2020 Regulatory Field Guide

REGULATORY FIELD GUIDE 2020 REGULATORY FIELD GUIDE

CONTRIBUTORS

Derek Coyle, Vice President | [email protected] Jamie Dickson, Assistant Vice President | [email protected] Eimear Hennigan, Senior Vice President | [email protected] Laura Murray, Vice President | [email protected] Eamonn O’Callaghan, Vice President | [email protected] Chris Pigott, Senior Vice President | [email protected] Bijal Shah, Vice President | [email protected] John Siena, Senior Vice President | [email protected] Bob Stewart, Senior Vice President | [email protected] Ryan Sullivan, Senior Vice President | [email protected]

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2020: THE YEAR OF REGULATORY CLARITY AND PRECISION

Dear Reader,

As we enter a new decade, it is an opportune time to accuracy of data required. As the search for transparency reflect on what has passed, but also a chance to look continues, among regulators, investors, and asset man- ahead to future challenges and opportunities within asset agers, we’re likely to get a closer look inside things like management. If the last ten years were largely defined management fees, performance fees, and fund liquidity by large scale regulatory implementation, the next ten stress testing results. And as technological evolution ac- are likely to involve more focused revisions to existing celerates across asset management, regulators must con- rulesets as regulation looks to keep pace with societal sider how to best oversee nascent technologies and asset and technological evolution. classes to protect investors and monitor systemic risks without stifling innovation or better investor outcomes. It Which brings us to the theme of this year’s Regulatory is a delicate balance that will set the tone for the industry Field Guide: clarity and precision. Regulators, to a much throughout this decade. greater degree than in the past, are presenting a clearer view of what is expected from firms and investors. Our 2020 Regulatory Field Guide contains insights from Greater levels of prescription and certainty within rulesets the regulatory experts at Brown Brothers Harriman and are helping industry constituents come to terms with the asset management industry. We hope you find this the tangible benefits and effects of regulations. Greater guide helpful and informative as you grasp the intricacies transparency is also enabling these stakeholders to of regulatory change throughout a year of increased clarity objectively view whether or not the regulation is working and precision. as intended.

While the focus for many regulatory developments this year will be on clarifying the finer details of a regulation, this does not mean there is a lack of “mega regulations” on the horizon. Brexit remains unfinished, the global focus Adrian Whelan on framing appropriate environmental, social, and gover- Senior Vice President nance (ESG) regulations will continue, as will the increasingly louder calls to more formally regulate the use of new technology. In such an environment it may be the most For more commentary on the latest flexible and agile rather than the biggest and strongest developments in the world of financial regulation visit who thrive.

With all that said, three areas stand out surrounding the global regulations of 2020: reporting, transparency, and modernization. With increasingly stringent reporting requirements, managers must ensure they have a proper data strategy in place to handle both the volumes and

2020 Regulatory Field Guide | 1 2 | CONTENTS

4 For All to See: The Wide-Angle Lens of SRD II 16 SEC Zeroes in on Modernization in 2020 A sweeping new set of rules aimed at improving com- The SEC was created in the wake of the 1929 Wall Street munication between European companies and their crash and many of its rules from that period have largely shareholders takes effect in 2020. When it does, asset stood the test of time. Now, the SEC is on a push for managers can expect a heavy administrative lift. modernization in 2020.

6 In Transition: What’s Next for LIBOR 18 The Asset Manager’s Perspective on 2020 With the impending retirement of LIBOR, one thing Gareth Murphy, Chief Risk Officer, and Christine Brentani, is certain: current users must get comfortable with Regulatory Developments and Relationship Manager alternative benchmarks. at Standard Life Aberdeen, highlight the key issues and trends shaping the global regulatory landscape in 2020. 8 China Sets Sight on International Access Greater access to China could be a once in a lifetime 20 EU Regulations: How Asset Managers opportunity for asset managers – there is no other place Can Keep an Eye on the Ball in the world where trillions of dollars of new capital are Global asset managers have become accustomed to up for grabs. navigating the perilous shoals of cross-border regulation, but new regulatory developments in the EU may make 10 CSDR: Failure Will Soon Come at a Cost some unexpected waves. Beginning in 2020, cross-border settlement failures will come with a new set of potentially costly penalties thanks 22 Long Range Regulation: The Global Reach of SM&CR to the new settlement discipline rules. The UK has introduced some of the strictest standards of conduct for senior asset management staff, setting a new 12 A New Vision: Regulators Push ETFs to bar across the globe. Modern Era Regulators in the US, Europe, and Asia are paving the way 24 AMLD Continues to Sharpen Its Focus for new types of ETFs, which could keep the ETF boom As regulators and the financial services industry continue alive for years to come. to combat money laundering and terrorist financing, AMLD 4, 5, and 6 are all in play in 2020.

2020 Regulatory Field Guide | 3 sweeping new set of rules to improve communications between European companies and their shareholders, known Aas the Shareholder Rights Directive (SRD) II, takes effect September 3, 2020, imposing a number of new requirements on asset For All to See: managers, custodians, and other intermediaries in the share-ownership chain.

SRD II was adopted by the EU in 2017, The Wide-Angle updating the original SRD passed in 2007. The goal was to encourage longer time horizons for shareholding, drive shareholder engagement, and require more transparency Lens of SRD II and accountability to shareholders regarding company director pay and conflicts By: Derek Coyle and Bob Stewart of interest.

4 | SRD II takes a long-term view 2018 to protect the privacy of individuals The directive provides that any charges Taking note of the fact that the average resident in the EU. levied by an intermediary on sharehold- shareholding period is only eight months, ers, companies, and other intermediaries The transparency requirements for annual the European Commission said that “the should be non-discriminatory and propor- general meetings (AGMs) are also elabo- performance of asset managers, employed tionate to the actual costs incurred for de- rate. SRD II says that shareholders must be by institutional investors to manage their livering the services. In addition, any differ- given sufficient notice of company events assets, are often evaluated on a quarterly ence between the charges levied between so that they can closely examine the vari- basis or even on shorter periods, which domestic and cross-border exercise of ous options. When shareholder votes are doesn’t allow them to take into account rights must reflect the actual costs incurred submitted to the company by electronic long-term performance and puts pressure for delivering the services. platform, the shareholders must be notified on them to deliver short-term returns.” that their votes have been tallied within Another requirement is that investment In an effort to reverse what the EU saw as 15 days. firms and institutional investors must now a negative trend, central securities deposi- publicly disclose their shareholder engage- While the directive requires that compa- tories (CSDs), custodians, intermediaries, ment policy, which explains how they plan nies have a right to data concerning share- and asset managers will be required to: to integrate shareholders into their invest- holders, it provides that member states ment policies – or if they don’t plan to do • Answer requests from companies may limit the identification of shareholders that, publish an explanation of why not. based in Europe for data about share- to those holding at least half of a percent of holders in their firms, often within the company’s outstanding shares, which SRD II also contains language requiring 24 hours. would limit the burden considerably. a code of conduct for proxy advisers, the firms that research and advise asset man- • Convey information about a company’s Addressing misgivings over manage- agers on how to vote on issues at AGMs. general meetings to shareholders. ment pay It provides that proxy advisory firms should The EU has expressed concern that man- provide accurate and reliable recommen- • Facilitate voting by those shareholders agement pay at companies is sometimes dations to the firms they advise, but does on issues at the general meetings. out of step with the company’s financial not spell out how it expects this issue to performance. As a result, SRD II requires be implemented. • Convey those votes to the company or that companies establish a remuneration its agents, as well as inform the share- policy, which must be submitted to the In summary, it’s clear that SRD II repre- holder that the company had received shareholders for a vote at least every four sents a heavy administrative lift requiring their votes. years, and submit a pay report for an ad- action in 2020. Custodians and financial institutions are expected to be the first With more than 8,000 affected compa- visory vote annually. If these votes fail to intermediary in the chain for most commu- nies in the EU, the directive will apply to all gain approval, the directive provides some nications in order to respond to or redis- firms in the custody chain that are holding key follow-on steps. tribute requests as soon as possible. Asset European equities or investing in them, SRD II also imposes rules governing admin- manager and institutional investor readi- whether they are located within the EU or istrative costs, including for implementing ness for SRD II focuses on the definition of not, making it one of the most sweeping SRD II itself. For example, intermediaries shareholder engagement policies that high- changes to corporate governance regula- need to be transparent about proxy costs light transparency and long-term thinking in tion ever. The administrative burden on and the provision of proxy services, which their approaches. firms across the globe will be substantial. should be published visibly (such as on a BBH will continue to support messaging Conforming to GDPR and transparency company website) so both end investors regarding general meetings, proxy noti- requirements and regulators can find it. It is likely that SRD II will mean that global proxy notifica- fications, and corporate actions, and will Intermediaries will have to ensure that re- tions would become a mandatory service, meet the same day turnaround times quests from issuers for shareholder data where it is currently an elective option for to either answer such requests, or pass are legitimate and that they conform to the the EU locations in scope. them on through the intermediary chain rules of the EU’s General Data Protection as needed. Regulation (GDPR), which took effect in

