limited to retirement accounts only. The rule requires a broker-dealer to act in the best interest of a retail customer when making suggestions of any securities transaction or investment strategy, making clear that the broker cannot put its own financial interests ahead of its clients’. The industry believes this new standard will enhance the need for advisors and broker-dealers to seek out highly transparent products with lower fees and less complexity, thus possibly favoring ETFs and index-based mutual funds.

Packaged Goods

There has been a multiyear debate in Europe over regulation of Packaged Retail Investment and Insurance-based Products (PRIIPs). Regulators wanted the UCITS industry to fall under PRIIPs rules, but the industry pushed back because of concerns over the descriptions of costs and charges, which might force asset managers to project forward possible returns. Policymakers in Brussels had second thoughts and have now pushed implementation of the PRIIPs rules for UCITS from 2020 to 2022, which comes after the election for a new European Parliament. Additionally, ESMA recently suggested that perhaps both existing UCITS KIIDs and new PRIIPS KIDs should be made available to investors after 2021 to cater to different client profiles – a suggestion strongly opposed by the industry.

China Opens Up

Although many headlines in 2018 highlighted the increasing trade frictions between China and the US, Chinese regulators continued to push ahead with efforts to open the economy to outside investment. In addition to existing equity connections that allow foreign institutions to buy Chinese A shares from Shanghai and Shenzhen in Hong Kong, there is now a channel through which foreign asset managers can buy Chinese bonds in Hong Kong. Called Bond Connect, the channel cleared the way for Chinese bonds to join the Bloomberg-Barclays Global Aggregate Index, meaning that asset managers who track this index will have to buy Chinese securities.

Beijing also announced enhancements to the Mutual Recognition for Funds (MRF) program, which allows asset managers in China and Hong Kong to distribute their funds in each other’s territories. Although there are currently quotas on the amounts involved, this was a big step toward opening China’s huge markets to outside asset managers.

The other trend to keep a close eye out for is the new MRF deals Hong Kong looks to sign in 2019. Hong Kong has already signed agreements with Switzerland, France, and the UK. As Hong Kong continues to try to solidify its status as a fund hub in the Greater China region, we expect to see more such agreements signed with other significant fund domiciles in 2019.

As we sign off for 2018, the On The Regs team would sincerely like to wish all our readers a peaceful, festive break! Look for more updates coming in January.