Asset Management after Brexit: Responding to the New Reality - Michael Hodson, Director of Asset Management and Investment Banking

Speech delivered to the British Irish Chamber of Commerce: Financial Services Seminar

Introduction

Good morning ladies and gentlemen.

It is a pleasure to join you at this financial services seminar which has been organised by the British Irish Chamber of Commerce.

Brexit has been a dominating theme over the last 2 years and it is likely to remain so over the coming years. This is reflected in our Strategic Plan for 2019-2021 with Brexit included as one of the key strategic themes for the Central Bank. What is noticeable to date, is that the Brexit impact is vast and spreads across many different areas including political, social and business.

The title of today’s seminar is “Asset management after Brexit” and as I was thinking of this, I hoped that maybe post Brexit we can get back to business as usual. A world where firms are concentrating on developing and managing products that serve the needs of the customers while we as regulators can fully focus on our role of ensuring firms are well governed, operate sustainable business models and can recover if they get into difficulty.

On that basis I will spend a part of my speech addressing a number of topics that are important for the sector today and after Brexit. I will then spend the rest of the speech discussing matters more directly related to Brexit.

British Irish Chamber of Commerce

But first, I am cognisant that since its establishment in 2011, the British Irish Chamber of Commerce has continued to go from strength to strength. Today it plays a vital role in maintaining a focus on the value of trade between the UK and Ireland.

I must commend the Chamber’s hands-on approach, which includes organising network events like today’s seminar, facilitating the “Greater Dublin’s Greater Than Ever” initiative launched in 2017 and the work of the Chamber’s Financial and Professional Services Committee.

To be brief, I am certain that in a post-Brexit world, the Chamber will continue to thrive in its unique role representing the interests of businesses on both sides of the Irish Sea.

Asset Management – Sector Specific Topics

If I may now take a few moments to speak about a number of topics including ESG, Fintech, the PTIF and outsourcing, that you in industry and us as regulators must not lose sight of, even if at times these topics seem to be overshadowed by Brexit.

Sustainable Finance / ESG Investing

In the funds space, sustainable finance or ESG investing, is fast becoming a key theme. At its simplest, the aim of sustainable finance is to shift to an economic model more focused on long term value creation by promoting investments which factor environmental, social and governance considerations. 

Spurred on by the targets set down in the Paris Agreement, the international regulatory community is looking at how it can address these ESG considerations. At an EU level, the first response has been the publication of the EU Commission’s Action Plan on Financing Sustainable Growth, published in March last year, followed soon after by the first legislative proposals to initiate parts of the Action Plan. One of the central aims of these proposals is to increase capital flows toward sustainable investments by promoting transparency to end investors of the sustainability risks of their investments.

For the funds industry, one of the proposals will mean that market participants will have to, if they do not already, assess the risks arising from sustainability factors in their investment and advisory processes and to disclose to end investors the result of this assessment and any potential impact on returns. It will be incumbent on firms to have risk policies in place addressing sustainability risks.

Another proposal is seeking to create an EU taxonomy, or classification system, on what can be considered a green economic activity for investment purposes. This is the first of a range of taxonomies, with ones focused on what can be considered, for example, a socially inclusive economic activity, to come.

Getting these proposals through the legislative process is high on the EU Commission’s agenda. The speed at which policy is being developed and implemented in this area is indicative of a growing initiative amongst policymakers to shift to this new economic model. For the Central Bank, this will be a growing focus of ours over the coming years with Governor Lane planning to address this and the implications of climate change for the Irish financial system in a forthcoming speech. For industry, you should be proactively considering and adopting to this new economic model now and not waiting for legislative changes as a springboard for action.

Fintech

We can expect technology enabled innovations in financial services – or Fintech as it is commonly known – to continue to disrupt the traditional structures within the industry. We are seeing the degree of this disruption continue to grow over time, with implications for both financial market participants and regulators alike.

For example, the latest applications of machine learning in the funds industry today such as computerised models, distributed ledger technology, robo-advisers and algorithmic trading, all have potential benefits in terms of efficiency. At the same time, they can also introduce new or enhanced risks, particularly during market stress. For the Central Bank, we realise the importance of engaging effectively with these innovations so as to allow for their risks to be managed without getting in the way of their benefits.

To help with this, in April last year, the Central Bank established an Innovation Hub, a direct point of contact for innovative firms; and also launched an industry engagement initiative. So far, we are seeing these function as intended with a good amount of enquiries and engagements held to date.