2020 Regulatory Field Guide | 5 In Transition: What’s Next for LIBOR By: Bijal Shah

ecause credit lubricates the ma- Complicating matters for market partici- LIBOR is calculated from a daily survey chinery of just about every aspect pants, LIBOR is the interest rate bench- of 20 leading banks in London, which left of the financial industry, figuring mark used to price mortgages, credit card the process open to a rate-fixing scan- out how to manage the looming rates, and an estimated $300 trillion in dal. SOFR, on the other hand, is based on Bretirement of the interest rate benchmark fixed-income derivatives, and while LIBOR Treasury overnight repurchase agreements, known as the London Interbank Offered is sure to go away, no single replacement or repos, while SONIA is calculated by Rate (LIBOR) has moved to the front burn- rate has been agreed. Instead, five so- the Bank of England from interest paid on er for many firms as they head into 2020. called risk-free rates, which might more ac- Sterling one-day deposits. curately be termed “nearly risk-free rates,” Although LIBOR will not completely disap- have been developed. The Federal Reserve has been pressing pear from the market until the end of 2021, financial firms aggressively to adopt SOFR the need for an end-to-end credit rethink Among the five, the main contenders are as soon as possible. Federal Reserve Bank – from examining all documentation that the Secured Overnight Financing Rate of New York President John Williams has refers to LIBOR, incoming and outgoing (SOFR), which the Federal Reserve intro- expressed concern that firms were drag- loans, client arrangements, and a deep dive duced as a LIBOR alternative in the US, ging their heels in transitioning to the new into a panoply of risk functions – means and the Sterling Overnight Index Average benchmark. “I don’t always sense urgency that the process must be well underway (SONIA). among market participants on this issue,” before the deadline nears. Williams said. “Tellingly, contracts refer- encing US dollar LIBOR, without robust

6 | fallback language, continue to be written” Because of this complexity — the final in- overcharged for the new rates. The acid he said in an August 2019 speech. terest rate is often not known until after the test, as FCA Chief Executive Andrew Bailey term has expired — financial firms need to puts it, is whether firms are seen to have To ensure the transition moves ahead, the understand what this sea change actually done right by their customers. US government has started flexing its con- means for their business. So far, the indus- siderable muscle to promote adoption of try approach to products based on the new “For many, LIBOR transition will impact SOFR. Mortgage guarantee agency Fannie benchmarks has been cautious. their overall business strategy and front-of- Mae has issued $6 billion of SOFR-linked fice client engagement, rather than being a bonds and the Federal Housing Finance For example, the Eurodollar futures market narrow legal and compliance risk,” the FCA Agency, which regulates Federal Home is a bet on future interest rates paid on dol- said. “Potential impact and risk therefore Loan Banks, said the institutions shouldn’t lar deposits outside the US. Many firms needs to be considered and addressed in issue new financial instruments tied to use these derivatives to hedge against an appropriately coordinated way across LIBOR after the first quarter of 2020. The interest rate swings, but without a term a firm.” 13 banks have about $221 billion in out- rate, that will be more difficult. The Chicago standing LIBOR-connected notes. Mercantile Exchange has started issuing What’s next Eurodollar futures based on SOFR, but If LIBOR transition isn’t incorporated into SONIA is also getting attention, with the there has been limited uptake by investors project planning for 2020 it should be. As European Investment Bank issuing a £1 so far. we described, regulators are keen to see billion SONIA-linked bond, the first SONIA- some demonstrable progress from firms linked floating rate note. The bond pro- SOFR’s implementation hit a temporary with clear evidence of strategic planning. In Transition: vides for quarterly interest payments at the snag in September 2019 when turmoil in The closer we get to 2021, the date from compounded daily Sonia-rate plus 35 basis the US money markets prompted the repo which the FCA will no longer compel banks points per year. The World Bank also has is- rate to spike, causing SOFR to reach 5.25 to maintain the LIBOR rate, the less integri- sued two SONIA-linked £1.25 billion bonds. percent temporarily before the Fed inter- ty associated with LIBOR. Alternative rates What’s Next for LIBOR vened by injecting cash into the market. will start to increase in prominence, liquid- In preparation for the transition to risk-free It was an alarming lesson, causing some rates, the Financial Stability Board, the in- ity, and infrastructure, and therefore should market participants to avoid SOFR-linked start to look more viable. ternational financial monitor set up in the debt, at least temporarily. wake of the Great Recession, called on However, this move is a process, not an the International Swaps and Derivatives An urgent need to focus on risks overnight deliverable, as so many areas of Association (ISDA), the derivative indus- As part of the preparations for the transi- a firm’s business are involved in the transi- try’s trade body, to add what it termed a tion away from LIBOR, regulators are ask- tion. In order for a successful transition, “pre-cessation trigger” into contracts for ing financial firms to demonstrate their this move needs careful global choreogra- derivatives that still reference LIBOR. The readiness to make the change. In a letter phy to avoid pitfalls attendant to interna- reasoning is that if LIBOR ends for some to the CEOs of major banks, the UK’s tional regulatory arbitrage. The first step reason prematurely, derivatives should be Financial Conduct Authority (FCA) and is to determine which benchmark to rely switched to the risk-free rates. Prudential Regulation Authority asked that on. SONIA has been in existence for long Drawbacks of replacement rates that firms’ senior managers and boards enough to prove a credible alternative “understand the risks associated with this for sterling, but it will remain to be seen One problem for many financial institutions transition and are taking appropriate action whether the US dollar replacement SOFR is that the new risk-free rates are back- now so that your firm can transition to al- can win the confidence of the critical mass. ward-looking interest rates, while LIBOR ternative rates ahead of end-2021.” Whatever it takes for issuers, lenders, bor- is a term rate for seven different maturities rowers, and other users of LIBOR to get with a built-in term credit risk premium, Perhaps because the changeover has its comfortable with the benchmark alterna- which risk-free rates do not contemplate. roots in the LIBOR scandal, the UK’s FCA is tives, one thing is for sure – they must find As a result, finding the future cost of loans also trying to get firms to focus on conduct an alternative. and derivatives is more problematic using risk – behavior that might harm customers the risk-free rates, which are composed of or have a negative effect on the financial synthetic terms based on three-month av- system during the transition. For example, erages of the overnight rates. it is trying to ensure that clients don’t get

