Current regulatory issues and challenges for the funds industry
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Speech by Dan Waters, Director of Retail Policy and Asset Management Sector Leader. FSA
TISA Annual Conference, London
Wednesday 14 November 2007
Introduction
Good afternoon ladies and gentlemen. I have been asked to address the key regulatory challenges facing the fund management industry. There are many issues that could be covered, but let me confine my remarks to three principal areas:
(1) First, the Retail Distribution review and its import for the fund management community; (2) Second, the FSA’s Treating Customers Fairly initiative, where there are important questions for the fund management industry that have not in my view been adequately addressed to date. (3) Third, and no less important, the significant developments in fund management occurring on the European stage, including the Commission’s forthcoming reform of UCITS, which will have important effects in the UK.
Current Market Conditions
But before turning to those topics, I want to say a few words about the current market conditions, their impact on fund managers and some of the regulatory concerns that arise. It is well known that many of the current problems with the market have evolved from the sub-prime mortgage market in the US. It has been the increasingly complex packaging of these sub-prime mortgages, for example in asset backed securities and collateralised debt obligations, which has proved difficult for many market participants. While these structures have distributed risk to different sectors of the market, they have made markets more interlinked, thus amplifying contagion risk.
These recent events have highlighted a number of shortcomings in the financial services market, not least the ability of many investment banks to value illiquid and complex instruments. Asset managers have also faced similar concerns, but these may well be exacerbated, as many asset managers have less depth and expertise in-house to value these instruments. It is therefore possible that asset managers could be or become over-reliant on counterparty valuations. This could pose a risk to those firms and to the FSA's statutory objectives, including difficulties in valuing and trading a portfolio, which in turn could risk inequitable treatment of consumers and reduced consumer confidence. While current market events highlighted the ABS sector, other assets like property, private equity and venture capital trusts can pose similar illiquidity and complexity issues.
All this has arisen as the FSA is pursuing a regulatory regime which remains committed to implementing a more principles based approach to regulation. I am aware that a number of commentators have asked whether this is approach to regulation is appropriate to deal with such circumstances. I would respond that the challenges arising from the volatility of recent markets reinforce, rather than undermine, the benefits of the move to more principles based regulation.
Principles based regulation means that firms will be under a constant obligation to review the conformity of their business practices, whether in calm or in turbulent markets, with our principles and high-level rules. The focus will be very much on outcomes being delivered in the real world: are customers are continuing to be treated fairly, are conflicts of interest are being managed appropriately, are financial instruments being valued fairly and in accordance with firm policies are the business risks being appropriately and vigilantly managed. We think a firm focus on the key outcomes that really matter is a sound approach to tackling the challenges that turbulent markets bring.
This focus on real-world outcomes leads me to my first main topic of discussion today; that of our Retail Distribution Review.
(1) The Retail Distribution Review
The Retail Distribution Review is the most fundamental review of the retail financial services market and its regulation undertaken in the 20 year history of regulation of this market. It is not about tinkering at the edges as some have asserted. It is a review of the market structure and the fundamental economic and behavioural drivers of the market, with a view to achieving a step change in the retail market through better outcomes for retail consumers, sustainable business models that provide fair treatment of consumers, and wider consumer access to support and advice in financial decision-making.
You will notice, I hope, the strong linkage of the RDR to TCF: both have at their heart the importance of achieving better outcomes for consumers. The RDR focuses on market structure and drivers that inhibit or contribute to that aim – basically the big picture. TCF is very much focused on individual firms and their business models, and how they deliver better outcomes to their consumers. That in a nutshell is the difference and I think it helps to keep that in mind in understanding where the FSA is coming from.
I have said that the RDR is focused on the structure and drivers of the retail market. We know that the retail market for investment products in the UK is characterised by products that are sold rather than bought, by consumers who struggle to understand their own needs. Even those that do understand their needs often struggle to meet them competently, partly because of the complexity of offerings in the financial services marketplace, partly because the performance of financial products may not be known for years, so that it is hard to learn from experience. Information asymmetry, inherent product complexity and general consumer mistrust and apathy further complicate the picture.
