In the aftermath of the financial crisis, the EU, UK and US embarked on an unprecedented overhaul of financial regulation. Some of the main reforms sought to:
Increase oversight over previously unregulated market participants and products.
Strengthen liquidity, prudential and risk management standards.
Rearrange the financial regulatory architecture.
Practitioners believe that, in 2011, the financial services industry will start feeling the practical effects of some of the main reforms enacted over the past two years.
Against this background, this article examines the potential impact of the following key regulatory developments:
Margaret Chamberlain, partner and Head of the Financial Services and Markets Department at Travers Smith, highlights the difficulty for firms in coping with the scale and pace of regulatory change. She comments that firms are required to "run their day-to-day business and keep it compliant with the existing rules, prepare for new rules that they know will soon be in force, and keep track of the vast range of proposals that might affect them in the future and try to contribute to the debate, so as to ensure that their business is not derailed by legislation prepared in ignorance of the industry viewpoint."
The aim of the AIFM Directive is to introduce a harmonised regulatory framework across the EU for EU-established alternative investment fund managers (AIFMs), including private equity and hedge funds.
After almost a year and a half of heavy negotiations, the European Parliament adopted the final text of the AIFM Directive on 11 November 2010. At the time of writing, the Directive was pending formal approval by the EU Council, which is expected in early 2011.
Even though the Level 1 Directive has been agreed, there is still a vast amount to be done at an EU level. In December 2010, the European Commission delivered its mandate to the Committee of European Securities Regulators (CESR) (now the European Securities and Markets Association (ESMA)) requesting technical advice on Level 2 measures for the Directive.
The list of level 2 implementing measures, technical standards and guidelines comprises 99 separate topics and ESMA only has until 16 September 2011 to deliver its advice. The sheer volume of work and relatively short timeframe could create a serious challenge for ESMA.
Chamberlain is concerned about the brevity of the period for responses allowed for ESMA's call for evidence (which opened on 3 December 2010 and closed on 14 January 2011). Given the complexity and importance of the numerous rules to be produced, "the time frame for responses was too short for the issues to be given proper industry consideration and, whilst the trade associations responded… the exercise had to be rushed and was unsatisfactory". Chamberlain laments how "short consultation periods on complex far reaching topics" are generally becoming more common at both the UK and EU levels, and comments that such short consultation periods "threaten to turn the consultation process into a box ticking exercise, and undermine any idea that principles of good regulation are being followed".
Jonathan Herbst, a partner at Norton Rose, acknowledges that "there is still a lot of work to be done in relation to the AIFM Directive. Many provisions in the final text, such as those dealing with third country issues, were the product of political compromise and are somewhat unclear as a result. The Level 2 measures will need to clarify the scope and operation of the Directive."
Practitioners hope that the Level 2 rulemaking process will not be as politically-driven as the debates leading to the adoption of the AIFM Directive's final text. According to Ben Kingsley, a partner at Slaughter and May, "it is difficult to escape the suspicion that the AIFM agenda was, at times, driven more by politics than by a rational assessment of the need for harmonised regulation of the alternative investment industry". It is possible "that some of the details that will now need to be set out in the Level 2 measures will be driven by similar considerations".
Herbst thinks that the planned Level 2 measures will primarily address the Directive's technical aspects. However, he admits that there are still potentially contentious areas outstanding. Similarly, Chamberlain thinks that "there is a very real risk that we will end up with a highly prescriptive, inflexible and 'buttoned-down' regime for an industry which simply does not have the degree of homogeneity which the politicians seem to think it has".
Kingsley acknowledges that the AIFM Directive will curtail the operational freedom which the alternative asset management sector has traditionally enjoyed, and increase operational costs for AIFMs. He also notes, however, that "some of the most worrying aspects in early drafts were substantially smoothed through political compromise". For instance, "passporting rights should improve ease of access to European investors and ultimately align national alternative investment regimes throughout the EU. This will reduce the industry’s long-term costs and should, in theory, generate increased returns for investors".
Chamberlain also points to the potential impact of the Directive's provisions relating to depositaries on the custodial and prime brokerage sectors. She suggests that there is "a risk that, unless successfully clarified at Level 2, the effect of the provisions regarding liability for loss may be to make depositaries assume and absorb some of the risks of investment which should properly remain with the investor, with a consequent risk for pricing and competition."