Specifically, in the fund service providers sector, last year we issued a questionnaire to 189 firms to develop our understanding of how firms are interacting with technology and innovation. The survey results indicate that 51% of firms are currently developing FinTech solutions while 70% stated that they see FinTech as being significantly important to the sector over the next three years.

These engagements are allowing us to gather intelligence on the latest technologies and feed these learnings back into our supervisory process.

Over the coming period, we will continue to engage with innovators to help mitigate the risks arising from Fintech, and to identify the opportunities and challenges they present. In this way, we will ensure that the Central Bank adapts with industry and technology, whilst also enhancing our effectiveness in protecting consumers and safeguarding financial stability through greater use of data analytics.

Exchange traded funds (ETFs)

ETFs continue to be an area of focus for the Central Bank and we are keen to ensure that, consistent with Ireland being the largest European domicile for ETFs, a proactive approach is taken in this area which is also a matter of interest for international regulators.

It may interest you to hear that IOSCO’s work on ETFs is progressing. It is taking two work streams forward which can be broadly split into two areas. The first work stream will consider product-facing, investor-related issues. The second work stream will consider matters which are more market-facing, including arbitrage and trading issues. The Central Bank is taking a leading role in the second work stream. We will use the valuable input provided by industry to inform our contributions and in looking for consistency of approach on a global basis.

I would also note that the increased focus on ETFs is not limited to IOSCO and that international regulatory authorities such as the ESRB and the FSB are also considering matters related to ETFs, in addition to work being carried out by other regulators.

The new prudential regime for investment firms

This is another area of interest. The European Commission’s proposals, which were published in December 2017, are progressing well through the European legislative process, with the Council of the EU agreeing its position on the proposals earlier this month.

The Central Bank is generally supportive of the proposals. In terms of prudential requirements, the proposed new categorisation of investment firms is designed to ensure that the new regime has an in-built level of proportionality. This includes that the largest, ‘bank-like’ investment firms should remain subject to the CRR/CRD4 regime, while the very smallest, lowest risk firms will have the lightest set of prudential requirements applying to them.

In the context of Brexit, the original proposal from the Commission contained some targeted amendments to the third country equivalence regime under MiFID II and MiFIR, mainly centred on additional reporting requirements. The agreed Council text proposes some further changes in this regard, including, for example, the granting of additional intervention powers to ESMA and certain additional powers to the Commission.

The final text of these proposals must now be discussed and agreed between the Council and the European Parliament, however progress to date points to a prudential regime for investment firms that overall will be more appropriate to their level of risk.

The stress testing of investment funds

This topic is on ESMA’s agenda under two different but related workstreams. In the case of money market funds, the EU MMF Regulation requires ESMA to develop guidelines with regard to the common reference parameters of the stress test scenarios on which stress tests of MMFs should be based. The ESMA guidelines are to be updated annually. ESMA consulted on amendments to the first set of guidelines last year, proposing additional guidelines to develop the specificity of the 2017 guidelines, and in particular, seeking to provide guidance on how the common reference stress test scenarios are to be applied across MMFs. Responses received were published recently and are now being reviewed.

As many of you will know, ESMA is also working on the development of guidelines on liquidity stress testing for all funds, both UCITS and AIFs, taking into account the recommendations from the ESRB on this topic. We expect that the consultation paper will be published by ESMA in the first quarter of 2019.

Central Bank’s UCITS Regulations

We will shortly publish a revised set of our UCITS Regulations. They represent a consolidation of all Central Bank UCITS Regulations to date and take account of regulatory and technical updates which we consulted on last year. Amendment of the Regulations reflects the Central Bank’s commitment to keep rulebooks up to date.

Outsourcing

In recent years, the Central Bank has noted a significant rise in the scale of outsourcing activities by supervised firms. Today, it is an integral part of the business model for many firms. However, such firms must not lose sight of the importance of having strong controls in place around the governance and oversight of outsourcing arrangements. This was one of the key findings of a review undertaken by the Central Bank in 2016 on the outsourcing arrangements of fund administrators¹.

More recently, we completed a review of outsourcing across the wider financial services sector in Ireland. This body of work culminated in the Central Bank publishing a paper last November² entitled ‘Outsourcing – Findings and Issues for Discussion’. The paper outlines the Central Bank’s findings and observations. It also communicates our minimum supervisory expectations around the management of outsourcing risk, as they pertain to the areas considered in our cross sector survey of regulated firms’ outsourcing activity.

Let me be clear when I say that the Central Bank’s work on outsourcing will not conclude with the publication of this paper. As a next step, we will be organising an outsourcing industry conference to take place in quarter two of this year. The feedback we receive on this paper and at that conference will inform on-going discussions on outsourcing and also assist the Central Bank in determining the appropriate regulatory response.