The RDR aims to assess the core structural and behavioural features of the market so as to identify what interventions would improve its overall effectiveness and efficiency. This is not, I hasten to add, an exercise in regulatory design of market structures. It is an effort to identify industry initiatives, facilitated and if necessary supported by regulatory interventions, which will achieve a significant improvement in the way the retail financial services market operates. At Gleneagles in September of 2006, Callum McCarthy painted a picture of a market in which consumers, providers of products and services and intermediaries all struggled to find benefits. That portrait of the market was broadly accepted. The challenge of the RDR is to figure out what to do about it.
We published our discussion paper in June as you know. The discussion period is deliberately longer than usual – six months instead of three. We are very keen engage with as wide an audience as we can as we develop our analysis. We have to date more than 250 responses to the DP, a very large number indeed, with many more expected over the forthcoming six weeks.
I have heard some commentators say that the RDR is only really focused on intermediaries in the retail market, but this is not the case. It is aimed at the distribution of all retail investment products and services and so includes all participants in that market, including all of you present here today. Fund managers I talk to have a keen interest in the quality of those who are distributing their products. It would be strange therefore to be indifferent to fundamental changes in distribution structures, incentives and behaviours.
It is too early to draw conclusions from the views expressed so far, but it is fair to say there has been much discussion around issues like primary advice (Is there really a market for this, especially post-Personal Accounts? Is this really advice or is it some kind of guided help?); professionalism (Are there too many tiers of advice and will this confuse people? What would be the impact of higher standards across the board?); remuneration (What does consumer agreed pricing mean in practice? Will consumers understand and engage with it?); and independence (Is independent pricing enough? How important is the whole-of-market offering to consumers?) With six weeks to go in the DP period we remain in “listening mode”. Contrary to what some commentators have suggested, we have not come to any conclusions and we do not have a secret road map in our back pocket or an answer that we prepared earlier.
We do have a strong preference for solutions that are driven by the industry itself and not by regulatory intervention. We believe that there is a widely recognised acceptance that the retail market is not working optimally and that this is an important opportunity to achieve fundamental change. We are prepared, if we need to, to lift the regulatory pen, but if we do that we will be, quite properly, constrained by our normal disciplines of market failure and cost-benefit analysis.
In that vein, I should also note that we are doing a substantial amount of research and analysis to test the leading ideas that have emerged so far in the RDR. We are analysing the economics of the potential market for Primary Advice. We are looking at the impacts of various different approaches to the treatment of capital requirements for intermediaries. We are doing additional consumer research on understanding of needs and preferences of consumers for products and services. We are reviewing the lessons of the Basic Advice regime and the impact of depolarisation on the market. We are exploring what customer agreed remuneration means in practice and what it might look like. In the coming months, as the discussion continues, we will be sharing this research and analysis with the market to take the debate forward and narrow down the range of possible solutions. The issues are complex and it is important that we get it right. We will not be rushing towards solutions and we will be cognisant of the fact that some of them may well imply periods of transition to maximise our desired outcomes.
(2) Treating Customers Fairly
Let me turn now to our Treating Customers Fairly initiative. You will all be familiar with TCF, which has been at the top of the FSA’s agenda for the retail market for the past two years and more. To be frank, however, I have been concerned about the risk of misunderstanding in the asset management industry in respect of this initiative. More that one senior industry person whose opinion I respect has said to me that TCF does not really touch their business model in any new way. They are self-described wholesalers of funds and do not have direct interface with the retail clients who, at the end of a number of different business chains, may end up holding their funds. Let me try to explain why we consider that the asset management community needs to take TCF seriously and to engage actively with it, as I know many of you already are.
You will be aware of the work in the TCF model on the product life cycle, whereby we challenged firms to ensure that customers were treated fairly at all stages in the life of a product. Those stages were: (i) product design and governance; (ii) identifying target markets; (iii) marketing and promoting the product; (iv) the sales and advice process; and (v) after-sales information and complaint handling.