2020 Regulatory Field Guide | 7 China Sets Sight on International Access By: Chris Pigott

s the Chinese mutual fund Foreign majority ownership Setting up business in China industry continues along its One of the most noteworthy develop- One of the more popular options for for- reform agenda of internation- ments in recent years has been the China eign asset managers setting up business- alization, regulatory devel- Securities Regulatory Commission (CSRC) es in China has been the Wholly Foreign Aopments are driving new opportunities. paving the way for foreign asset managers Owned Enterprise (WFOE) route. As of Historically, access for foreign asset to take a majority ownership position in their October 2019, there were more than 50 managers has been highly restrictive, joint venture fund management companies investment WFOEs with two viable paths but plans made in 2019 and new options (FMC). As part of the original proposal, for- for structuring onshore products: available in 2020 are presenting oppor- eign ownership caps will be fully removed tunities for foreign asset managers to by 2021, which would allow foreign asset 1. Applying for a private fund manage- evaluate. The ability for asset managers to managers to take 100% ownership of the ment (PFM) license to set-up do- increase their access to this market could domestic FMC. In July 2019, the CSRC an- mestic private funds be a once in a lifetime opportunity for the nounced a series of policies to further open 2. Applying for quota for the Qualified industry – there is no other place in the the financial sector. This included accelerat- Domestic Limited Partnership world where trillions of dollars of new cap- ing the timeline for removing FMC foreign (QDLP) scheme and launching do- ital are up for grabs for asset managers. ownership limits by one year to 2020. The mestic funds CSRC subsequently clarified that effective April 1, 2020, FMC foreign ownership limits will be removed altogether.

8 | WFOEs provide foreign asset managers operational tasks to be outsourced to third- the ability to set-up a domestic funds busi- party providers, while in China, the FMC ness, engage with regulators, establish is responsible for these roles. As a result, servicing relationships, as well as under- FMCs have built out operational teams The ability for asset managers stand the onshore distribution dynamics. within their firms to perform NAV calcula- to increase their access to this For most foreign managers, WFOEs have tions and other operational responsibilities. been a stepping stone in their strategy market could be a once in a life- Outsourcing is beginning to make more with the end goal of establishing a retail time opportunity – there is no funds business through an FMC. This path progress in China. Aligned with foreign became clearer in August 2019 when the managers applying for FMCs, the regula- other place in the world where Asset Management Association of China tor is evaluating a public fund outsourc- (AMAC) announced they will welcome ing pilot for onshore banks and securities trillions of dollars of new capital PFM WFOEs to enter the China public fund firms. This pilot would allow the outsourc- are up for grabs.” industry. At this point, no further guidelines ing of certain operational tasks to third- related to the conversion of a WFOE to an party firms. The rules for this pilot have yet FMC have been announced, but it seems to be announced, however, it is understood there is an option to simultaneously oper- that both the outsourcing provider and the ate a PFM and FMC. There is some prec- FMC would need to undergo on-site in- Flexibility and patience will be critical as edent where domestic PFMs have tran- spections to ensure the appropriate control foreign asset managers continue to de- sitioned to FMCs, but it is not clear if the environment is in place including, but not velop their China strategy and expand their same requirements would be applicable limited to, systems, experienced person- onshore footprint to capitalize on the ex- to foreign asset managers going through nel, and oversight best practices. The an- panding pool of capital that resides outside this process. nouncement is expected to coincide with the asset management industry. the first foreign managers receiving their Aligned with the removal of FMC foreign FMC license subsequent to the removal of It is clear the sophistication of the market ownership limits, the expectation is for a the foreign ownership limit in April 2020. and investors continues to increase as the group of existing PFM managers to ap- Once the licenses are issued, the clock be- capital markets continue to open to for- ply for their FMC license in the first half of gins and managers will have six months to eign participation. The reform agenda will 2020. Pivoting from a PFM business that launch a product. progress with a focus on shifting assets limits the managers to distribute products into the traditional channels away from the to qualified Chinese investors to an FMC Currently in China, outsourcing is much legacy bank wealth management products. business that provides access to the full re- more prevalent in the private funds space Policies that are specific to inbound invest- tail market will come with new operational and those tasks are mostly performed by ment is also being updated to ease foreign and distribution challenges. securities firms. For public funds, there is access to the onshore equity and bond one example of an approved outsource ar- markets. Outsourcing pilot rangement, which was completed in 2017. As we all know, change in China can hap- As foreign players develop their public fund What’s next? pen rapidly and optionality is important for strategy, Chinese regulators are further any onshore strategy. evaluating areas where their market is dif- As we head into the next phase of the ferent than international standards. An China market development, foreign as- area of recent focus is the outsourcing of set managers will have a role to play. As core operational tasks including the fund’s highlighted by operational outsourcing, valuation, transfer agency, and financial the domestic market operates in a manner reporting. Globally, it is common for these that doesn’t follow other global markets.

2020 Regulatory Field Guide | 9 n old investing adage holds that success has many fathers, but failure is always an orphan. Beginning in 2020, cross- Aborder settlement failures will also come with a new set of potentially costly penalties thanks to the new settlement discipline rules contained in the EU’s Central Securities Depository Regulation (CSDR).

Adopted in 2014, CSDR was primarily aimed at harmonizing the way central securities depositories (CSDs) operate across the EU. Some 15 CSDs now have the official stamp of approval and operate with the strict prudential and conduct rules that CSDR established.

But CSDR also contained a provision to establish “settlement discipline” that begins to bite in November 2020. Industry associa- tions are proposing for a further implementation delay, potentially to early 2021, in order to allow for better operational readiness to support the settlement discipline regime. In an effort to reduce the number of settle- CSDR: ment failures in the EU, the new CSDR rules provide for two penalties:

• Cash penalties for failed settlements, Failure Will with a basis point penalty applied depending on the type of asset involved.

• A mandatory buy-in mechanism after Soon Come four business days of failing. The new rules are important for both buy- side and sell-side trading desks to prepare at a Cost for and apply to non-EU counterparties as well.

By: Derek Coyle and Bob Stewart For the uninitiated, a buy-in is a contrac- tual remedy for a buyer of securities when the selling counterparty fails to provide settlement of the purchased securities on time. The buying counterparty obtains the

10 | The EU regulation made clear that the in- develop their back- and middle-office sys- While most market partici- tention was to impose different cash pen- tems and processes to reduce the chances alties for settlement failures based on the for a settlement failure and, when failures pants have welcomed the liquidity of the assets involved. “Where do occur, to determine liability and ensure efforts to streamline the shares have a liquid market and could cost is attributed to the responsible party. therefore be bought easily, settlement fails This could be especially difficult when settlement process, the should be subject to the highest penalty there are multiple parties within a given rate in order to provide incentives to fail- train of transactions. new rules also have a ing participants to settle failed transactions potential downside: they in a timely manner,” the regulation states. While most market participants have wel- “Shares that do not have a liquid market comed the efforts to streamline the settle- could dampen liquidity in the should be subject to a lower penalty rate ment process, the new rules also have a potential downside: they could dampen debt securities market by given that a lower penalty rate should still have a deterrent effect without affecting liquidity in the debt securities market by making it more difficult for the smooth and orderly functioning of the making it more difficult for borrowers and markets concerned.” lenders to efficiently trade bonds. For ex- borrowers and lenders to ample, the International Capital Markets efficiently trade bonds.” How CSDR will play out Association (ICMA) said in a study of the Market participants generally commu- impact of the mandatory buy-in provisions nicate their purchases and sales us- that “liquidity across secondary European securities from a third-party, and if the price ing the European Central Bank’s Target2 bond and financing markets will reduce is higher than at the time of the original Securities (T2S) platform or through their significantly, while bid-offer spreads will sale, the selling counterparty has to make CSD. According to the new rules, CSDs widen dramatically.” up the difference. While previously option- will calculate cash penalties daily for each ICMA argued that spreads on liquid sov- al, the buy-in process now becomes man- business day that a transaction fails to be ereign bonds may double and secondary datory for liquid securities four business settled after its intended settlement date markets for less liquid corporate bonds days after the intended settlement date (ISD) and report the cash penalties through may “effectively close.” It suggested that (ISD+4 in EU parlance) and in seven days the chain of custody. Penalties will roll over the rules might force market makers to for illiquid securities (ISD+7). If the buy-in from day-to-day until the settlement takes retrench from providing liquidity to the mar- mechanism is unsuccessful, the selling place. Penalties can be calculated using ket. Buy-side traders need to be aware of counterparty has to pay a cash penalty to what are called Late Fail Matching Penalty the possibility that market liquidity in debt the buyer equal to the difference between (LFMP) or Settlement Fail Penalty (SEFP) may be in short supply. the original agreed price and the current definitions. market value of the securities. Based on the push for delay, CSDs may get In the case of appeals there is a 10-busi- an extra few months to comply, but that The regulation states that third-party buy- ness day period after the receipt of the would need be confirmed by ESMA and in agents (most likely brokers and dealers) monthly penalty summaries in which a pen- the EU Commission. Something to watch will support the buy-in and the counterpar- alty can be appealed and, in some cases, in 2020. ties will trigger the buy-in by engaging the adjusted before final penalty settlement buy-in agent to source available securities is expected. from their failing counterparty. Custodians will manage the communication and As a result, CSDs, custodians, and both operational support needed to facilitate buy-side and sell-side market participants trade settlements. are making significant investments to

2020 Regulatory Field Guide | 11 12 | A New Vision: Regulators Push ETFs to Modern Era

By: Eamonn O’Callaghan, Chris Pigott, and Ryan Sullivan

ith assets in exchange 2020, thanks to two decisions handed traded funds (ETF) growing down by the Securities and Exchange to over $6 trillion globally Commission (SEC). at the end of 2019, it might Wseem hard to imagine how ETFs have Adoption of Rule 6c-11 (dubbed the ETF further room to grow. However, separate rule) will have far-reaching implications. Ever decisions by regulators to ease ETF regis- since the first US ETF was born in 1993 tration and permit the issuance of several (the S&P 500 SPDR), the SEC required ETF new fund breeds — ranging from so-called sponsors to go through a lengthy and costly semi-transparent funds in the US to com- process to obtain what it called “exemptive ingled listed and unlisted shares in an ETF relief” from the 1940 Investment Company structure in Ireland — are likely to keep the Act (’40 Act). boom alive for years to come. However, in 2019, the SEC publicly recog- Beyond new ETF product types, glob- nized the benefits of ETFs to US investors al regulators continue to assess liquid- and sought to enshrine these products with ity and counterparty risks relating to the their own regulatory framework, rather ETF market and whether further mitigants than continue to shoe-horn approvals under are needed. So far, they’ve stopped short regulations intended for mutual funds. In of proposing any additional limits. New 2020, ETFs that qualify for the rule (e.g., European rules about settlement failure ‘40 Act open-ended RICs) can simply file a could prompt changes to market structure registration statement and comply with the and product design. And in the Asia Pacific applicable ETF regulations. region, regulators are positioning ETFs for 1. The adoption of the ETF rule helped further growth and scale. Here, we break to modernize ETFs and create a more down key regulatory developments in the even playing field for managers. A key US, Europe, and Asia Pacific regions. element of the regulation permits and US leads the regulatory easing standardizes the use of custom baskets for all ETF issuers. ETFs publish a bas- In the US, we expect to see a new crop ket of securities each day, usually based of managers enter the ETF space in

2020 Regulatory Field Guide | 13 The impacts of CSDR may be felt by an ETF holding European securities, regardless of the funds’ domicile.”

on an index or a pro-rata slice of the Tractor, and T. Rowe Price. Precidian’s The reason ETFs are likely to be the first to fund’s holdings, to inform authorized ActiveSharesSM ETFs became the first suffer is that ETFs often have a high rate participants (APs) what securities to to win SEC approval in late spring, fol- of settlement failure. That’s because of a deliver to the fund when creating ETF lowed by other so-called proxy-based, structural mismatch between the ETF and shares, or what securities they should non-transparent active ETFs. the underlying securities: the ETF shares expect to receive when redeeming. may settle in two days (T+2), while the in- Following these moves by the SEC, the Custom baskets allow ETF managers vestments underlying the ETF shares may listing exchanges (NYSE, NASDAQ, and to create baskets for specific create or require five or more days to deliver (T+5). CBOE) all sought rule changes that would redeem orders which can help improve make listing ETFs more consistent with the Two things may happen in 2020 as a result. the fund’s tax efficiency and liquidity. new ETF rule. ETFs that qualify for 6c-11 Increased costs to ETFs for failures could However, only a subset of managers will automatically fall under the exchanges’ be passed on to investors. Alternatively, had SEC approval to use these types of generic listing standards, remove the IIV the market may be prompted to change baskets. This provision in the ETF rule from listing requirements, and reduce the the way the system operates, particularly should allow for a more consistent ap- necessary seed capital to list an ETF to the way in which APs create and redeem proach and oversight in how custom $100,000. shares. These impacts may be felt by an baskets are used. ETF holding European securities, regard- With the new disclosure policies available Additional provisions in the rule did less of the funds’ domicile. and the ETF rule making it easier to launch away with the requirement of an intra- products, managers will have more choices Another regulation that is likely to impact day indicative valuation (IIV) and clarifies available to enter the ETF market. Active the European market is the Central Bank ETF disclosure policies of fund holdings firms that have been on the sidelines now of Ireland’s (CBI) decision to allow spon- and secondary market trading metrics. have a new path to protect their IP and sors to comingle ETFs and unlisted (mutual 2. The second major development fo- take advantage of the lower cost and tax- fund) share classes in the same UCITS cused on active ETFs and gave a boost efficient ETF wrapper. structure. With comingled assets, the ruling to a new class of ETF structures that promotes economies of scale, attracts in- Europe gauges the risks will not have to disclose their current vestors who prefer investing via the mutual holdings to the public on a daily basis. Across the Atlantic, European regulators fund wrapper, and may succeed in attract- This change had long been sought by haven’t yet accepted the SEC’s liberal ing new institutional investors that have active managers concerned about tip- views on transparency. Instead, their focus minimum fund size thresholds for invest- ping off the market as to the implemen- has been on the upcoming implementa- ment. A similar rule exists in Luxembourg, tation of their investment strategies. tion of the Central Securities Depository which is the second largest ETF domicile Regulation (CSDR). ETFs are likely to be in Europe. In the US, funds with comingled A number of firms had proposed vari- heavily affected when the regulation starts mutual fund and ETF share classes are ous approaches to changing the dis- imposing what is termed “settlement disci- only offered by Vanguard as they have a closure requirements of ETF hold- pline” later this year, penalizing settlement business method patent on this structure. ings, including Precidian, the New York failures with two types of fines. [Notably, the SEC did not include this type Stock Exchange (NYSE), Fidelity, Blue of ETF in rule 6c-11 and will still require

