Sunday, November 10, 2013

U.K. FCA Will Engage in Reform of the Asset Management Sector at Domestic and E.U. Levels Says Martin Wheatley

The current U.K. asset management regulatory regime is neither sufficiently transparent nor accountable, noted Martin Wheatley, Chief Executive of the Financial Conduct Authority. In recent remark at an asset management seminar, he noted two persistent problems. First, services are being bundled together, with eligible and non-eligible services being mixed. Second, when this information is provided back to the client, there is a lack of clarity or adequate transparency around how their commissions have been spent. Almost concomitantly, the FCA issued a report on outsourcing in the asset management business.

The asset management industry is plagued by an outdated bundled charging system, noted the FCA official, and the use of dealing commissions to purchase research lacks transparency, distorts competition, and supports unsustainable business models. Moreover, the link between volume of trading and research expenditure appears to be flawed. It creates pots of research commissions that the fund manager is then incentivized to spend regardless of the added value of the services, he said, thereby creating a potential conflict of interest.

The system is not working as intended, he emphasized, and thus wider reform is now required to address flaws that cannot simply be addressed by incremental improvements to existing rules.

The FCA is greatly concerned that firms are pushing the definition of research by using client commissions to cover non-eligible costs and services, including a significant chunk of clients’ commission being paid for corporate access services from investment banks and brokers. The FCA estimates that up to £500 million of dealing commission was spent in 2012 to facilitate corporate access. This averaged out to each individual investment manager paying over £100,000 just to gain access to the management of companies they wanted to invest in. The FCA believes that this is just one area where firms are allocating commission to ineligible services and paying more for services than they would if they had to pay for them out of their own money.

This practice transfers the firm’s costs onto the client, he noted, which clearly works against the client’s interests. It additionally raises a concern because asset managers do not control costs indirectly borne by the client with the same rigor as costs they incur directly. On the other side of the transaction, chief executives and investor relations officers have learned that their time is being billed to the industry by brokers.

While the FCA has no particular concerns with the purchase of corporate access, it believes that asset managers should be using their own funds if they wish to purchase access. Investment banks appear to sell or provide additional services such as corporate access to the highest bidder. In the view of the FCA, this practice favors high degrees of trading, distorts the market, and causes asset managers to pay increasingly more for research even if they receive very little value from it.

Moreover, the prevalence of bundled services, combining eligible with non-eligible services, can also disguise overpayments for eligible services. This cross-subsidizes services that asset managers should pay for from their own funds, observed Mr. Wheatley, and, in turn, sustains business models that would quickly fail under increased global competition

As a result of these findings, industry members and representatives, including the Investment Management Association, have recognized that certain practices need to change. While acknowledging that reform must ultimately and ideally be at the E.U. level, the FCA chief opened a domestic debate on the need to reform the asset management sector. He said the FCA will issue a Consultation Paper in November seeking views on how to improve the current regime. Specifically, the Consultation will focus on providing clarity around how ``research ‘’ is defined and what is eligible and non-eligible when purchasing goods and services from clients’ dealing commissions.

At the same time, the FCA will continue to engage at a European level. The changing E.U. asset management regulatory regime is in development and the FCA has engaged and influenced the Markets in Financial Instruments Directive (MiFID), for example, from the outset, which Mr. Wheatley views as the main vehicle for E.U. reform.

In principle, the FCA supports an approach that applies across Europe so if the end destination becomes un-bundling, for example, then this would apply unilaterally across asset management in Europe. The advantage of progressing this at the E.U. level is that it will ensure a level playing-field and allow firms to adapt their business models before implementation.

The key findings of the report on outsourcing in the asset management industry is that asset managers were largely unprepared for the failure of a service provider undertaking critical activities, as firms’ contingency plans had not considered how to maintain operations and service to their customers. An asset manager is engaged in outsourcing if it appoints a service provider to conduct an activity which the asset manager would otherwise complete itself while conducting its regulated business.

The report also found reassurance that asset managers had oversight arrangements in place to oversee their service providers. But the effectiveness of oversight arrangements varied from firm to firm, with only some asset managers able to demonstrate high standards of oversight consistently across all outsourced activities. Where oversight of an activity was lacking, the main cause was insufficient internal expertise to carry out the oversight.

In light of the findings, the FCA urged asset managers to review their own outsourcing arrangements and, where appropriate, enhance their contingency plans for the failure of a service provider providing critical activities, taking into account industry-led guiding principles where applicable; and assess the effectiveness of their oversight arrangements to oversee critical activities outsourced to a service provider, ensuring that the required expertise is in place.

No comments: