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28 September 2004
Speech by Hector Sants

Good morning, I am delighted to welcome you to the first FSA asset management conference as someone who has worked with asset managers for much of my career, and in my new role as Managing Director of the Wholesale and Institutional Markets Division, which is responsible for supervision of nearly half of the firms in the sector. I will start with the high importance we attach to the sector and how we are organising ourselves to deal effectively with sector issues. After that and in line with our agenda for today I will talk about current issues from an international perspective followed by domestic risks, priorities and challenges.

I think we should start by reminding ourselves of the importance of asset management to the UK. As I know from first hand experience of working for a large global firm dealing with asset managers, the UK is a global leader in asset management.

It is hard to be precise about the exact figures for assets under management. Surveys come up with slightly different results and there is an element of double counting when for example pension funds or private client portfolios hold collective investment schemes or investment trusts. However all the surveys show that we have £2,000 bn or more in assets under management or nearly twice the UK GDP at £1,100bn. This is confirmed by an exercise we did internally to measure assets under management of authorised firms which gave a figure of £2,100bn in 2002.

This means, 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. Estimates also vary on the level of non-domestic client assets under management from some going as high as £800bn in the UK, which is quite a vote of confidence by overseas clients in the UK industry. (Source: IFSL 2003). This is reflected in the sub-sectors of the industry. We are second to the US as a domicile for hedge fund managers and are estimated to be second to Switzerland in terms of winning non-domestic private client investment mandates as well as being a recognised centre for running pension fund mandates.

Our Principles of Good Regulation require us to consider the effects of our regulation on international competitiveness and I wish to emphasise that I am keen to use my commercial experience to ensure the FSA lives up to this principle.

But as you will know better than me, the picture is not entirely rosy. 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). However in the UK it seems the stringent cost control measures that many have implemented during the past three years are paying off. A recent IBM consulting survey showed that traditional institutional and retail managers had improved margins after the initial effect of the bear market in equities although margins are not back to the levels of 2000.

We estimate that there are nearly 1,400 authorised firms where asset management is the primary business (for the authorised firm not necessarily the group of which the authorised firm is a part). The split in numbers of firms between the wholesale and retail business unit is about 50:50.

Within the business units, asset management firms have been assigned to a number of different divisions. Also, the authorisation function which touches any new asset management business is located in the Regulatory Services Business Unit. It was clear to John Tiner 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. Dan Waters who is chairing the conference today was appointed Asset Management Sector Leader in April this year and in line with the other sector leaders has four basic objectives as he mentioned.

 

There are five goals I have for the FSA in dealing with the asset management sector:

• to improve our partnership with the industry;
• to work with the industry to encourage them to implement their own solutions to their problems without detailed guidance from us.
• for the FSA to be seen as a regulator which only intervenes from necessity;
• to recognise the importance of asset management to the UK; and
• encourage recognition that good asset management has an important role to play in helping to encourage long term saving.

Having set out our philosophy, I will try to make a few comments from the geographical perspective not only as a way of setting the context for our guest speakers but also – under the domestic heading – highlighting our key initiatives.

 

Summary of international developments (SEC and Europe) SEC

I am very pleased that we have Susan Nash from the SEC here today. Asset Management is currently high on the agenda for US lawmakers and regulators. The market timing scandal and abuses uncovered by the SEC in respect of the breach of client agreements regarding differential fund fees raised concerns about the mutual fund industry which has generally had a good image with US retail investors and regulators alike. The industry in total comprises some 8 trillion dollars of investor assets. With these sorts of sums at stake, firms and regulators around the world take note.

Regulatory changes such as requiring that the Chairman of a mutual fund be independent of the fund manager and that 75% of the fund directors are independent of the manager have attracted of lot of interest in UK investment circles. Also more recent SEC proposals for the mandatory registration of hedge funds managers above a certain size are being viewed with interest from this side of the Atlantic. This may involve some firms based here having to register with the SEC as some private client investment firms already do. We know the SEC are also interested in our proposals for soft commission and unbundling, so we envisage a high level of dialogue and co-operation between the FSA/SEC going forward on a number of sector issues.

 

IOSCO and Europe

I am also very pleased that we have Hubert Reynier, from the French regulator - the AMF- here today who is also Chairman of the Investment Management Standing Committee of the International Organisation of Securities Commissions (IOSCO). IOSCO seems to be focussing more on asset management issues lately. Mandates of particular interest are those to develop global best practice standards for fund governance (authorised CIS) and for dealing with the challenge of Market Timing activities.

In asset management, as in every other area of financial services regulation, the emergence of the European agenda is key development. The FSA and the industry have to rise to the challenge of shaping that agenda in ways that will yield proportionate and sensible regulation of the asset management industry. It is pleasing to see that the European Union has for the first time formally addressed itself to asset management as a separate sector, rather than as an appendage of banking or insurance.

A separate Expert Group on Investment Management as been established under the umbrella of the Commission of European Securities Regulators or CESR. This group, on which Dan Waters sits, comprises senior asset management officials from all 25 European countries. It has replaced the UCITS contact committee in dealing with implementation of the UCITS directives, but also has a wider remit to cover the whole of asset management, including provision of portfolio management services. Its agenda has been heavily 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 a number of 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. Some members of the Expert group have quite an appetite for major overhaul of the entire range of conduct of business requirements. We are currently resisting that sort of initiative and are emphasising the need to concentrate on issues that are hampering an effective single market in funds.

Independent intermediaries still account for around two thirds of sales of retail products in the UK. (Intermediaries here include IFAs and fund supermarkets, but of these IFAs are by far the dominant part). Tied agents have much lower market share than IFAs (Source: IMA and ABI 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.