For more information on the AIFM Directive, see Practice note, Hot topics: The AIFM Directive (www.practicallaw.com/1-503-3820).
In December 2010, a number of major reforms to the international prudential framework for capital requirements known as Basel II were finalised. These reforms are known as Basel III.
The European Commission intends to implement the Basel III reforms through a directive (CRD 4) amending the Capital Requirements Directive (2006/48/EC and 2006/49/EC) (CRD). It intends to publish legislative proposals for CRD 4 in the first half of 2011.
The reforms will affect banks, building societies and investment firms in a number of areas including the quality and quantity of capital they will be required to hold and their risk coverage mechanisms. Basel III also introduces new prudential requirements such as counter-cyclical capital buffers, leverage ratios and liquidity requirements which the EU is likely to implement in CRD 4.
According to Simon Morris, a partner at CMS Cameron McKenna, the Basel III reforms and their proposed implementation in Europe through CRD 4 are manifestations of what he sees as the overwhelmingly important topic for all major firms at present, the inexorable rise of G20-driven macro-prudential regulation.
As Morris notes "a few years ago, UK financial services regulation could be viewed as subservient to the will of the EU Commission. Over the past two years, however, EU regulation has become increasingly subservient to the G20 process. Last year's G20 summit in Toronto evidences the extent to which macro-prudential risks are being tackled at a G20 level".
The effect of the Basel III reforms will be felt across the capital markets. Morris believes that the reforms will dampen issuance and give greater importance to risk-weighting of instruments as a driver in the design of capital markets. He also thinks that the reforms could lead to the establishment of new capital instruments which mandatorily convert into equity or are automatically written down in pre-defined circumstances.
For more information on Basel III, see Practice note, Basel III: an overview (www.practicallaw.com/7-504-1959) and for more information on CRD 4, see Practice note, Hot topics: CRD reform: CRD 4 (www.practicallaw.com/5-501-9596).
Although the Markets in Financial Instruments Directive (2004/39/EC) (MiFID) has met many of its original objectives since coming into force on 1 November 2007, the financial crisis revealed areas where the EU authorities believe there is scope for improvement. Moreover, since MIFID's original implementation, there have been technological advances and developments in trading patterns, such as the rise of high-frequency trading (HFT), which have altered the structure of equity secondary markets.
In March 2010, the European Commission asked CESR for technical advice on a number of MIFID-related issues. Throughout the second half of 2010, CESR published a series of documents providing recommendations on issues such as:
Pre- and post-trade transparency for equity secondary markets.
Issues relating to investor protection and intermediaries.
Extension of the transparency regime to non-equity markets.
Position and transaction reporting for OTC derivatives transactions.
Increased standardisation, and organised platform trading, of OTC derivatives.
Following CESR's recommendations, on 8 December 2010, the Commission published a consultation paper on the review of MiFID outlining a series of proposed amendments (Consultation Paper). The Commission now expects to publish a legislative proposal for a directive amending MiFID (known as MiFID II) in May 2011.
According to Kingsley, some measures proposed in the Commission's Consultation Paper, "are cases of regulatory policy catching-up with market and technological developments. This cannot be objectionable."
Other proposals, however, in Kingsley's view indicate that the Commission is beginning to adopt a more prescriptive approach "in response to the perception or suspicion of investor detriment". He highlights the "lack of a cost benefit analysis or empirical evidence of wrongdoing or detriment" underlying many reforms envisaged in the Consultation Paper.
Kingsley believes that, although many proposals in the Consultation Paper lack sufficient precision and clarity to assess their potential practical impact, some reforms, if implemented, could become onerous, disruptive and damaging for European investment firms and markets. These include:
The suggestion that firms located in non-EEA jurisdictions which are not deemed “equivalent” could be denied access to the EU's wholesale markets. This "overtly protectionist proposal" could, in Kingsley's view, deprive European professional clients, such as large companies and pension funds, of direct access to non-EU banks, brokers and markets and would severely impact on their ability to spread and hedge investment risk and access global funding sources.
The recommendation that the Commission, ESMA and national regulators should move from a supervisory to an interventionist position, which would in principle empower them to halt particular activities or ban particular products other than in purely exceptional circumstances.