14 | these structures to seek exemptive relief. Hong Kong Global ETF issuers should watch this de- In Asia, Hong Kong’s funds regulator added Hong Kong is also spearheading several ini- velopment as it could provide an efficient this share class structure in early 2019.] tiatives focused on enhancing liquidity for and cost-effective way to enable distri- ETFs listed in the territory, including launch- bution into Hong Kong and the broader Finally, European regulators continue to ing the Designated Specialist program, Asian market. assess ETF liquidity and interconnectiv- which allowed a broader group of global ity of the market participants. Key themes Australia market makers access to provide liquidity within this area are the risk of contagion, for Hong Kong ETFs. Transparency is also under the microscope how much attention should regulators pay with the funds regulator in Australia (ASIC) to the interconnectivity of the ETF eco- In July, the Hong Kong Exchange (HKEX) pausing approvals of new actively managed system, and the ability for investors to launched a pilot program to provide an ETF ETFs in July 2019 due to concerns related redeem if there is an event which impacts buy-in exemption for market makers. This to market making. The review was focused the secondary market. ETFs are already program provides these institutions one on the internal market making function regulated by a triumvirate of EU legislation: extra day on top of the standard settlement where the ETF issuer acts in this capacity UCITS, MiFID II, and EMIR to some extent. cycle to cover any short positions result- in Australia. ASIC published their findings The question now is: are more ETF specific ing from their market making activities. In in December 2019, including recommenda- rules needed? December, the exchange announced a new tions for compliance, oversight, and ensur- ETF-specific spread table, which is sched- Asia Pacific looks to standardize ing information barriers are in place and uled to be introduced in late February 2020. functioning properly. ASIC will continue to Regulators in Asia Pacific are focused on The new spread table, as well as a new monitor international ETF developments in positioning the ETF industry in their respec- set of market making obligations, will align these areas and they have re-opened the tive markets for further growth and scalabil- Hong Kong with international standards. door for new actively managed ETF listings. ity. Many of the new enhancements have emphasized the importance of standardiza- In Hong Kong, expect to see the first ETF What’s next? issuer take advantage of HKEX being tion in the market and aligning the region 2019 was a momentous year for ETF added to the international central securities with international best practices. regulation. Rule makers across the globe depository (ICSD) ETF settlement model. acknowledged the importance of ETFs to China This enhancement allows a streamlined retail and institutional investors alike and settlement process for UCITS ETFs that are Since the middle of 2018, the onshore brought standardization to much of the cross-listed into Hong Kong, while signifi- ETF market in China has grown rapidly to global market. 2020 will see many of these cantly reducing the risk of settlement fail- exceed $70 billion in assets as of the end rules take effect, with impacts across prod- 1 ure of the ETF shares. of November 2019. Even with the recent uct development, regulatory compliance, outsized growth, ETF adoption is still at a Issuers are planning to bring a wide range and operations. Further rules may be com- nascent stage in China and only accounts of new products to the market. Supporting ing as analysis of liquidity, product struc- for approximately seven percent of total product design, the Securities & Futures tures, and transparency all remain at the investment fund AUM. But a number of Commission (SFC) recently announced forefront of the regulatory agenda. reforms are likely to bring about a shift in streamlined eligibility requirements for assets from the traditional wealth man- ETFs adopting a master-feeder structure. agement channels into public funds, with This structure allows Hong Kong domi- ETFs particularly well positioned to capital- ciled ETFs to invest into a single master ize on this reallocation of assets because fund, which would need to be regulated of their flexible, transparent, and low-cost in a recognized jurisdiction, have a mini- structure. mum asset size of $1 billion, a track record of more than five years, along with other requirements. 1 ETFGI

2020 Regulatory Field Guide | 15 SEC Zeroes in on Modernization

The US Securities and Exchange Commission was created in 1934 in the wake of the 1929 Wall Street crash and many of its rules from that period have largely stood the test of in 2020 time. However, due to significant market changes, the SEC has recently been pushing for modernization. Here’s a closer look at the areas they will zero in on in 2020.

In late November, the SEC voted to propose amendments to the existing derivatives rule that would establish new criteria for funds to follow when using derivatives. Though the new draft is similar to the SEC’s 2015 proposal, The SEC’s advertising rules there are a handful of critical have remained largely changes. They’re expected unchanged since 1961. But to release the final ruleset in November, proposals to following and based on the amend the rules received current comment period. unanimous approval from DERIVATIVES DRAFT DRAFT DERIVATIVES RULE 2.0 all five commissioners. The proposals now go through a public comment period prior to implementation, which is set for November 2020. ADVERTISING ADVERTISING RULES

16 | In September, the SEC passed perhaps one of the most anticipated ETF regulations to date: the so-called “ETF Rule.” The ETF Rule (formally known as Rule 6c-11) represents a seismic shift for both incumbent and prospective ETF issuers, with impacts spanning much of the ETF ecosystem. In another boost to the industry, in December the regulator for the first time approved a new wave of

ETF RULES semi-transparent active ETFs. REGULATION BEST UPDATED INTEREST CUSTODY RULE

In recent years, the SEC has felt compelled to release a plethora of FAQs on the “Custody Rule” Taking effect in June 2020, Regulation Best (Rule 206(4)-2) to address market innovations that Interest requires broker-dealers to only are not adequately addressed in the existing ruleset. recommend financial products to their cus- These innovations range from new asset classes tomers that are in their customers best like crypto-assets and non-delivery versus payment interests and to clearly identify any potential (DVP) securities, to the types of entities who may conflicts of interest or financial incentives they act as qualified custodians. Rather than continue may have with those products. this dynamic alignment process forever, similar to ETFs, it is highly likely that the SEC will look to revamp the rule entirely to address these topics. PROXY VOTING The definition of “Accredited RULES Investor” has remained unchanged since 1933, but we expect 2020 to be the year that chang- The proposed proxy voting changes are now subject es. The updates will likely aim to allow to a public comment period which remains open for 60 “retail” investors greater access to days from publication. That means interested parties hedge funds, private equity, and ven- have until mid-January 2020 to submit comments, and ture capital funds. This is a big growth it appears that a vocal and robust public debate on the opportunity for US alternatives, but various changes will ensue. there has been some push back in the industry by those who don’t believe retail investors should be allowed to invest in risky and less liquid asset classes, partially for their own protection. REDEFINED ACCREDITED ACCREDITED INVESTOR” “

2020 Regulatory Field Guide | 17 The Asset

The implementation and embedding of Manager’s these regulations have created challenges for all stakeholders. The ESAs and national regulators have substantial remits but have Perspective limited resources. Asset managers have had to allocate significant resources on implementing complex rule books and ensuring compliance with them. One particular on 2020 point that warrants mention is the collection of regulatory data across the vast body of financial regulation which is not well joined up and, in my opinion, may be a major source of operational and compliance risk for financial services firms.