Product design
In the time available today, I would like to look at product design and target markets. Product design is of course is home territory for many firms represented in this audience. We have been engaging with the industry on the very important question of how retail financial services products come to be designed in the first place. I have often had the uncomfortable impression that the consumer of retail financial services products is forever doomed to be the person who comes to the party after all the cool people have left. I refer here to the recurring phenomenon of retail products being launched that seem to lag rather than lead market movements.
It could be argued that this is to a large extent driven by the fund management business model. Fund managers will say that the economics of the business imply that institutional client mandates are the leading-edge of new product development and design and that retail business is destined to follow the trends set in the institutional market. Others tell us that in developing new product ideas for the retail market they are influenced to a significant extent by information from their distributors about what clients want. Couple these factors with the relative information disadvantages of retail consumers. They are almost by definition going to be keen on something that has already captured the popular fancy and may be on that part of the investment roller coaster ride that is at the crest of a hill before an exciting downward plunge. You can see then the risk that a sort of 'bandwagon' mentality can take hold in retail investment product design.
That's one of the reasons that the FSA has been speaking more explicitly in terms of focusing on consumer outcomes in our TCF work. I think some are interpreting this to mean that the only products that should be designed and sold to retail consumers are those that minimise investment risk. That is a fundamental misunderstanding of what we are saying. Risk and reward are fundamental to all investment choices. Our point is to emphasise the importance of making a clearer link between product design and consumer investment needs, to try to minimise mismatches. That is not at all the same thing as looking for a world in which investment risk is removed. That would be a world in which no one's interests – consumers' or investment firms' - would be well served.
I have lost track, as you may have, of the number of fund management conferences that have devoted major sessions to the importance of fund managers focusing on client needs. It seems blindingly obvious that one should do so. Yet in a market where consumers don’t know what they need and are unlikely to demand it, it is easy to undervalue or miss this essential element.
There have been a number of interesting studies done - for example, by McKinsey’s on the US asset management market - which suggest some areas of possible interest. The McKinsey report identified a number of major trends that McKinsey believes will shape the asset management industry over the coming years. While their research focused on the US market, I believe many of their views have broader application. These include changes in demographics which is likely to focus more attention on decumulation and protection products than traditional accumulation products and McKinseys conclusion that the asset management industry would be better off focusing on 'outcome-based' products (i.e. products that focus on meeting consumers' needs) rather than existing 'style-based' investment strategies (i.e. traditional fund strategies such as growth, balanced, etc).
I therefore challenge the industry to think more carefully about the kinds of products and services that different segments of consumers need and to work with distributors to make the benefits of those products clearer to consumers.
Target market
The debate around target market has been very lively indeed, triggered in part by the speech Clive Briault made at the FSA Annual Asset Management Conference in September. I think it is important to remember that in addressing this issue, the FSA is looking to cover a wide range of investment and savings products and services that compete for consumer investment, right across the range of trackers and actively managed collective investment schemes, to unit-linked and with-profit investment offerings on the life side, to listed investment company structures, to structured and guaranteed products, to alternative investment vehicles such as hedge funds, property funds and funds of hedge funds. This covers a huge range of strategies, structures and investment approaches, from the plain vanilla to the highly bespoke and encompasses products with a broad spectrum of risk characteristics.
It is clear that there are bound to be significant differences in what the concept of target market means in different sectors of this vast array of investment products. It's pretty difficult, for example, to say much that is enlightening from the point of view of target market when one is dealing with a generic index tracker fund. There are certain investors, for example those who are not prepared to accept any risk of capital loss, for whom such funds might be considered to be inappropriate. So they would not be part of the target market. At the other end of the spectrum could be a UCITS III fund which has structured in a strong element of protection / hedging against downward market movements, rather than focusing on significant high performance opportunities.
In between, there are multiple variations on the theme of the target market. The challenge for providers of investment products across this spectrum is to consider carefully the question of what the target market is for the products they offer. Many may be suitable for quite a broad spectrum of investors and there is nothing wrong in that. But others might be geared to customers with more particular needs. The TCF message is not about inventing categories of target audiences for the sake of it, or producing management information that does not add value. It is about the product provider being as clear as is possible in its assessment of where it would expect its products to end up. Sometimes that will be a pretty specific audience, sometimes not. We think bringing greater clarity here is an important part of enhancing the quality communication that occurs between fund managers and their distributors. That can only enhance the quality of consumer outcomes at the end of the chain.