Chamberlain also believes that several of the Commission's proposals "appear to be based on unsupported statements, rather than analysis". She identifies a number of controversial proposals in the Consultation paper. These include:
The proposed widening of the scope of MiFID's market structure regulation to include "organised trading facilities". This proposal, which would capture "broker crossing systems and inter-dealer broker systems which bring together third party interests, represents a continuation of the Commission's ongoing battle against investment firms and broker-dealers which offer services which it sees as "exchange-like" and which it therefore thinks should be regulated like exchanges". However, Chamberlain comments "there is no definition of an "organised trading facility", little justification for the proposal or explanation as to what it is intended to combat, and apparently no realisation of the vast range of arrangements that might fall within scope".
The suggestion that all trading in derivatives "deemed eligible for clearing and which are "sufficiently liquid" (as determined by ESMA) would have to be carried out on a regulated market, MTF or a specific sub-regime of "organised trading facility". Chamberlain notes that this proposal has led to a "worrying suggestion that MiFID could effectively ban certain types of OTC derivative".
The proposed extension of the scope of the regime and of pre-trade and post-trade transparency requirements, which, among other things, could lead to "a significant reduction in the time allowed for reporting, and extending the requirements to "equity-like" products (such as depositary receipts and ETFs) and certain non-equity products (such as bonds, structured products and derivatives eligible for central clearing)".
In addition, Chamberlain sees the proposal to empower the Commission "to go over the head of a national regulator and ban specific services, products or activities where there are significant and sustained investor protection concerns or the product or activity threatens the financial markets or financial stability" as particularly worrisome.
In Herbst's view, some of the key macro implications of MiFID II include:
The standardisation of trading and monitoring of derivatives transactions which, in conjunction with EMIR, could lead to the demise of the OTC market (see The European Market Infrastructure Regulation (EMIR) below).
Threats to the continued existence of certain business models, such as HTF.
Greater transparency requirements.
Increased consolidation of market information.
He believes that some of the key micro implications include
The effect of the new obligations on execution quality/best execution.
The impact of the reforms on the eligible counterparty regime.
For more information on the Commission's review of MiFID, see Practice note, Hot topics: European Commission's MiFID review (www.practicallaw.com/6-503-3276).
The new UCITS Directive (2009/65/EC) (known as "UCITS IV") was adopted in June 2009. The deadline for member states to implement UCITS IV is 1 July 2011. The UK authorities are currently consulting on the implementation of UCITS IV in the UK.
Chamberlain believes that "UCITS management firms are not viewing the new Directive with anything like the trepidation with which hedge fund managers and private equity firms are eyeing the AIFMD". Her impression is that UCITS IV is "generally being welcomed by the industry".
Moreover, Chamberlain thinks that several measures in UCITS IV should "undoubtedly … enhance the attractiveness of the UCITS product and facilitate operational efficiencies in the management of such schemes". These measures include:
Breaking down the barriers to the cross-border marketing of UCITS.
The improved management company passport.
The introduction of a fund merger regime.
The ability to use "master-feeder structures".
That said, Chamberlain also draws attention to "new obligations under UCITS IV on UCITS management companies, in particular as regards prudential requirements, conduct of business rules and risk management processes". She believes that firms should review "their existing procedures and [assess] what changes are required in order to comply with the additional rules requirements that will be introduced in transposition of UCITS IV".
The changes which Chamberlain believes firms should prepare for include:
New risk management process requirements "which are not simply based on MiFID measures. Firms will need to ensure they have got to grips with the proposed amendments to the Collective Investment Sourcebook (COLL) and review their risk management procedures and make changes where appropriate".
The replacement of the Simplified Prospectus with the new key investor information (KII) document. Although "firms have until 30 June 2012 under the transitional period offered under the Directive in which to complete this exercise", Chamberlain cautions firms against "underestimating the time involved in designing the new documentation and reviewing it from a legal perspective".
Finally, Chamberlain warns that the Commission is already consulting on a further set of changes to the legislative framework (UCITS V) with particular reference to the UCITS Depositary function and UCITS manager remuneration with a view to producing a new Directive in 2011.
For more information on UCITS IV, see Practice note, Hot topics: The UCITS IV Directive (www.practicallaw.com/2-381-9515)and for more information on UCITS V, see Practice note, Hot topics: The Commission's review of the UCITS depositary function (www.practicallaw.com/3-501-2652).