Christine Brentani: The amendments to ESMA’s founding regulations will have an impact on its governance, organizational structure, and mission from 2020. ESMA will take on increased responsibilities in Gareth Murphy, Christine Brentani, terms of direct supervision, investor protec- Chief Risk Officer Regulatory Development and Relationship Manager tion, and other goals which will impact its Standard Life Aberdeen Standard Life Aberdeen governance, organizational structure, and mission and we will have to see what this Gareth Murphy, Chief Risk Officer, and Christine Brentani, means for impacts on firms. Regulatory Developments and Relationship Manager at When regulators implement regulations differently in different ju- Standard Life Aberdeen, highlight the key issues and trends risdictions, it can pose challenges for firms running global business shaping the global regulatory landscape in 2020. They sat models. Firms would generally prefer a level playing field approach down with BBH’s Adrian Whelan to discuss regulatory priori- by regulators in terms of implementation of the same regulations ties for asset managers in the year ahead. across the globe. This allows for less costly implementation and Adrian Whelan: After a decade of new regulations, it seems managing of regulations across the business. It would be benefi- like we’re entering a period of refinement and improvement. cial for firms if regulators could better align rules globally as they Do you feel the regulatory framework now works as intended? review, assess, and tweak the rules which have already been implemented. Gareth Murphy: It’s fair to say that there was a huge volume of new regulations produced at quite a fast pace over the last What do you think will be the biggest regulatory issue for as- decade or so. Major regulations such as the European Market set managers in 2020? Infrastructure Regulation (EMIR), the Alternative Investment Fund GM: Interesting question! But I would say there is more than one Managers Directive (AIFMD), the second Markets in Financial big regulatory issue for this year such as the implications of Brexit Instruments Directive (MIFID II), the fourth Capital Markets for financial services, the development of more demanding re- Directive and Regulation (CRD IV), and the review of the European quirements around operational resilience, and the setting of higher Supervisory Authorities (ESAs) means that there is now some tidy- standards of senior executive accountability. On the third point, ing up to be done of these regulations. We are in a period where it the UK is well down this path and other European countries are is appropriate to revisit and refine those rules. following in their own ways.

18 | CB: Two other regulatory initiatives that asset managers will be ESMA always has a robust regulatory change agenda. What working on include roll-out of the EU (and domestic) sustainability are the key issues to look out for in 2020? agendas and LIBOR transition. GM: The approach to assessing the UK as equivalent across regu- Do you think we’ll at any point see a period of deregulation? lations such as MiFID II, EMIR, and AIFMD will be critical. Another key issue will be the impact of Brexit on third-country (non-UK) GM: Not in this life – maybe the next! relationships, especially in the area of delegation. Also, as I mentioned, we should expect to see further initiatives in relation to Actually, I see three things happening in parallel. First, old rules will supervisory convergence achieved through ESMA using its newly be tidied up — but slowly. Second, new rules will come in, but I minted powers more fully. am not sure whether they will be written better than the old rules. And third, supervisory approaches will become more demanding. CB: ESMA has already published its 2020 annual work plan stating that its key priorities are supervisory convergence, risk assess- CB: It will also be interesting to see how regulators use new tech- ment, single rulebook, and direct supervision. nology (regtech and fintech) solutions for the analysis of the vast amounts of regulatory data they are currently collecting. What ef- Beyond ESMA, sustainable investing and the integration of envi- fect will this have on their current approach to supervision? Will ronmental, social, and governance (ESG) considerations into in- they be able to do more with less? Beyond their own use of new vestment decision-making, the MiFID advice process, and firms’ technology, regulators, now more than ever, must be knowledge- operating models will continue to be significant areas for policy- able about nascent technology as they are often tasked with decid- makers. The development of a regulatory framework by EU policy ing whether to regulate it or not. makers to support ESG has posed some challenges. Lack of relevant ESG data remains a fundamental concern for asset managers We have also recently seen the genesis of regulatory sandboxes when it comes to the implementation of recently adopted regula- globally. These allow firms to test products and services in a con- tion on disclosure and the EU taxonomy to determine whether an trolled environment. Again, it is not just industry participants that economic activity can be deemed sustainable. In addition, some of are evolving to take into account new complex technological dy- the detailed requirements on sustainability-related disclosure and namics; regulators are too. changes to the operating models of UCITS Mancos, AIFMs, or the There was a global focus on fund liquidity in 2019. Where does MiFID advice process still need to be finalized by EU legislators. this debate go in 2020? Asset managers, in turn, will need to have sight of the expected rules sooner rather than later to manage the challenge of a rather GM: It continues. It is instructive to look back at the much-pub- tight timeline for application. licized ESMA Liquidity Stress Testing Guidelines from 2019. Embedded within the guidelines are expectations of how “open” The EU Commission must consider issues to do with the taxono- certain funds should be and how liquidity should be managed and my definitions, time periods for implementation, and consistency reported. These expectations remain at the forefront of of approach across all regulations (e.g.: MiFID II, UCITS, AIFMD). the debate. Firms will be poised to see how they can implement these new rules as an opportunity for their clients. The challenges of imple- An increase in market volatility leading to reduced liquidity or dif- mentation apart, the new rules should provide an important mech- ficulty in pricing, similar to what happened in 2008-2009, could ex- anism to bring more transparency into the ESG market and ensure pose weaknesses in some funds and may even stress the autho- clients are better informed about the sustainability-related risks of rized participant model (AP) that supports exchange traded funds their investments, as well the actual impact of products marketed (ETFs). Should pronounced volatility reappear this year we can as sustainable. anticipate liquidity will be front and center once again. The positions expressed are those of the authors as of 12/19/19 and may or may not be consistent with the views of Brown Brothers Harriman & Co. and its subsidiaries and affiliates (“BBH”), and CB: I’ll add that the UK has also issued new rules recently for illiq- are intended for informational purposes only. Information contained herein is based upon various sources believed to be reliable and subject to change without notice. uid assets in open-ended funds which ensures the focus on liquidity will continue throughout 2020.