As you can see, there are quite a lot of developments in the asset management sector that are currently or will demand considerable attention in the coming months. From a regulatory viewpoint, these topics will inevitably seep into our on-going supervisory strategy and this is in line with our forward looking approach to risk based supervision.

Notwithstanding the above, we have recently completed our supervisory plans for 2019 and firms can expect supervisors to continue to provide robust challenge on the implementation of MiFID II and CP86. In addition, we will maintain a high level of visibility with our firms on the protection of client assets while also continuing to engage with firms on their contingency planning for Brexit.

Brexit – Hard Brexit & Cliff Effects

At this juncture, perhaps I can turn to Brexit.

“Nothing is agreed until everything is agreed” is a well-used phrase and this is evidently still the case as we have seen last week with the outcome of the vote on the withdrawal agreement in the House of Commons.

Both industry and regulators must remain mindful that the Brexit clock is still ticking and the risk remains of a hard Brexit scenario.

In preparation for this plausible scenario, last year the Central Bank undertook a sector wide analysis to identify potential “cliff edge” effects that could cause significant disruption to the Irish market in the event of a hard Brexit.

One of the most salient risks relates to the loss of the financial services passport. This would mean that after Brexit, UK firms will no longer be able to avail of the passport to provide services into Ireland and the rest of the EU.

It would also present the scenario whereby Irish firms may not be able to passport their services to clients or customers in the UK. Although, it is worth noting that this risk has been alleviated to a certain extent with the FCA’s recent announcement that the window for notifications under their temporary permissions regime is now open. The onus is on firms to notify the FCA by 28th March 2019 if they wish to enter the temporary permissions regime.

Specifically, in the context of the asset management sector, the loss of the passport would mean that UK fund managers could no longer act on behalf of Irish funds. There is also the risk that Irish AIFMs, UCITS management companies and Irish funds would no longer be able to delegate portfolio management to UK investment managers.

This matter is a live matter at a European level as outlined by ESMA’s Chair, Steven Maijoor, in a keynote address³ last year and in the EBA’s 2019 Work Programme⁴ . Moreover, in a recent address⁵, the Central Bank’s Deputy Governor, Ed Sibley, noted that it was “reasonable for firms to plan on the basis that MoUs will be in place by 29th March”. In my mind, all of these communications should now give industry sufficient confidence on this matter.

Brexit – Central Security Depositary Services

Furthermore, another critical Brexit risk which the Central Bank has been closely monitoring relates to continued access to Central Security Depositary (CSD) services which are currently provided by Euroclear UK & Ireland (EUI). Clearly any disruption to this critical market infrastructure, which allows for the settlement of Irish equities, would have a material financial stability impact.

In recent months the European Commission issued a statement that a 24 month temporary equivalence period for UK CSDs would be provided for in the event of a hard-Brexit. The Central Bank is working closely with ESMA and the Bank of England around the practicalities of implementing the associated recognition process for EUI. We are also working with the ECB and EUI on the continued provision of euro settlement upon EUI being recognised as a third country CSD.

However, while temporary equivalence is welcome and would alleviate the short-term cliff edge risk, it also means that an alternative long-term arrangement must be in place once this period comes to an end. Euronext Dublin has expressed a preference to migrate its market to Euroclear Bank Belgium. Both parties are working with market stakeholders, including issuers, registrars and brokers, to operationalise the implementation of this model.

Brexit – Engagement with existing supervised entities

Perhaps I can now briefly touch on the work that the Central Bank has undertaken with our existing supervised firms on their preparedness for Brexit.

In previous speeches, I have discussed how supervision teams have written to firms across both the MiFID and fund services sectors on their Brexit planning and the impact that Brexit will have on their business. This engagement has enabled us to identify common risks across both sectors, including access to a CSD, UK market access, investor impact and risks relating to data protection and transfer. These risks have since been communicated to firms and we have also undertaken follow-up work where we have determined that plans were insufficient.

The Central Bank continues to engage with firms across multiple sectors. We expect firms to have effective contingency plans in place for all Brexit scenarios and the onus is on industry to ensure that your firms are adequately prepared.

Brexit – Authorisations

Turning to the Central Bank’s authorisations role.

Since the Brexit referendum, we have seen a notable uplift in the number of firms seeking authorisation with applications ranging from banks, investment firms, electronic money institutions and insurance companies.

