At first glance, last week’s publication of a letter about the Alternative Investment Fund Managers Directive (AIFMD) from the European Securities and Markets Authority’s (ESMA) to the European Commission doesn’t seem like big news. Isn’t AIFMD a somewhat obscure piece of legislation that is a minority interest? Not really.
The EU sees the investment funds market in two segments. UCITS funds, which are subject to high levels of regulatory protection because they are sold to the public, and alternative investment funds (AIFs) sold to institutional investors and sophisticated retail clients.
The combined UCITS & AIF segments are huge: EFAMA says there are 61,000 funds managed by 4,500 buy-side firms with the value under management is €16.3 trillion. But despite a large amount of overlap between the two segments the regulatory treatment has, historically, been quite different.
What makes this significant is that ESMA is now acknowledging these discrepancies and is making clear that whatever revisions are agreed to AIFMD will also apply to the UCITS segment. In effect, the two separate pieces of legislation will not be combined but will be harmonised.
The other key issue that will be unearthed during the AIFMD review is the post-Brexit relationship between the EU and the UK. Two issues are front and centre in the review: delegation and substantive-presence.
Delegation is the practice of registering a fund in a single location inside the EU (typically Ireland or Luxembourg) enabling retail sales across the whole EU. The actual management of the fund can be done in another location.
Many of the bigger investment managers are geographically dispersed and typically very little of the front-office tasks — such as asset allocation, stock picking, risk management — actually happen in Dublin or Luxembourg.
They can perform these roles anywhere in the EU, or even outside. One of the largest European tech funds is controlled by a portfolio manager located in Taipei.
What happens in Luxembourg and Dublin is primarily back-office functions like fund accounting and shareholder record keeping.
Substantive presence is a closely related subject, which has come into focus due to Brexit and the shift of investment banking activity from London to Frankfurt. The EU, very understandably, wants to avoid Cayman Islands style shell companies that are registered and legally domiciled in the EU but where all real activity takes place in London.
So-called “brass plate” companies are not acceptable. Regulators require a local entity to be properly staffed and resourced on the ground. The by-product is a growth of high-paying jobs in the local market. This is clearly a political win.
The AIFMD review will bring both issues into the spotlight. One possible outcome is that the current arrangements will persist. But the ESMA letter appears to make this very unlikely.
Firstly, the letter links delegation to “operational and supervisory risks”. It isn’t specific and doesn’t provide any evidence or examples. But the tone is clear.
Secondly, it connects differences between EU and non-EU regulatory standards to “circumvention” and “regulatory arbitrage”. This is quite a contentious opinion and could be seen as a somewhat politicised viewpoint. Again, the direction of travel is quite clear.
The letter specifically refers to the opacity and confusion that surround these issues – even amongst the regulators themselves.
It therefore proposes a further definition of what activities should be classified as “core” versus “supporting” tasks. Presumably, the core activities must meet the substantial presence requirements.
Clarity is always welcome, but the result could be uncomfortable. If the outcome is that core functions must be performed within the EU, which appears to be the political ambition, substantial organisational change is inevitable. And to make it more delicate this is not purely an EU-UK issue.
The delegation model has a global impact because whatever new rules are defined surely have to apply equally to all non-EU countries.
The AIFMD review isn’t a technical exercise on an obscure piece of legislation. It’s a test-case of how EU financial services will be structured post Brexit. It deserves very close attention.