2020 Regulatory Field Guide | 19 EU Regulations: How Asset Managers Can Keep an Eye on the Ball

By: John Siena

lobal asset managers have be- Just as AIFMs have come to terms with counterparties (CCPs) in the UK may no come accustomed to navigat- these changes, new considerations and de- longer be presumed eligible to clear trades ing the perilous shoals of cross- velopments continue pull them back to sea. for EMIR purposes once the UK becomes border regulation, but new a third country. In this case, much depends Gregulatory developments in the EU in 2020 With the UK’s imminent withdrawal from on how the EU treats the UK as “equiva- may make some unexpected waves. the EU, questions remain about how the lent” — the devil will be in the details and EMIR requirements will be incorporated there may be unanticipated effects. For ex- The EMIR riptide into UK law post-Brexit. It is likely that the ample, even if equivalence decisions under A major change that took effect in 2019 UK will be considered a “third country” EMIR are made regarding the UK, manag- under the European Market Infrastructure under EMIR, meaning EMIR will no lon- ers in the US who are subject to EMIR re- Regulation (EMIR) was the EMIR Refit, ger apply directly in the UK following the quirements will need to consider whether which among other things reclassified all transition period. Although the UK already UK CCPs will be treated as equivalent by AIFMs – wherever located – who manage agreed to compliance with EMIR in its EU non-EU (e.g., US) regulators. Currently, EU-domiciled alternative investment funds withdrawal documents and UK Treasury the US Commodity Futures Trading (AIFs) as “financial counterparties” and regulations reflect this approach. Commission treats EU CCPs as equivalent for US purposes, but once the UK leaves non-EU AIFMs managing non-EU AIFs as In any case, trades between a UK entity the EU, whether it will continue to do so “third-country entity” financial counterpar- and an EU entity will still need to comply remains to be seen. ties, subject to reduced burdens compared with the collateral exchange and clear- to those AIFMs operating within the EU. ing provisions of EMIR. However, central

20 | Another major development taking effect — which take effect April 2020 — will re- investment managers may find that the under EMIR in 2020 — and having particu- quire depositaries to maintain their own arrangements they have established will lar effect on investment managers — is sets of books and records that are “inde- become more complicated. The custodian what used to be referred to as Phase 5 of pendent” of any sub-custodians to whom industry has sought to ensure this does the implementation of initial margin (IM) they delegate “custody” of the investment not happen while still demonstrating an requirements for OTC derivatives. fund’s assets. Such “delegates” typically “independent” view of investment fund include prime brokers and collateral agents. positions as an added measure to protect In recognition of the broad state of unpre- investors against risks to fund assets. paredness of impacted sectors, regulators announced in September 2019 they were Brexit redux putting in place a revised timetable for the Another concern worth watching in 2020 “final” phase, dividing Phase 5 in two and is the fallout from a likely final Brexit deci- thereby providing smaller market partici- Currently, the US sion by the UK in January on fund manag- pants with additional time to prepare by Commodity Futures Trading ers based outside the EU. We mentioned pushing back their compliance date to the potential indirect impacts on clearing ar- new Phase 6 in 2021. Commission treats EU rangements but, more fundamentally, the Firms with an aggregate average notional CCPs as equivalent for US European Commission has made clear that amount (AANA) of more than $50 bil- it will not be “business as usual” for fund lion will need to comply with the rules by purposes, but once the management firms operating in London and hoping to do business in the European September 2020 (revised Phase 5) and UK leaves the EU, whether an estimated several hundred smaller in- Economic Area. vestment management firms and regional it will continue to do so Many fund management firms already have banks with an AANA of more than $8 billion remains to be seen. transferred staff from London to places like will be required to comply by September Dublin, Frankfurt, and Paris. What is still 2021 (new Phase 6). up in the air are the so-called substance Once a firm is determined to be in scope, requirements needed to be considered an market participants must carry out several EU-based fund. Individual member states While some depositaries (depending on steps ahead of the compliance deadline. – such as the Luxembourg CSSF – have jurisdiction and local practice) may already These include engaging with counter- provided clarity regarding requirements for comply with these requirements, some parties in order to confirm scope of the local management and operations but oth- may not. Local regulators historically have impact, including which legal entities are er jurisdictions have been less clear on this varied in their approach to this issue, but covered, putting in place agreements con- aspect. Meanwhile, ongoing post-Brexit the 2018 amendments are intended to fos- firming how IM is to be calculated, agree transition discussions between the EU and ter harmonization across all EU member eligible collateral and haircuts with each the UK will likely determine whether some states. The industry in some countries is counterparty and with third-party custodi- form of mutual equivalence can minimize still waiting to see how their local regula- ans or tri-party collateral agents. The length disruption for fund managers. If negotia- tor will implement the revised rules. Any of time and complexity for putting neces- tions do not go well, UK-based fund man- meaningful deviation from a harmonized sary arrangements in place should not agers may need to restructure further or approach may trigger intervention by the be underestimated. find alternative means of access to the EU European Securities and Markets Authority market (with EU managers possibly facing AIFMD and UCITS: Keeping the records (ESMA), who is charged with preventing similar barriers by the UK). straight divergence by member states.

A less obvious development potentially im- Here, too, the devil will be in the details: pacting investment managers is a change if requirements are imposed in a way that being made to the bookkeeping and re- is too stringent, or that requires depositar- cords requirements for depositaries of ies to effectively intervene in the process AIFs and UCITS funds. 2018 amendments flow between buy-side investment manag- to both AIFMD and the UCITS Directive ers, prime brokers, and collateral agents,

2020 Regulatory Field Guide | 21 Long Range Regulation: The Global Reach of SM&CR By: Jamie Dickson

n the aftermath of the financial crisis, The SM&CR’s global reach impact on customers, markets, or the firm. regulators globally recognized a need While the FCA is based in the UK, key as- The rules will also apply to all other employ- to reduce risks by ensuring that firms pects of the new rules can apply to senior ees other than those who do not perform a set rules of behavior for their staff and managers in other countries when they role specific to financial services. Imonitored their actions on a regular basis. are responsible for business operations of The SM&CR places asset managers and The UK introduced some of the strictest their UK firm. As a result, senior managers other firms solely regulated by the FCA in standards of conduct in late 2019, with of US or Asian firms with UK subsidiaries one of three buckets: full implementation taking place in 2020. need to be aware of their responsibilities Regulators in other jurisdictions, such as under the regime. • Enhanced — the largest and most com- Ireland and Singapore, are likely following plicated firms suit soon. SM&CR rules came into force for investment managers on December 9, 2019, but • Core — the majority of firms The UK’s program, known as the Senior this will be followed by a one-year transi- • Limited Scope— which will have fewer Managers and Certification Regime tion period to train staff that are not senior requirements than core (SM&CR), is an evolution of the previous managers or certified staff and assess cer- The FCA has published a guide to SM&CR monitoring program, the Approved Persons tification personnel for their suitability. regime. SM&CR has applied to banks since that explains how to determine which cat- 2016 but will now impact firms solely regu- The conduct rules will apply to senior man- egory your firm is in, and what the differ- lated by the Financial Conduct Authority agers and what are deemed certification ences are in requirements. (FCA), including most asset managers. staff — people who are not senior manag- Under the new rules, firms will have to ers but whose jobs could have a significant ensure that every affected area of their

