Current regulatory challenges: an update from the FSA
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Speech by Dan Waters, Director Retail Policy and Themes & Asset Management Sector Leader
RBS Fund Management Industry Conference
24 January 2008
Good morning ladies and gentlemen. Thank you for your invitation to speak here today. As you will note from the programme, I have been asked to cover the following topics:
First, an update on UCITS discussions. Second, the Call for Evidence on Product Transparency, and Third, feedback on some recent work the FSA has done on unbundling of commissions.
I also want to take this opportunity to address two other timely issues, namely current issues for open-ended property funds and the TCF good practice illustrations that we published earlier this month.
(i) Property funds
As you will doubtlessly be aware, developments in the property fund sector have featured heavily in the press in recent weeks. You will also not be surprised to hear that the FSA has been taking a keen interest here for some considerable period.
Whilst many property funds continue to operate as usual, some funds are experiencing liquidity difficulties. Three main factors have combined to create this situation: (i) the significant fall in commercial property values in recent months; (ii) the illiquid nature of some of the underlying investments, particularly relevant for those funds investing directly in bricks & mortar; and (iii) the significant growth in redemptions in these funds. This combination of factors has led to some funds having to defer redemptions, affecting both institutional and retail investors.
As you would expect, approaches to these redemption issues vary from firm to firm and from fund to fund. The FSA's major consideration is to ensure that consumers are treated fairly: that is, that the interests of redeeming investors are balanced against those of investors remaining in the fund. We must avoid situations where one group of investors is preferred over another group.
We also expect firms to consider on an ongoing basis how they communicate with investors. It is critically important, of course, for a firm to ensure that its promotional materials explain the particular nature of the risks associated with such funds, in particular the potential risks around liquidity and valuation. As important as this disclosure is, it is also essential that firms monitor on an ongoing basis their marketing literature and communications with intermediaries and investors to ensure these are continuing to provide a true reflection of the risks inherent within these products. Further, we expect firms to communicate important issues, such as the suspension of redemptions, to investors in a timely and balanced manner. So my message to you today is to ensure that you have the interests of your investors uppermost in your minds when making decisions about how to deal with the challenging current market conditions.
On a separate but related point, you may be aware that the European Commission in its white paper on enhancing the single market framework for investment funds asked whether UCITS ought to be expanded to include investments in real property. As a result, an expert group was set up to look at real estate open-ended funds which will report in the first quarter of this year. IOSCO Standing Committee 5 is also examining issues related to open-ended funds investing in property, so there is growing international regulatory interest in these types of funds.
(ii) Treating customers fairly and UK CIS operators
Let me turn to our recently published TCF good practice illustrations for managers of UK collective investment schemes. When we published the general TCF Guidance last July, we said there were likely to be some difficult or complex areas where additional clarification of what we expect of firms would be helpful. We acknowledge that the CIS industry in the UK is subject to a unique set of regulatory requirements under the COLL sourcebook and also provides products the great majority of which are sold through distribution channels not controlled by the CIS Manager.
The TCF good practice illustrations provide practical examples as to how CIS managers can meet the requirements to collect Management Information in two specific areas – identifying their target market and reviewing how their products are actually being distributed.
The FSA has drafted these good practice illustrations in collaboration with the industry, following a 'working group' that met twice during December 2007. It captures the existing good practice many firms already undertake regarding these two provider responsibilities. We are very grateful to the firms and to the IMA who participated actively and constructively in this effort.
We hope that firms find these illustrations useful – they have been issued in the spirit of seeking to clarify the relevance of Principle 6 for firms operating a typical CIS manager business model, which of course will be subject to individual variation. These illustrations are another example of practical delivery of our commitment to more principles-based regulation. We embrace this principles-based approach at home and increasingly try to encourage this style of thinking in many of our on-going discussions with the European Commission and our international regulatory counterparts.
This leads me to my the first of my agreed topics for discussion today: an update on UCITS - the fundamental framework of cross-border funds business in Europe.
(1) An Update on UCITS discussions
(a) CESR consultation on Key Information Document and the Review of the Simplified Prospectus
Part of the Commission's wider work to revise the UCITS Directive is to replace the current Simplified Prospectus with a disclosure document that will be more meaningful and helpful to retail investors. Work on the challenging question of how to achieve has been making very good progress. With my counterpart, Hubert Reynier at the Autorité des Marchés Financierès in France, I have been co-chairing a CESR working group, with representatives from ten European regulators, to consider the issues and make recommendations to the Commission.
In October 2007, CESR published a consultation paper setting out its proposals on what was then known as Key Investor Information but is now likely to be called the Key Information Document or KID. The Consultation Paper followed two calls for evidence and a questionnaire on related subjects published earlier in 2007.
CESR looks set to recommend replacing the Simplified Prospectus with a very short document, one focused on communicating key information to consumers, assisting 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.
In addressing what to do with the KID, we must consider the real world context in which consumers will receive and use this information. It is vital to understand the highly diverse and complex structure of distribution in European retail markets, the differing behavioural and cultural characteristics, 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.
