22 June 2004
Speech by Dan Waters

Good morning ladies and gentlemen. I am delighted to join you at this important annual gathering of the unit trust and oeics industry leaders. I do so wearing my FSA Asset Management Sector Leader hat.

1. FSA Structure and Asset Management Sector Role

Before I turn to the important topic of the major regulatory challenges and risks that the FSA sees in respect of the fund management industry, let me say just a little bit about my new role in the FSA as Asset Management Sector Leader: how it fits into the FSA’s new structure, what the job is and why you should be interested in it.

Then I will offer a quick overview of the fund management sector in the UK, including the CIS subsector in particular. Finally I will turn to the major regulatory challenges and risks that are on my radar screen and hopefully on most of yours as well.

As you may know, John Tiner as new chief executive of the FSA is determined to raise the regulatory performance of the organisation, building on the undoubted strengths of the FSA’s early years. He is very keen to get on with the implementation of the substantial regulatory reforms coming out of Europe and UK government policy over the past few years, while keeping a tight reign on new, discretionary policy making initiatives. He promised to halve the number of consultation papers this year, and we are on target to achieve that. We are also working hard to make the FSA easier to do business with from the perspective of regulated firms and consumers.

To support these overarching objectives, John decided early in his regime to restructure the FSA along wholesale and retail lines. In a way this should not be too surprising – UK financial services regulation from the start has sought to distinguish between the sort of regulation that is appropriate for market counterparties, and that which makes sense for retail consumers of financial services. Indeed FiSMA itself requires the FSA to take into account the knowledge, experience and understanding of consumers in exercising its regulatory powers to protect them.

The new FSA structure has three important business units, each headed by a managing director reporting to John Tiner. They are Hector Sants for Wholesale and Institutional Markets, Clive Briault for Retail Markets, and David Kenmir for Regulatory Services. We think of the business units as subsidiaries of a group company, each with its own set of objectives and deliverables, which contribute to the overall FSA Business Plan. If you look at our Business Plan for 2004-05, published in January, you will see that clear chunks of it fall to each of the business units. There is a much stronger emphasis on teamworking at all levels within the FSA to deliver these challenging objectives.

Managers of unit trusts and oeics fall within the retail markets sphere, which means that your supervisory teams are located in one of the divisions within that area. Most of the large fund managers, including those that are part of large life insurers, have been assigned to the retail markets area, since their principal business is the manufacture and/or selling of investment products for the mass retail market. A fund manager where 25% or more of its customers are retail should be in the retail area, any other to wholesale. (Note, this is not the percentage of funds under management but of customers – i.e. weighted to place emphasis on firms distributing product to individuals. Distributing units in a collective investment scheme is also counted as distribution to retail customers.)

Those fund managers that tend to fall on the wholesale side include the managers who are subsidiaries of investment banks, the venture capital sector, boutique hedge fund managers and depositaries.

Institutional lines are never crystal clear – there will be some fund managers whose business encompasses both wholesale and retail aspects. Such a firm will be supervised from one team within the FSA depending upon the predominance of its business. That team will need to understand the full scope of the firm’s business.

You might observe that in this structure fund management firms will have been assigned to a number of different divisions across the two principal business units, and you would be right. Indeed the authorisation function which touches any new fund management business is located in the Regulatory Services area. It was clear to John that the FSA needed the ability to take a cross-cutting view of each of the major financial services sectors, hence the creation of the Sector Leader roles. There are eight of them: Asset Management, Banking, Capital Markets, Insurance, Retail Intermediaries, Consumers, Financial Crime and Financial Stability. The structure of their core functions is similar, so I will explain it in terms of my role in Asset Management.

The Sector Leader role comprises four basis objectives: risk assessment/mitigation; staff development; representing the FSA on sectoral issues; and overview of the coherence of FSA regulation of the sector. Let me say a few words about each of these.

Risk assessment and mitigation

You would expect the FSA, the world’s leading proponent of risk based regulation in financial services, to start with risk. As ever, we are in the business of trying to spot risks early and acting to mitigate them before they become problems. As sector leader I am supported by a small core team with substantial fund management experience. They are augmented by a virtual team of experienced regulators in all the major divisions of the FSA, each of whom has dedicated a proportion of their time to work on asset management issues. This is in addition to and separate from the roles that they and others have in direct supervision of asset management firms. We also have a wider network of interested people across the organisation, all of whom are in the business of sharing intelligence about what is happening in their areas, and trying to spot risks as they emerge so that we can assess and decide whether to act. The Asset Management Risk Committee meets monthly to assess and prioritise risks, but communication is far more frequent and informal than that.