With these challenges around product design, target markets and the other elements of TCF in mind, I am pleased to announce the establishment of a small working group of industry practitioners to work urgently alongside the FSA to develop further ways in which the TCF initiative can be delivered in the asset management sector. The working group will include market participants and FSA staff from the Asset Management Sector Team and the TCF central team. This group will begin meeting very soon and will move the debate forward, through illustrative work on good and poor practice. We are giving this work a very high priority in the FSA, given the fast approaching TCF deadlines.
(3) European Developments
Let me turn now to the third area I wanted to focus on today, namely, European developments. As I am sure you know, the Commission’s agenda is extremely active at the moment. It is absolutely critical that the UK asset management industry engages constructively and effectively in this debate. Decisions made over the course of the next couple of years will set the tone for the next decade or so of European funds regulation.
The Commission is actively pursing three major areas at the moment. First, significant amendment of the UCITS directive, the fundamental framework of cross border funds business in Europe. Second, possible European solutions for alternative investments, beginning with real estate investment funds. Third, exploring the difficult issues around cross-sectoral competition – that is, banking, insurance and funds products – and the regulatory arrangements that apply to them.
Let me turn to the changes in the UCITS directive. A great deal of this is a good news story. The Commission has published a set of ‘orientations’, which propose amendments to the UCITS Directive in the following areas: (i) the notification procedure; (ii) cross-border fund mergers; (iii) asset pooling; (iv) the management company passport; (v) strengthening supervisory co-operation and (vi) the simplified prospectus.
The notification procedure will be simplified and will be made regulator-to-regulator. We have tried hard within the CESR Investment Management Expert Group to improve the operation of the notification procedures, but more was clearly needed. The Commission’s proposals are brave and will radically simplify and shorten the process. Please give them your support as there are forces that would seek to continue to slow things down.
Developments around the management company passport are less encouraging. There is strong resistance in a handful of member states to allowing the increase of flexibility that the full manco passport would provide. While there are real issues about allocation of supervisory responsibility and effective cooperation between supervisors to be resolved, there are also parochial interests that are working against the single market and the enhanced freedom the full passport would provide. The Commission should be encouraged to resist these retrograde forces.
The work on the challenging question of how to improve the failed simplified prospectus is proceeding apace. With my counterpart Hubert Reynier at the Autorite des Marches Financieres in France, I have been co-chairing work on what is now called Key Investor Information. This would replace the simplified prospectus with a very short document, focused on communicating key information to assist consumers in making their decision to invest. It will not be, as the simplified prospectus has become, a document designed more to protect against liability than communicate effectively. CESR’s consultation on proposed solutions is going on as we speak, and will continue for a month. Please do get involved with this and provide your input.
In addressing what to do with Key Investor Information, we must consider the real world context in which this communication to consumers is going to take place. It is vital to understand the highly variable and complex structure of distribution in European retail markets, the differing behavioural and cultural characteristics in these markets and the increasingly complex product packaging of UCITS, to come up with a sensible answer to the puzzle of how to achieve effective communication of key risks and issues about fund products at and around the point of sale.
Thus, for example, our desired simple disclosure will need to be suitable for a retail client who is buying a straight UCITS, but also (as is increasingly the case) a UCITS within a tax wrapper, or as part of a savings plan, or a fund-of-funds, or where the charges that the consumer pays are dependent on the distribution channel. In these circumstances, in order to be helpful and useful to consumers, information on the fund must be combined with other information about the product that is actually being bought.
Where there are multiple layers of 'product' between the UCITS and the consumer, the consumer will need to know about the overall package. The Key Investor Information will not meet this need unless it is flexible enough to allow the information to be incorporated, or makes clear that the harmonising scope of the directive does not extend to such information.