22 | visits and cannot assert pure reliance on reduction in pay or a claw-back of bonus- the third-party firm as a defense to breach. es, or if the senior manager received a written warning about a breach of the For employees below senior manager conduct rules. For other employees that level, but who hold so-called certifica- fall under the scope of the conduct tion functions, such as traders who could rules, the firm need only to submit a cause harm to customers, the firm, or report of conduct breaches once a year. markets, the firm is required to assess Importantly, the conduct rules are not their performance on an annual basis and limited to the financial operations of the “certify” that the employee is “fit and firm — a breach can occur for sexual proper” to perform the function. harassment or poor behavior in the office. Long Range Regulation: In the current transition period, firms are In perhaps a good sign but unintended required to train their employees on how consequence, during implementation over conduct rules — like acting with integrity the past three years, some firms actually — apply to their specific job functions. filed too many regulatory reports about The Global Reach There also are specific rules of conduct for minor infractions. Applying best prac- senior management functions. tice in relation to disciplinary issues, as set out by the Advisory, Conciliation and What the SM&CR rules require Arbitration Service (Acas), and making of SM&CR The new rules are expected to have a informed and educated determinations major impact on human resources de- regarding reportable disciplinary cases, partments at covered firms. When a new will ensure these new rules will bring senior manager or certified employee is about the intended results without unnec- hired, for example, the firm is required essary personal and professional conse- to request a regulatory reference from quences. The FCA is creating a register business has a senior manager respon- every firm the person has worked for in of employees, which will allow firms to sible for that activity, that senior manag- the past six years. While this will become quickly review and verify any senior man- ers have a “statement of responsibilities” standard practice in UK financial firms, it agement or certification functions, as well that states what each senior manager’s could be problematic if the employee did as positions under the previous regime, responsibilities are, as well as a duty of not work in financial services previously or held by potential hires in their past and responsibility, meaning that they have to worked in another country. The FCA has any regulatory sanctions or prohibitions take reasonable steps to avoid a violation said firms must take sufficient steps in issued against them. of the rules or they could be held account- their due diligence process in this regard. able by the FCA. Significantly, there is no However, if a reference is not forthcoming The FCA is making clear that these new territorial limitation for enhanced firms. despite these efforts, a record of emailed rules are an evolution, not a revolution. So, a senior manager in New York who and telephoned requests could be used Some banks spent vast sums overhaul- oversees a business area in London could to document due diligence with regard to ing their HR systems, which later proved be subject to these rules. this requirement. not to be the most effective approach. The important thing is to consistently A senior manager’s responsibility also Disciplinary cases that relate to a breach update your firm’s knowledge about extends to any third-parties the firm of the conduct rules also must meet what is required, including any relevant uses for things like back office functions. specific FCA requirements. Firms have feedback from the industry and regu- Managers must be able to demonstrate seven days following the conclusion of a lators, and which employees will be that they are overseeing the outsourced disciplinary process to notify the FCA if specifically affected. function through such steps as collecting it resulted in disciplinary action against data and conducting on-site due diligence a senior manager such as dismissal, a

2020 Regulatory Field Guide | 23 AMLD Continues to Sharpen Its Focus By: Eimear Hennigan and Laura Murray

ne area where global regulators have been consistently According to the revised law, individuals who own more than 25 raising the bar for asset managers is legislation to prevent percent of a company are considered beneficial owners and must money laundering and terrorist financing. In Europe, those be identified. The law also provides for identification of the benefi- efforts in 2020 will be primarily focused on clearly identify- ciaries of a trust and controlling figures of a foundation. Trusts are Oing certain beneficial ownership of investments and making sure that more common in Luxembourg, where investments are more com- investors in EU prescribed countries are subject to extra scrutiny. plex and more real estate focused.

A major step in the crackdown was the adoption of the fourth EU When the beneficial owner of a company can’t be properly identi- anti-money laundering directive, known as AMLD 4, in 2015. The fied, fund managers “having exhausted all other means of identifi- directive required managers in the EU to establish the ultimate cation, and provided there are no grounds for suspicion, may con- beneficial owners (UBOs) of UCITS and AIF funds and called for sider the senior managing official(s) to be the beneficial owners,” the establishment of a registry of beneficial ownership that could ALMD 4 says. be accessed by security authorities. With the adoption of AMLD 5 in July 2018, the regulations have been tightened even further, The senior manager rule has also been implemented in with the UBO registry becoming public in most cases. Member Luxembourg and Ireland where many UCITS funds are registered. states were given 18 months to implement the latest AML direc- What that means for asset managers is they have to verify the tive, and the deadline for enabling legislation to be in place was senior managing official (SMO) of certain entity types and in January 10, 2020. some cases, validate the information provided by the investor. It will require looking through the company structure and validat- Identifying beneficial ownership ing what they have been told. Ongoing customer due diligence The EU above all other global policymakers have been most fo- reviews will help monitor the accuracy and veracity of entries to cused in requiring disclosure of beneficial ownership information these registrars. relating to financial accounts. Not only is each country to set up The directives also specify that managers must carry out en- a registry of beneficial ownership, but the EU is establishing a hanced due diligence on certain corporate customers. They in- central registry for all 28 members (though whether the UK will clude corporates operating with nominee shareholders, where the participate after Brexit is an open question.) While the obligation to beneficial owners are not clearly identified, and investors from 16 consult UBOs starts in 2020, the central registry for companies is countries which have been identified by the EU as having deficient to be up and running by March 2021. anti-money laundering rules in place. The higher degree of due

24 | diligence usually involves obtaining information about the source While managers are still working to implement AMLD 5, the EU of funds for each investment being made by the higher-risk cus- also adopted AMLD 6 in December 2018, which will come into tomer. Luxembourg allows nominee shareholding but also asks force in December 2020. The directive is aimed mainly at harmo- managers to request nominee shareholders to provide information nizing laws in member states on money laundering and definitions on the UBO. of money laundering crimes. But AMLD 6 also introduces a rela- tively new concept of “failure to prevent money laundering,” which Another consideration for managers is the sharing of data about could expand the legal scope of money laundering prosecutions UBOs obtained as part of their anti-money laundering require- and require managers to take additional due diligence steps. ments. Under separate legislation called the Common Reporting Standard, European governments have agreed to provide informa- Interestingly, the UK has said it will opt out of AMLD 6 on the tion about financial accounts to tax authorities in other states who grounds that domestic legislation is already largely compliant with have adopted the rule. the directive. “The Government decided not to opt in as we did not consider that opting in would enhance the UK approach to tackling Across each new version of AMLD, regulators continue to stress money laundering,” it said. But the decision raises a larger debate the importance of AML governance. This means firms need to: about Brexit: will the UK stay equivalent with European regulation on money laundering or diverge? If the UK diverges, it could be- • Understand their roles and responsibilities (and where they can come more difficult for UK firms to gain access to European capi- delegate work but retain responsibility to third-party providers) tal markets. Ireland also has the option to opt-out, but it is unclear • Instill well documented policies and procedures around AML at this time if this will occur.

• Provide proper employee training and support The EU continues to assess the AML regulatory landscape with some calling to retire the AML directives in lieu of direct regula- AMLD 5, 6, and beyond tion (similar to GDPR). Plans are also at advanced stages at the After AMLD 4 was adopted, the EU also adopted a regulation on European Commission to create a supra-national AML regulator preserving the security of data for individuals in the 28 member (with extra-territorial powers) under the authority of the European states. Managers have to ensure that data is deleted after five Banking Authority (EBA). years and that their sharing of information related to AMLD is compliant with the data regulation.

2020 Regulatory Field Guide | 25 REGULATORY

2020 FIELD GUIDE

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