I am very clear that we will not get better at risk identification unless we are in closer contact with the industry and interested users of the sector. So I am in regular contact with all the relevant trade bodies, and make it my business to meet with key people in firms across the sector on a regular basis. Having ears to the ground on new business models, new investment strategies and trends, new threats to profitability, etc. makes it much more likely that the FSA will spot potential regulatory issues before they crystallise into problems. I have established an Asset Management Forum, with senior representatives from trade bodies, consumers and other users of the sector which will help in identifying emerging risks. Our first meeting is in mid-July.

Deciding what to do about identified risks is of course crucial. An urgent issue involving a firm or perhaps group of firms may simply be passed to the supervisors involved for action. A larger issue, for example outsourcing, that seems to cover a wider range of firms and subsectors of the market might warrant a special team to focus on it and decide the best way to get on top of the issue. An appropriate response might also include further research, which we can commission from our knowledgeable economists either in the central strategy and risk unit of the FSA or in the business units. A speech or a “dear CEO” letter might be appropriate for particular kinds of risks. The range of tools is wide, and it is important to act in a proportionate manner, and in accordance with the FSA’s wider priorities.

Staff development

The second objective of the sector is staff development. I think it would be fair to say that the fund management industry has felt for some time that the FSA did not understand its business as well perhaps as the predecessor regulators did. I think some of that feeling is inevitable, given the large size and scope of the FSA’s role, and the fact that the insurance sector has been under such intense scrutiny during the first years of FSA’s life. There has also been a lot of turnover of staff at the FSA during the first six years – less than half of our supervisory staff worked for any previous regulator. We are therefore committed to a step change in our training and development of staff on sectoral issues. This will involve in my case development of a core curriculum of fund management issues, supplemented by secondments both inward and outward, and invitations on a regular basis to industry experts to offer talks and seminars at the FSA for our staff. We have already begun this work, and I am pleased to say that the industry response has been very positive. I hope that in future you will see a difference in the quality of the contact that you have with FSA staff.

Representing the FSA

Today is of course an illustration of the external representational role that I am now playing for the FSA in respect of the asset management sector. I am pleased to say that the diary is filling up with these sorts of engagements, which I welcome. We are also putting together our own FSA asset management conference on 28 September. Please mark that in your calendars, details will be published quite soon on our website. But more than just speaking engagements, as I mentioned before I am making a point of trying to get in touch with the sector through much smaller-scale, individual-firm focused meetings and discussions. These are not supervisory visits, they are opportunities for you to share your views about the challenges that your business faces in today’s rather daunting environment, and for me to think creatively with you about how the regulatory risks arising from these challenges can best be addressed. As I mentioned, regular contact with the trade bodies and other interested groups is also the order of the day for me and my sector team, so we have plenty to do. I will say something about the international representational role in a minute.

Regulatory Coherence

The last key objective of the sector leader is to take an overview of the coherence of the FSA’s requirements and policies toward the sector. In the case of Asset Management, there are a number of important changes that are occurring right now, which makes the creation of this position very timely. The most obvious is the recent substantial reform and simplification of the regulation of unit trusts and oeics, about which you will hear a good deal today. This was a major overhaul of a very complicated and detailed rulebook, and could not have been successfully accomplished without very substantial and constructive input from a large number of industry participants. There are other potential areas of regulatory reform that will be of great interest to this audience, including the current work on softing and unbundling, market timing and fund governance, to which I will turn in a moment. It is part of my responsibility as sector leader to keep an eye on the continuing appropriateness of our regulatory requirements given the constantly evolving business world in which all of you must operate.

I hope that this canter through the key elements of the role helps you to understand better where the FSA and I are coming from in respect of the fund management industry. The bottom line is that we are looking to engage in constructive and forward-looking dialogue with you on sectoral issues. We know that there are problems, in some case very significant problems, and we as a regulator must of course deal with those. But the aim of sectoral work is not to sort out the past; I am not responsible for managing those aspects of the FSA’s work. They belong in supervision or enforcement if necessary. The sectoral job is forward looking and proactive. I will need your support to succeed.

Let me turn now to the UK asset management sector itself, with particular emphasis as you would expect on collective investment schemes. Before sharing with you our view of key regulatory issues, it would be helpful I think to remind ourselves of where we are at the moment as a business sector.