Negotiations on the UCITS package are expected to begin in the first quarter of 2008 and continue possibly until end 2008 or early 2009. Implementation of the package is not expected until 2010 or 2011. The Commission has done a good job of synthesising views on what the shortcomings are with the current Directive and its application in the field, and most importantly, building consensus on what we can do to improve matters. We are confident that, working with the Commission and other Member States, we will design and build a new UCITS Directive which will not only preserve the real strides forward that we have made in developing a popular retail investment product, but also add flexibility, clarity and improved efficiency in its operation, in accordance with the Single Market credo.
Alternative Investments including REITS
Another important issue for the UK fund management industry is the question of regulation of alternative investments. The Commission's blueprint for modernising UCITS, which I mentioned earlier, did not – for good reasons - deal with a number of important issues which are currently outside the UCITS framework, including open-ended real estate funds (or REITS), funds of hedge funds and national private placement regimes. The FSA, for one, has strongly encouraged investigation of whether a European private placement regime is feasible, particularly since it is already possible for funds to be constituted as securities and passported under the operation of the Prospectus Directive.
As regards REITS, the Commission has worked throughout this year with an expert group on open ended real estate funds. The group's task has been to advise the Commission on the risk and performance characteristics of open-ended real estate funds, and in particular to:
- Describe the European market for real estate funds, including open-ended funds;
- Analyse the existing or likely future demand for providing open-ended real estate funds across borders;
- Examine the barriers to cross-border development of open-ended real estate funds; and
- Evaluate existing national regulatory (including tax) approaches to open-ended real estate funds.
The expert group is due to produce a report before the end of the year or at the start of 2008, which will provide important input to policy reflection and serve as a starting point for debate and discussion with Member State authorities and other stakeholders. So I would encourage you to take a look at this important document and to engage in the debate which will doubtlessly occur following its publication.
FAIF’s regime
Before I leave the area of alternative investments, I would like to take this opportunity to announce an update on our proposals to allow UK retail consumers to invest in funds of alternative investment funds. You will recall the Consultation Paper (CP 07/6) we published in March of this year. We had planned to issue a Policy Statement and final rules towards the end of this year, which would allow funds of alternative investment funds (or FAIF’s), including funds of hedge funds, to enter the UK retail market. However, as we identified in the consultation, there are a number of difficult issues to resolve in order to make the FAIF’s regime effectively operational. The Treasury is currently considering these issues in conjunction with the offshore funds tax regime and, therefore, the FSA considers it appropriate to delay the publication of our proposals until the situation is clearer, which we anticipate will be early in the New Year. Whilst the delay is disappointing, it does provide an opportunity for further discussion and consideration before the rules are finalised. We are aware that it is important for the UK to have a retail-oriented regime for funds of alternative investment funds and we will continue our constructive dialogue with HMT and others to find a way to achieve this.
Competing products
The third area of European development I would like to touch upon is the regulation of so-called "competing products". The Commission has published a call for evidence on the impact of the fragmented regulatory landscape for retail investment products. The main purpose of the call for evidence is to establish whether a fragmented regulatory landscape leads to unacceptably large variation in Conduct of Business (COB) rules and in the level of product disclosure, which would result in a real and significant (as opposed to perceived or theoretical) risk to investor protection. The deadline for comments is 18 January 2008 and the Commission intends to publish a feedback statement on the responses received in March 2008. Workshops with industry representatives are planned for April 2008 with an Open Hearing & Commission working paper expected in June 2008. This will allow the Commission to draw evidence-based and informed conclusions on the need for action in this area in autumn 2008.
Because the FSA has plenary authority over investment products regardless of the distribution channel or product packaging, we have always sought to adopt an approach that levelled the playing field in respect of our own regulation. There are of course significant differences arising from tax treatment of various vehicles, which have their own implications and impacts. We think it important that the Commission, in undertaking this analysis, proceed on the basis of sound evidence of market functioning and characteristics and consumer behaviour, and we consider that a good start has been made.
Conclusion
In conclusion, I have mentioned but three of the significant regulatory challenges currently facing the asset management industry. There is much more I could have spoken about, but all three of these matters have potentially significant and long-lasting affects on this sector, so if you have not already done so, I strongly encourage you to join in these debates.