In September 2010, the European Commission published a legislative proposal on over-the-counter (OTC) derivatives, central counterparties (CCPs) and trade repositories (also known as the European Market Infrastructure Regulation (EMIR)). The Commission intends to finalise the text of EMIR by the end of 2011.
The objective of EMIR is to establish a harmonised regime for the regulation of OTC derivatives trading in the EU. The proposed regime seeks to:
Ensure that all eligible derivatives to contracts undergo clearing through CCPs.
Require parties to derivative contracts which are not eligible for clearing to implement certain risk mitigation techniques.
Govern the establishment at supervision of CCPs in the EU.
Improve disclosure and transparency in the derivatives market.
EMIR will overlap with some areas of MiFID such as transaction reporting. Indeed, Herbst urges anyone looking to examine the potential of MiFID, CRD 4, EMIR, and revisions to the Market Abuse Directive (2003/6/EC) (MAD) to approach these developments as pieces of a larger regulatory jigsaw rather than focusing solely on the impact of individual proposals.
That said, Herbst identifies several specific aspects of EMIR which are of particular concern to market participants. These include:
The segregation of collateral requirements and the extent to which they will protect buy-side participants against the insolvency of a counterparty.
The application of the Regulation to non-financial entities. At present, the Commission seems in favour of applying a threshold approach to determine which entities should be covered by the mandatory clearing requirement. This approach would differ from the criteria in Title VII of the Dodd-Frank Act in the US.
The authorisation structures for CCPs and repositories and the equivalence criteria for such institutions in non-EU countries.
For more information on EMIR, see Legal update, European Commission legislative proposal on OTC derivatives, CCPs and trade repositories (www.practicallaw.com/5-503-3385).
The UK government intends to restructure the current system of UK financial services regulation, which will result in the FSA ceasing to exist in its current form by the end of 2012. The FSA's functions are to be transferred to three new bodies. These include:
The Financial Policy Committee (FPC), a committee of the Court of Directors of the Bank of England (BoE), which will be responsible for macro-prudential regulation with a focus on systemic issues and risks.
The Prudential Regulation Authority (PRA), a subsidiary of the BoE tasked with micro-prudential supervision.
The Consumer Protection and Markets Authority (CPMA), an independent company limited by guarantee responsible for regulating the conduct of all firms in their dealing with retail consumers and the wholesale financial markets.
The government plans to put the necessary primary legislation before parliament in summer 2011 with the aim of it receiving Royal Assent in summer 2012. The new structure is expected to be established by the end of 2012. Although Chamberlain would not be surprised if the timing slips, she suspects that "things are going to move very quickly with the risk that we will end up with unsatisfactory legislation".
Practitioners identify the proposed overhaul of the UK's financial services regulatory architecture as one of the most important issues likely to take place in the near future. Chamberlain also emphasises the importance of firms engaging "in the process of trying to shape the new regulators". She points to a number of recent examples, such as the Government's decisions to keep the UK Listing Authority (UKLA) within the CPMA's market division and the FSA's criminal powers in relation to market conduct within the CPMA (both of which were largely influenced by participants' responses) as evidence that "robust and well-reasoned responses to consultations can work".
Chamberlain notes that firms may be aggrieved at the fact that "they will... be paying, through the FSA levy, for a reorganisation of domestic regulation that was essentially presented as a fait accompli and the benefits of which are not at all clear to them."
There is considerable uncertainty about how the new regulatory bodies will operate and interact with each other. Two of the key objectives of the primary legislation to be unveiled in 2011 will be to demarcate the specific competencies and powers of each body while at the same time establishing mechanisms for communication and co-operation.
"The enactment of primary legislation establishing these new bodies will be an important development but not a radical change" notes Morris. "We can expect the new bodies to continue with the FSA's current flagship policies of credible deterrence and intensive supervision. Moreover, as is the case with the FSA, a substantial part of the new regulators' role will be to implement EU legislation".
Kingsley believes that putting the Bank at the heart of prudential regulation and financial stability seems to be a sensible and justifiable policy move. However, the reorganisation of roles, responsibilities and reporting lines is likely to give rise to significant practical difficulties in both implementation and application. He notes that the new UK financial regulatory architecture will require "intensive co-operation between the FPC, PRA and the CPMA".