2. View of the Asset Management Sector

To state the blindingly obvious, the UK is a global leader in asset management. We have the third highest amount of Funds under Management (FuM) after the US and Japan and account for around 8% of global FuM. We are second to Switzerland in terms of the ratio of FuM to GDP. This reflects a level of domestic retail and institutional investment and savings in the UK, but it also demonstrates our success in winning mandates from non-UK clients. We have some £800bn of non-domestic client assets under management in the UK, compared to a total £2,600bn. (Source: IFSL 2003).

But as you will know better than me, the picture is not entirely rosy. In fact it has been a very, very hard slog making money or even keeping above water these past few years. A recent survey of asset managers globally found 20 percent of the industry is unprofitable and a further 20 percent is only marginally profitable (Source: Boston Consulting Group 2003). In addition, UK managers seem to have a lower average profitability than those in the US and Europe. (Source: McKinsey Survey 2003). While the factors behind this are not fully known, it does seem that the high proportion of lower-margin institutional mandates in the UK is likely to be an important factor. We have a high proportion of segregated pensions and insurance mandates compared to Collective Investment Schemes (CIS) (Unit Trusts and Oeics). A bit of good news is that the stringent cost control measures that many of you will have taken during the past three years or so are beginning to pay off. There are indications of a small improvement in the profitability of UK managers this year, reversing the earlier trend.

This chart shows gross sales, redemptions and net sales of CIS from Q1 2000 to Q3 2003. Net sales of authorised CIS were positive every quarter over this period, which is no mean accomplishment. Gross sales of funds fell but the level of redemptions was steady, suggesting there was no panic selling - just less appetite to invest more. Corporate bond funds have been popular. One might expect that these savings and investments vehicles should do well as confidence improves.

Independent intermediaries still account for around two thirds of sales of CIS. Intermediaries here include IFAs and fund supermarkets, but of these IFAs are by far the dominant part. At this point fund supermarkets account for less than 5% of distribution, although this number is rising. Tied agents have much lower market share than IFAs (Source: IMA 2003). It is interesting to contrast this picture with that in continental Europe, where tied agents of banks and insurers are far more important than independent intermediaries. This is one of the many differences between UK and continental retail financial services markets that we need to understand better – more on this in a moment.

It will be interesting to see how depolarisation affects this distribution structure. There are some pressures that would suggest consolidation – including PII availability and forthcoming changes driven by the EU in the level of PII required. The FSA is also consulting on a new regime for stakeholder products, which if implemented could also affect the shape of distribution in ways which are not at the moment clear, and will depend on both the scope and shape of any new regime, and the potential profitability of the business.

3. Regulatory Challenges and Risks

Let me turn now to the advertised topic my remarks today – namely the FSA’s perspective on the major regulatory challenges and risks facing the asset management sector. Our risk assessment work in the FSA has identified quite a long list, actually, but I am going to limit myself today to five.

1. Maintaining confidence in fund governance

The first is maintaining confidence in fund governance. You might think this is an odd one to start with. This is a huge issue of course in the United States, where a very severe market timing scandal emerged, and where abuses were uncovered by the SEC in respect of breach of client agreements regarding differential fund fees. Against the backdrop of other corporate failures in the US, these have combined to create a crisis in confidence in the governance of mutual funds, an industry which in total comprises some 8 trillion dollars of investor assets. With these sorts of sums at stake, you can understand why regulators get nervous.

The SEC is in the final stages of a quite detailed set of new rules in respect of fund governance, including requiring that the Chairman of a fund be independent of the fund manager, that 75% of the fund directors be independent, that a compliance function be established, to name a few. This action is likely to forestall Congressional intervention that would otherwise certainly have occurred.

Why should we worry about this here in the UK, where, thankfully, our investigation into market timing demonstrated that there was not a problem on anything remotely approaching the scale of difficulties in the US? Because market timing is not the only concern that touches on fund governance. It is quite clear to us from our work on softing and unbundling, to which I will turn in a moment, that simple disclosure was never going to be a sufficient resolution of the inherent conflicts of interest that exist in such remuneration arrangements. One of the reasons for this has been concern about the quality and range of oversight provided by trustees of pension funds. But related issues arise in respect of the roles of trustees and depositaries of CIS, if not perhaps in respect of quality as much as in respect of the scope of issues that they are intended to and in practice review.