For these reasons, thinking on the KID initially focused on the idea of a ‘building block’ approach, where the fund manager would make available information about the fund which could then be combined or adjusted by entities further up the distribution chain. However, this approach is not practical. There are a number of reasons, but an important one is that achieving effective outcomes for retail investors would likely have entailed reviewing the requirements of a raft of different directives, including MiFID. I am sure no one in this room would thank us if part of our proposal was to rewrite MiFID, which we have only just implemented.
As a consequence, the KID work focused instead on proposals for a simple, plainly worded document for UCITS funds, strictly limited to the key information needed by retail investors to make informed investment decisions. Research with investors has repeatedly underlined their preference for a simple and brief presentation of core facts. For UCITS these core facts most obviously included the fund’s objectives and strategy, its risks and potential rewards, its performance and its charges. They also included some additional information of a practical or local nature, such as where to find further details. The core document could then be used virtually unchanged across Europe. Only requiring information in the KID that would not change cross-border could have the benefit of speeding up notification procedures and improving the single market in UCITS.
As a result, it was decided that the KID should be a strongly harmonised document. To address the retail investor’s legitimate need for local information, proposals have developed to use the technique of signposting to point the reader to where they can find further information. Of course, some distribution-specific information could also be partly addressed through requirements which already might apply to distributors – such as those flowing from MiFID.
The challenge now may be ensuring investors obtain an overall package of information which works well together.
(b) The notification procedure and the management company passport
Let me turn from the KID to the other elements of the amendment of the UCITS Directive. As you know, the Commission last year published a set of ‘orientations’, which proposed amendments to the UCITS Directive in the areas of (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.
I would like to be able to say to you that after nearly four years of hard work by the Commission, the community of European regulators and industry and investor stakeholders is going to deliver a suite of sensible changes that will significantly improve the operation of the cross-border European funds industry. I have said on numerous occasions that the Commission is to be congratulated on the way in which it has managed the process of amending the UCITS Directive. It started in the right place, with a Forum of market participants who identified key constraints and problems in the operation of the Directive. The Commission took great pains to engage the industry and the investing community over the past three years, through a series of consultations, open workshops and hearings. It has even, for the very first time in Commission legislative history, decided to engage in consumer research to test the efficacy of proposed interventions in the Key Information Document. In short, it has been the best example I have seen of the European Commission delivering better regulation; regulation based on real analysis of real problems, taking account of costs and benefits, and seeking to introduce meaningful change.
I am sorry to have to say to you that there is now a major risk that much of what we have all laboured so hard to achieve over the past four years will be destroyed by those who are fighting to limit the creation of major enhancements to the single market. I speak of course of the Management Company Passport. The partial passport unveiled by the Commission in its orientations was a good-faith attempt at a compromise. It is clear from analysis and industry commentary that the partial passport will not work. If the Management Company Passport is not delivered, major benefits linked to pooling and master feeder structures are then under threat. Failure to deliver these elements would be a crippling blow to the overall package of reforms. It could transform work that was a model of how better regulation can work in Europe into a particularly depressing example of how it can be undermined.
This is not to say, of course, that there are no difficulties or challenges with the full management company passport. Its supporters are keenly aware of the need to ensure that there are robust supervisory arrangements in place to operationalise the passport in a manner that will give confidence to regulators and more importantly will provide the degree of consumer protection that the Directive quite rightly requires. This is perfectly feasible, and proposals have been put to the Commission which, if implemented, would set us on the path of developing such structures and arrangements. No one wants a market in which poorly controlled fund management companies are passporting questionable funds across Europe. The Commission has the tools to write Directive amendments that will prevent that outcome, if only it will take them up.
I call upon the Commission to resist those retrograde forces that would roll back the clock on the single market and to focus on operationalising the full passport to support the continued development of a true European market for funds.
To those of you in the audience for whom the management company passport is important, it is not too late to let your voice be heard. I encourage you to write directly to Commissioner McCreevy to express your support for efforts to ensure that the benefits of a true cross-border regime for European funds are realised. He has been a consistent champion of evidence-based regulation and the single market and I am sure we all look to him to deliver the right outcome here.
(2) Call for Evidence on Product Transparency
I would now like to talk about the regulation of so-called 'substitute products'. The Commission has published a call for evidence on the impact of the varied regulatory landscape for retail investment products. The main purpose of the call for evidence is to establish whether the lack of consistent regulation leads to unacceptably large variations in Conduct of Business 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 was 18th January and the Commission intends to publish a feedback statement on the responses received in March. Workshops with industry representatives are planned for April, and an Open Hearing & Commission working paper is expected in June. This will allow the Commission to draw evidence-based and informed conclusions on the need for action in this area in the autumn.
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, proceeds on the basis of sound evidence of market functioning and characteristics and consumer behaviour. I would like to congratulate the commission on its paper which contains a thoughtful analysis of what is a pretty complicated issue.
(3) Feedback on some recent work the FSA has done on unbundling of commissions
The final topic that I want to discuss today is recent progress on our use-of-dealing-commission work, and in particular, the results of a piece of thematic work which are published on the FSA website today.