Morris also thinks that effective communication will be essential if the new regulatory bodies are to succeed, commenting that "in some respects the new structure mirrors the 1988-1997 period, when financial supervision and regulation was divided between five bodies." He points out that one of the key concerns which prompted the abolition of the FSA was the perceived inefficiency of the tripartite system of financial regulation and suggests that "the Government has now replaced the FSA with what is essentially another type of tri-partite. The FPC, PRA and CPMA will have to communicate effectively and avoid regulating in silos".
Chamberlain finds it "difficult to share the government's optimism about there being effective co-ordination and co-operation between the new regulators through legislative requirements and 'non-statutory protocols and arrangements'. The fact is that there will be more than one entity involved in regulation and there will simply be greater practical obstacles to achieving efficiency and co-ordination because of this".
The new regulatory bodies may also face greater scrutiny than the FSA. As Kingsley explains, "FSA regulators, until now able to pursue their intrusive supervisory approach with relative independence from Government, will be required to accept a more direct and intrusive level of supervision by the BoE". He comments that this relationship "may not be immediately harmonious".
Ian Mason, a financial services partner at Baker & McKenzie, believes that the challenge of dual-regulation will be particularly acute for large financial institutions: "Complex FSA-regulated firms such as large clearing banks will be regulated by the PRA in terms of their prudential and capital aspects and the CPMA in terms of their, often sizeable retail operations. Regulated firms could end up being unsure of which regulator to approach in the first instance if a problem arise."
The government has placed the BoE at the heart of its reforms. Its enlarged powers and responsibilities could also require an internal culture shift. As Kingsley notes, the BoE is not an institution that has "traditionally operated in a heavily rules-based regulatory environment" He comments that "a new supervisory culture will therefore need to be developed within the Bank which combines the desirable features of judgement-based regulation with an ability to interpret and apply rules transparently and consistently. This may not be easy unless the Bank can retain and draw effectively on the accumulated skills and knowledge of current FSA staff; staff the FSA is itself currently struggling to retain".
According to Kingsley, a really pressing question is whether the BoE will have the right quantity and quality of resources, and a sufficiently nimble governance structure, to manage its many roles and responsibilities more effectively than its predecessors.
One area where we might see a difference is what Morris describes as "greater economic interconnectivity". He comments that "the BoE is staffed largely by economists skilled in identifying emerging macro-prudential risks. Transferring responsibility for prudential regulation and financial stability to the BoE could enable the new regulators to identify macro-risks more efficiently and act upon them earlier".
Mason believes that the new regulatory bodies will continue developing the intensive approach to supervision and enforcement which the FSA embraced in 2008. He points to a December 2010 speech (www.practicallaw.com/1-504-3348) by Hector Sants, FSA Chief Executive, as evidence of the intention of post-FSA institutions to continue identifying and tackling risks at an earlier stage.
"What this means for firms", explains Mason, "is that, the FSA (and in due course the CPMA) are going to start intervening at a much earlier stage in the life-cycle of financial products, probably by focusing on the product approval stage and the processes surrounding that approval. This marks a significant shift in resources."
Mason believes that the FSA (and then the CPMA) may, over time, adopt a more thematic approach resulting in industry-wide interventions rather than individual routine inspection visits. "From a firm's perspective, rather than seeing the FSA every year, some (larger) firms may see them more often and some (medium-sized smaller firms) may see them less."
Mason also predicts that the FSA may take an increasingly strict stance towards enforcement in 2011. He comments: "the FSA overhauled its fining policy in 2010 and, as a result, average fines are now between two and three times higher than before. The new policy only became effective last year and its impact will start becoming more apparent as we start seeing more enforcement cases come through in 2011."
In addition, Mason believes that changes to the FSA's fining regime could cause a spike in the number of cases reaching the Upper Tribunal. "The stakes are much higher than before. If you are faced with a higher fine you may be more inclined to challenge it".
For more information on the new UK financial services regulatory structure, see Practice note, Hot topics: New UK financial services regulatory structure (www.practicallaw.com/5-502-5489).
The EU's financial supervisory architecture has also recently undergone a radical overhaul. On 1 January 2011, three new European Supervisory Authorities (ESAs) commenced operations:
The European Banking Authority (EBA).