The Investment Management Association as you will probably know has put in place a working group to examine fund governance issues. It is also important to note that the Investment Management Standing Committee of the International Organisation of Securities Commissions has also just approved a mandate on fund governance which will require its members, which include the UK and all of our major counterparts, to examine in some detail the arrangements in place for governance of funds. I do not think that we can afford to be complacent about this issue, indeed I think that we need to take care in looking not just at governance issues in respect of CIS, where happily there is a transparent and reasonably demanding regime, including a strong element of independence, but in respect of other collective structures including pension funds and unit-linked life funds. I do not start from a position of suggesting that we need to undertake radical change – I would be very surprised if that were the case. But I think that we need to take an honest look and satisfy ourselves that our arrangements are robust and up to global standards, which IOSCO will be looking to set. The restoration of investor confidence in markets will be bolstered by assurance that within the collective investment structures in which their assets are held, there are robust arrangements for the safeguarding of their interests.

2. Managing conflicts: reforming softing and bundling arrangements

It is one of FSA’s core principles that regulated firms, including of course fund managers, manage their conflicts of interest and act in the best interest of investors. CP176 as this room will know created a firestorm when it was first published. But through a lengthy and detailed period of consultation, it emerged that there was widespread acceptance of our analysis of the inherent conflicts that exist in the current arrangements, and the need for fundamental change. There was far less consensus, however, on exactly how to change the current system in ways that would benefit investors and improve the competitive functioning of the market.

After careful thought, and observing the changing behaviour that was already occurring in the market in respect of step-outs, shared commission arrangements, and other innovative steps to begin disaggregating and valuing bundled services, we determined that the best solution was to work with the grain of the market. We are very clear on what we want – transparency and disclosure in respect of execution services and research, yes, but also, the emergence of a truly competitive marketplace in the provision of research, both broker-produced and independent. Hence it has been critical to bring together the buy and sell sides of the market and the market users to try to meet these objectives. IMA, LIBA and NAPF are working hard, to a demanding timetable, to design an approach that will lead to unbundling of services, without the necessity of the FSA intervening to require rebating, as we had contemplated.

For its part, the FSA will need to address the vexed question of the definitions of execution services and of research. We will be consulting on that in the coming months. The IMA/LIBA/NAPF work has a delivery date of December for a disclosure regime that is effective and meaningful in creating the transparency and conditions of competition that we are aiming for. We think that this work will have implications as well for the trustees and depositaries of CIS going forward, and we will need to include them in our ongoing programme of work. We are also working closely with the SEC in this important area.

I do not for a minute underestimate the difficulty of this undertaking, but I am convinced that the FSA has taken the right approach, and one that is consistent with its regulatory philosophy of seeking proportionate, market-facing solutions to problems wherever possible. We stand ready, if necessary, to intervene in a more intrusive manner should the market fail to deliver. I include the work on unbundling therefore in my list of key challenges, both for the industry and for the FSA.

3. Shaping and responding to European legislation

There is a very good argument that this ought to be at the top of the list, but suffice to say that in fund management, as in every other area of financial services regulation, the emergence of the European agenda is of paramount importance. It is for the FSA and the industry to rise to the challenge of shaping that agenda in ways that will yield proportionate and sensible regulation of the fund management industry.

The good and very important news is that the European Union has for the first time formally addressed itself to the asset management sector as a separate sector, rather than as an appendage of banking or an afterthought in respect of insurance. Under the umbrella of the Commission of European Securities Regulators (CESR as we call it) a separate Expert Group on Investment Management as been established. This group, on which I sit, comprises senior asset management officials from all 26 European countries. Its remit is not only the Byzantine world of the UCITS directives, but the whole of asset management, including provision of portfolio management services. Its agenda, which is just now being finalised, has been heavily and helpfully influenced by the excellent work of an industry advisory group which recently produced a report to the European Commission on barriers to cross-border business in asset management. The priorities outlined there have in the main been imported into the working agenda of the Investment Management Expert Group. It will require a good deal of FSA time, and in due course of industry time in consultation, to reach some sensible improvements in the interaction of the UCITS directives, the implementation of the ISD2 (Markets in Financial Instruments Directive –MIFID) and the raft of other directives that influence the provision of asset management business cross-border. The Expert Group is advised by a team of industry experts – Will Knot from M&G is a member of this group.