 

Asset management risks, priorities and challenges domestically

Let me turn now to the FSA’s perspective on the major risks priorities and challenges facing the UK asset management sector. I have focussed on 8 priority issues. But if these are the wrong ones please let us know, because we are sincere and serious when we say we want a dialogue with the industry on emerging risks and priorities.

1. Restoring confidence in the savings industry
2. Maintaining confidence in fund governance
3. Soft Commission/unbundling
4. Growth in outsourcing for CIS
5. Rapid growth in hedge funds
6. Financial promotions
7. The shift to unit linked products from with profits in the life and pensions sector
8. The overhaul of the CIS sourcebook

1) Restoring confidence in the savings industry

This is an important overarching issue on which the Treasury Select Committee recently issued a report calling for improvement. This report follows on from a number other reports and initiatives in this area. In fact there have been so many reports the latest one felt the need to anticipate the risk of report fatigue by billing itself as “the report to end all reports”. This topic does not just relate to the asset management industry. The advice system, insurance industry, government and we among many others all have a responsibility to make a contribution. However, we do believe that a strong and ethical asset management industry has an important role to play in helping to encourage long term saving. It will be interesting to hear from the range of speakers assembled from the Treasury, the domestic trade bodies, consumer groups and the industry on how they see the way forward with this complex and important issue.

 

2) Maintaining confidence in retail fund governance

Another area where confidence in the savings industry needs to be maintained is confidence in fund governance. Our investigation into market timing demonstrated that there was not a problem on anything remotely approaching the scale of difficulties in the US. However 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. As I mentioned earlier the IOSCO Standing Committee on Investment Management has also 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.

 

3) Soft Commission/unbundling

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 you will know created a much controversy 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 difficult question of the definitions of execution services and of research. 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 will, however, 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.

 

4) Growth in outsourcing for CIS

Outsourcing can be a cause of regulatory problems, it can 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 and some firms are reporting problems to us. 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. 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.

 

5) Rapid growth in hedge funds

The rapid growth in the industry over recent years is a matter of record. In an environment of falling equity markets and falling interest rates the industry has been able to deliver a positive absolute return despite performance coming off the boil recently. This has attracted the interest of pension funds and firms wishing to sell these products to retail investors as well as traditional high net worth clients. The liberalisation of our CIS sourcebook and the spate of new hedge fund offerings with low minimum investment thresholds are all trends towards a blurring of the distinction between traditional authorised retail funds and hedge funds.

In addition to this, developments in Europe such as MIFID, the e-commerce directive and changes to regulations in other European jurisdictions will cause people to assume change, and is leading us to re-examine our current prohibition of the marketing of hedge funds to private customers (apart from listed fund of funds). This area will challenge to the full our need to fulfil our consumer protection objective and not stifle competition or restrict consumer choice. I have a considerable experience of dealing with this particular sub-sector of the industry and I am genuinely relishing the opportunity to use that experience to help the FSA achieve the right balance.

From the wholesale perspective, hedge funds raise a number of other regulatory issues in addition to retail access. The market impact of hedge funds is much greater than just considering their current assets under management given their leverage and high level of trading especially in illiquid assets. As has been commented on in the press, we are conducting a survey of prime brokers to get a feel for exposures as part of our prudential responsibilities towards authorised market intermediaries and as a way of more accurately assessing the impact of hedge funds on market stability. There is also the potential for conflicts of interest at prime brokers where profitability is increasingly linked to hedge fund trading activities.

 

6) Financial promotions

The upgrading of our focus on financial promotions can been as one aspect of our efforts to raise confidence in the savings industry. 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.

In the past the financial promotions area was very lightly resourced. There is now a new financial promotions department, run by a new head 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 of the Handbook rules, but do not seem to be aware of the import of the overarching principles. We have to balance the desire to stamp out mis-leading ads against the danger of preventing the industry from advertising its products and services in an interesting and engaging way.

We recognise that firms would like more help from us in understanding what we expect. As the new Financial Promotions department is now getting of the ground they will be looking at ways to do more of this. The Financial Promotions team are planning a number of workshops with the IMA which I encourage those from relevant firms in the audience to attend.

 

7) The shift to unit linked from with- profits life and pension products

There has been a substantial shift in sales away from with-profits to unit-linked in the life and pensions market. Unit linked products have many characteristics in common with authorised CIS. For example, the need to price accurately on a daily basis and the potential consumer detriment from the mis-pricing of funds. We have not focused on these funds to the extent we have with CIS.

The rules for CIS are much more prescriptive even following our recent slimming down of the sourcebook, and the previous regulators to the FSA had very different priorities when looking at insurance products. Insurance regulators quite correctly gave a much higher priority to prudential issues rather than systems and controls for accurate pricing.

We are keen to ensure we understand the unit-linked sector better and that there is a consistent approach to regulation and supervision of unit-linked products and CIS products. This is does not mean they have to be the same just that we are clear on how different regulation and supervisory approaches deliver appropriate levels of consumer protection.

 

8) The overhaul of the CIS sourcebook

The substantial overhaul of the CIS sourcebook has occupied a lot of part of the industry’s and the FSA’s time during the past year and more.

I believe that the manner in which that work was done was 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 fund of hedge funds and single hedge funds (Qualified Investor Schemes);
• Permission of limited redemption funds; (which can be used for property funds and guaranteed funds)
• Performance fees;
• Guidance on fair value pricing.

I realise that we 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.

 

Conclusion

I trust this run through the sector helps you to understand better where the FSA is coming from in respect of the industry. The bottom line is that we are looking to engage in constructive and forward-looking dialogue with you on industry issues and this conference is just one of the ways we want to do that.

In closing let me just thank you for your attention and say that I look forward to working with you as Managing Director of the Wholesale and Institutional markets for the FSA.