The European Insurance and Occupational Pensions Authority (EIOPA).
The European Securities and Markets Authority (ESMA).
The ESAs replaced the existing level 3 committees (Committee of European Banking Supervisors (CEBS), the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) and the Committee of European Securities Regulators (CESR)).
The new ESAs are vested with greater powers and more ambitious agendas than their predecessors. Indeed, some practitioners increasingly view the FSA and its proposed successors as merely vehicles for the implementation of EU-made financial services legislation in the UK (see The new UK financial services regulatory structure above).
ESAs have the authority to make decisions which are directly binding on market participants in certain circumstances. Mason regards this as a "massive change". He notes that, "up until now, you had the Lamfalussy which provided Member States with some clarity, consistency and some discretion regarding the implementation of EU financial services legislation into domestic law. However, ESAs will have the power to enact directly applicable rules with much less scope for local implementation."
One of the situations where the ESAs could overrule national regulators and make directly binding decisions (subject to certain limits) would be during a crisis such as a major bank collapse, particularly if they felt that the relevant domestic regulator was not doing enough to address the situation. Mason comments that, "one question that clients are quite interested in is whether this hypothetical intervention would actually work in practice actually and whether the ESAs would have the necessary legal power to act. If a UK bank collapsed and the EBA tried to intervene in the UK, I am not sure whether that could work. There are also issues with accountability and redress of grievances. FSA decisions can be challenged at the tribunal or through an application for judicial review, but the complaint-handling mechanisms in relation to actions by the ESAs are less clear."
Mason is not sure whether the ESAs are adequately resourced to fulfil their broad mandates at present. He expects that, until the new ESAs can recruit and train a substantial body of specialists with the requisite skill-set, they will depend heavily on secondees from national regulators such as the FSA and BaFIN.
There are also major questions about the UK's ability to influence this potential upcoming wave of directly applicable financial services legislation. Mason comments that "the FSA has been a very influential representative of the UK financial services industry in Europe" but, once the new regulatory structure is established, "the industry will no longer have a unified voice, which could make the UK's voice in European affairs less influential.
For more information on the new EU regulatory structure, see An overview of the EU financial services supervisory framework (www.practicallaw.com/4-504-3281).
Major amendments to the FSA's remuneration code, reflecting the requirements of CRD 3 (2010/76/EU) and affecting banks, building societies and investment firms, came into force on1 January 2011. Similar measures are likely to apply to alternative investment fund managers and UCITS managers if and when relevant measures under the AIFM Directive and UCITS V come into force.
Chamberlain points out that the Remuneration Code (which had previously only applied to 27 of the largest banks, building societies and investment banks) now applies "to an expanded 'constituency' of approximately 2,500 firms, including asset managers, hedge fund managers, UCITS investment firms and others."
Initially, the FSA expected all firms to be broadly compliant with the Code from 1 January 2011, except for the detailed "Principle 12" requirements relating to remuneration structures" (for which the deadline for compliance is 1 July 2011 provided that firms have taken reasonable steps to comply from the beginning of the year). As Chamberlain notes, "amongst other things… this means that − technically - all such firms should already a full written remuneration policy in place".
The FSA's final version of the Code and rules were not published until mid-December, which left firms with little time to comply the 1 January 2011 deadline. Consequently, explains Chamberlain, "the FSA has given firms until the end of January 2011 in which to identify any shortfalls in their compliance with the Code and to come up with a 'time specific plan' to rectify matters". She thinks that in light of "the rush in which the new requirements were implemented", the FSA is unlikely to criticise a firm for not managing to adopt a full remuneration policy by the 1 January 2011 deadline, although "it is absolutely essential that any such firm puts this right as soon as possible". She identifies some key steps which firms preparing for implementation should take. These include:
Mapping their existing pay and incentive arrangements against the Code.
Identifying relevant staff.
Reviewing the use of guaranteed variable remuneration.
Preparing at least an initial remuneration policy, with a view to being able to comply with the detailed rules relating to remuneration structures by 1 July 2011.
For more information on the Remuneration Code, see Practice note, Revised FSA remuneration code: frequently asked questions (www.practicallaw.com/4-504-0659), and for more information on CRD 3, see Practice note, CRD 3 (www.practicallaw.com/5-503-2593).