The Expert Group and some sub-groups under it will be looking to resolve myriad practical issues like transition arrangements for umbrella funds, notification requirements under the relevant directives, simplification of registration, and as mentioned conduct of business implications in the longer term. MIFID is likely to lead to changes in our rules – for example in the area of financial promotion, information disclosure, best execution and order handling, among others. You will not be surprised to learn that some of our continental colleagues seem to have quite an appetite for major overhaul of the entire range of conduct of business requirements. You will also not be surprised to learn that we are resisting that sort of initiative. But we are emphasising the need to concentrate on issues that are hampering an effective single market in funds.

4. Improving Financial Promotions

Those of you who have read the FSA Business Plan (and I commend it to you as it tells you the major things we are concerned about across the board for the next year or so) will have noticed the prominence given to our work on financial promotions. In the past the financial promotions area, through no fault of the team, was a bit of a backwater, and very lightly resourced. Events in recent years have demonstrated the damage that can come from misleading or unfair advertisements, and John Tiner has taken a personal interest in ensuring that the FSA raises the state of its game in this area very considerably.

There is now a new financial promotions team, run by a new head of department reporting to Anna Bradley in the Retail Themes area. The team has a target number of 30 staff, and will be taking a much more proactive role in identifying issues and working with the industry to resolve them.

One of the FSA's statutory objectives is to ensure the appropriate degree of protection for consumers. That is partly reflected in the Principle 6 requirement on firms to pay due regard to the interests of its consumers and treat them fairly and also in Principle 7 re communications with customers. These are the roots of the overarching requirement that financial promotions must be clear, fair and not misleading. We expect firms to approach financial promotions from that wider perspective. We still see too many advertisements where the firm has not clearly explained how the product works or what the risks are and the commitment required. While we fully accept the principle of caveat emptor, firms aren't fulfilling their part of the bargain by simply saying that all the relevant material is in the brochure somewhere and not telling any actual untruths. We expect firms to approach advertisements genuinely attempting to ensure that the customer will walk away with as good an understanding of any risks and drawbacks as of the benefits. The queries we get from some firms still suggest that they are looking for tick-box ways of ensuring that they are within the letter or the Handbook rules, but do not seem to be aware of the import of the overarching principles.

We recognise that firms would like more help from us in understanding what we expect. As the new Financial Promotions department gets off the ground they will be looking at ways to do more of this. Many of you will of course be closely involved in financial promotions, and I encourage you to make this a priority in your own business planning. With my Retail Policy hat on I will be looking with Anna Bradley and her team at the coherence of the regulatory arrangements that are currently in place in this area, and there may well be changes coming forward in due course.

5. Managing the rapid growth in outsourcing

I well remember from my IMRO days that outsourcing could be a cause of regulatory problems. It could also be an entirely sound and indeed lower-risk business strategy in many circumstances. The FSA has taken a very clear line on the need for those who outsource key functions to maintain adequate oversight of those arrangements, as ultimate responsibility remains with the firm that had done the outsourcing.

We recently sent a questionnaire to 100 medium and small authorised firms and found that 84 had outsourced some or all of their administration. We also know that a number of very large managers have recently outsourced very significant parts or indeed all of their administration arrangements. In aggregate, the message we are getting is that outsourcing is increasing at a very substantial pace. I would also note that the number of firms to whom substantial functions have been outsourced is not large, and this in itself creates a wider risk that we will need to examine.

I notice that outsourcing is on the agenda later today, and so I will not dwell on it further. Indeed, had I not had a conflicting engagement, I would have stayed to hear your discussion! Suffice it to say that the FSA will want to ensure in the coming months that it and the industry have an adequate grip on this important development.

4. Conclusion

It wouldn’t be right for the regulator at this conference to close his remarks with barely a mention of the substantial overhaul of the CIS sourcebook that occupied so much of the industry’s and the FSA’s time during the past year and more. I would re-emphasise that the manner in which that work was done was in my view exemplary and the outcome demonstrates what the regulator and the industry working together can achieve. To name a few of the major changes, the new regime allows:

  • A wider use of derivatives in UCITS schemes;
  • Shorter more focussed annual and half-yearly reports to unitholders;
  • Creation of types of authorised hedge funds (Qualified Investor Schemes);
  • Permission of limited redemption funds;
  • Performance fees;
  • Guidance on fair value pricing.

I realise that we perhaps did not go as far as everyone wanted in some of these areas, but the enhanced flexibility is substantial, and should enable the industry better to respond to the challenges to traditional business models and strategies that the current market environment presents.

In closing let me just thank you for your attention and say that I look forward to working with you as Asset Management Sector Leader for the FSA.

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