In the asset management sector, applications have spanned from small to large firms with many operating business models we are already experienced in supervising – such as MiFID firms and fund management companies, including those with individual portfolio management. In addition, a number of applicants are bringing new types of business to the Irish market and operating complex business models, which present new supervisory risks.

At this stage, a number of firms have already received approval for authorisation and we expect that a sizeable number will continue to be approved in the coming weeks.

My message to those firms who are currently in the authorisation process with us is to continue to actively engage with us to ensure that you are authorised by March 2019.

However, we remain committed to our rigorous gatekeeper role and this is important to ensure that we safeguard financial stability and protect consumers. On that note, I would like to make it clear that we will not lower our assessment standards and if you have not delivered on our expectations we will not authorise you. Our assessment standards include ensuring you are properly capitalised, have sufficiently experienced and knowledgeable people based in Ireland, a clear plan to when the firm will be operationalised and robust risk frameworks in place.

No firm should expect the Central Bank to provide an “insurance policy” for inadequate Brexit planning. We have no appetite for firms who have not done the work or for firms that have no real intention in setting up a substantial business in Ireland, but rather just see their authorisation as a last resort for a hard Brexit.

Against this backdrop, you may enquire as to how the Central Bank will engage with any firm coming to us now at this late stage. I would answer such a question by emphasising that the Central Bank remains an open and engaging regulatory authority. We will continue to deal with firms that approach us for authorisation but at this late stage, we will have to concentrate our efforts on those firms that have heeded our advice on engaging with us in a timely manner.

Brexit – Future Landscape

Before I conclude, let me give you some insight on the future of the asset management sector in Europe.

In the early months after the Brexit referendum the future was shrouded in a mist of uncertainty with many commentators expressing their views on which jurisdictions would see the most authorisation activity.

Today, it is clearer as to how the tectonic plates underpinning the sector in Europe are shifting. We are seeing many firms setting up operations across the EU27 and not all are locating in the one jurisdiction. Overtime, this will mean more of a fragmentation of the industry. It could also result in certain jurisdictions becoming centres of excellence for specific types of business.

These developments will lead many to question if jurisdictions have the required skillsets to carry out the various functions. In this regard, one must not forget that these skillsets are mobile and once firms setup operations within the EU27, however small at the start, they are likely to grow and attract people with the necessary skills.

From a regulatory perspective, pan-European supervisory colleges will become more prevalent as many firms expand their business to multiple jurisdictions across the EU27. Participation at such colleges will be important as they will enable NCAs to exchange information, discuss key issues and determine a common supervisory approach where possible.

Furthermore, the Central Bank’s participation at a European level, whether it be at ESMA, EIOPA or the ECB, will continue into the future and this is essential, as we have seen in the face of Brexit, to ensure a level playing field of supervision across the EU.

Finally, from my own participation at ESMA, I am well aware that the voice of the FCA will be a big loss at ESMA standing committees, task forces and networks. Their in-depth knowledge and contributions to date have proved invaluable especially from an Irish point of view when one considers the close links between both the Irish and UK financial systems.

Conclusion

I will stop there and summarise as follows.

There is a great Irish phrase, meon na ndaoine, which in English translates to “the mentality of the people” and I ask the question, rather rhetorically, what will our mentality be following Brexit?

I would hope that the close links that clearly exist between Ireland and the UK, across many different fields, will remain part of the mentality of the people post Brexit. For our part, we in the Central Bank recognise the importance of the relationships that we have built up with our colleagues in the FCA / PRA and it will be a part of our mentality to maintain and grow these relationships regardless of the Brexit outcome.

At this stage let’s not forget the good work that has been done to date by the Central Bank and industry in preparing for Brexit. Nevertheless, we remain on this Brexit path together. The Central Bank will continue to play its part with a view to mitigating the Brexit risks presented and we expect industry to do the same.

Thank you for your attention.

With thanks to Adrian O’Mahony, Catharine Dwyer, Des Bodley, Emily Shea, James O’Sullivan, Lorcan Byrne, Paul Delaney and Steuart Alexander for their assistance in drafting these remarks.

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¹ Central Bank of Ireland press release: "Central Bank reviews outsourcing arrangements of Fund Administration Activities", 7 March 2017.

² Central Bank of Ireland: Discussion Paper 8: Outsourcing - Findings and Issue for Discussion, 19 November 2018.

³ Maijoor, Steven "The state of implementation of MIFID II and preparing for Brexit", Esma, 3 October 2018.

⁴ European Banking Authority: "The EBA 2019 Work Programme", 23 October 2019.

⁵ Sibley, Ed: "Safety and soundness – Strategic priorities for the next three years", Central Bank of Ireland, 17 January 2019.