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Our new rules on the use of dealing commission were introduced on 1 January 2006, replacing the previous rules on the use of soft commission arrangements. The genesis of this work was Paul Myners' 2001 report on institutional investment in the UK, which raised concerns in respect of incentive misalignments in the use of dealing commission by investment managers and insufficient transparency and accountability in the way that those commissions were used.
The evolution of our policy on dealing commission is a long story, but in summary we sought to ensure that investment managers had stronger incentives to make efficient decisions about trade execution and the purchase of investment research and that they were fully accountable to their clients for those decisions.
We sought to achieve these outcomes by limiting the use of commissions to the purchase of execution or research services and by encouraging investment managers to seek, and brokers to provide, clear payment mechanisms that enabled these services to be purchased separately. Our new rules were an early example of the FSA's move to more principles-based regulation. They set high-level requirements for investment managers, requiring them to exercise their judgement rather than the FSA imposing prescriptive detailed requirements on the types of goods and services that could be purchased with commission.
Complementing our new rules, the industry has introduced codes of practice setting out enhanced disclosure requirements including the provision of half-yearly reports to pension fund trustees on the goods and services acquired with their commission.
Since the introduction of these new requirements and codes we have largely taken a step back and given the industry the time and space necessary to make the changes in behaviour required. Now, however, we are undertaking post implementation review work to measure the success of our policy intervention. A baseline survey of commission practices was taken as at 1 January 2006 and we will be repeating this measurement again in the third quarter of this year to determine the changes in behaviour. In advance of this formal performance measurement work we undertook a piece of thematic work with a sample of investment managers and brokers in the second half of 2007 to gauge progress and determine if any corrective action was necessary in advance of our second round of measurement.
So what did our thematic work reveal? Well, overall we are encouraged by the progress that we observed. Investment managers were found to have entered into meaningful negotiations with their brokers to agree a split of total commission rates between execution and research elements. The emergence of commission sharing arrangements in response to the new regime has also enabled investment managers to secure greater value for their clients by directing deals to those brokers capable of providing best execution whilst also enabling the manager to reward research that generates valued ideas. There is therefore strong evidence that the increased focus on value for money in the use of client commission that we had sought has been delivered.
It is not entirely good news however. As I mentioned earlier our rules set high-level standards which require firms to exercise their judgement in applying those standards to their particular business model. We have seen evidence that a minority of firms have been using the flexibility inherent in the rules to preserve existing payment practices rather than engaging with the outcomes that we are seeking. For example, we noted that some firms continued to use dealing commissions to pay for raw price feeds. We have previously stated our view that these do not meet our definition of research or execution and so should not be paid for out of client dealing commissions.
We also noted considerable variances in practice in respect of market data services. We have previously stated that elements of such services may meet the definitions of execution or research and that they could be treated as 'mixed use' with client commission paying for qualifying elements and the firm paying for the rest. We noted a number of instances where firms used client commissions to meet all the costs of market data services if the service was being used by an investment manager or a research analyst. The fact that such a service is used by front office staff is not, in our view, sufficient justification for all such expenditure being paid for out of client commission. I would like to take the opportunity here to reiterate our expectation that firms should make reasonable judgments based on the high-level criteria that we have set. We are communicating our concerns directly to the firms involved. We will also give consideration as to how we can make our expectations clearer to firms in this area, perhaps using case studies to provide examples of good practice.
A wider issue revealed by the thematic review was the low level of engagement by pension fund trustees with the new half-yearly commission reports. Investment managers informed us that they had received almost no feedback on the reports that they produced for their clients. We recognise that pension fund trustees are currently dealing with many high-profile issues; however we continue to believe that the commission reports are useful tools that can help deliver real benefits to the fund. It is doubtful that these benefits will be delivered without the trustees holding their investment managers to account for their decisions on commission spend
So, with this in mind, we intend to work closely with the trustees and the NAPF over the longer term to encourage them to engage on the use-of-dealing-commission issue. We will also be talking to other parties, in particular the pension fund consultants, to establish whether they can play a role in assisting their trustees in using the commission disclosures.
In relation to retail firms, as many of you are aware, DATA and the IMA have been working to finalise Disclosure Codes to assist the Depositary, as the investor representative, in deciding whether the managers' softing and bundling practices are operating in the interests of the funds' investors. We expect to see this long-running piece of work completed promptly. The results will assist Depositaries in determining how they should respond to the disclosure of commissions that fund managers are now making.
That is all time permits me to say on this matter. However a more detailed description of the scope of this work, and the findings, can be found in the report on this thematic work published on our website today.
Conclusion
In conclusion, I have discussed a number of regulatory challenges currently facing the asset management industry. There are many more I could have mentioned. The bottom line is that there are developments occurring now, particularly in Europe, which will have lasting impact on the industry in the UK. The UK industry and UK regulatory practice both need to be at the top of their game, both to influence the shape of things to come in Europe and globally and to ensure that high standards of investor protection and market confidence are maintained here at home.
Thank you.