Brexit and the evolving landscape of the asset management sector - Michael Hodson, Director of Asset Management & Investment Banking

Speech delivered to the Brexit Solutions and Trends in the Funds Industry, London Seminar

Good evening ladies and gentlemen. It is good to be here in London in Blackrock’s offices for this seminar on Brexit Solutions and Trends in the Funds Industry.

Over the last 18 months myself and my colleagues have provided lots of speeches around Brexit, however this particular speech has been one of the more challenging ones to finalise. Just two weeks ago we witnessed an agreed deal between the UK and the EU27 that appeared to confirm and give more confidence to a transitional arrangement. Since then though, we have seen much debate and daily press coverage ahead of the UK Parliament vote, which raises questions on whether a deal will be agreed or not.

What all of this brings to mind, for us as regulators and you in industry, is the continued uncertainty of Brexit. This uncertainty should serve as a reminder to us all of the importance of planning and putting in place the necessary contingencies in sufficient time to address all plausible events and a hard Brexit very much remains such a plausible event.

I will spend sometime this evening speaking about some of the potential Cliff Effects that may arise in the event of a hard Brexit, along with some of the changes we are seeing in the Irish financial service landscape as a result of Brexit. I will also set out what we expect of firms, both existing supervised and newly authorised, should there be a transitional period.

Brexit Cliff Effects

I will start with cliff effects and discuss them from the EU27 perspective.

Earlier this year the Central Bank conducted a sector wide analysis of the potential cliff effects of a hard Brexit and this work continues to evolve with a number of internal working groups established to further consider cliff-effect risks, the impact of each risk and the potential mitigants.

Given the audience present here today, perhaps I can hone in on some of the cliff effects that are most relevant to the asset management sector. 

• In the fund management space, there is the risk of UK fund managers losing their passport which enables them to act on behalf of Irish funds. While we have seen a number of fund managers engaging with us or our fellow EU27 NCAs, with a view to creating an EU27 entity, those that have not done, are now running out of time to find a solution.

It is therefore imperative that the boards of the underlying funds look at what contingency plans should be in place in the event of a hard Brexit – for example one option could be to move the mandate to another EU27 management company.

• The loss of the ability of Irish AIFMs, UCITS management companies and Irish funds to delegate their portfolio management to UK investment managers is another risk.

However, the MOU matter remains very much a live issue at a European level. Over the last number of weeks we have seen it addressed through various statements from EU based institutions.

For example, ESMA’s Chair, Steven Maijoor, outlined in a recent address that ESMA plans “to start negotiations with the U.K. with the objective to have these MOUs in place sufficiently on time before the end of March 2019”. In addition to this, the EBA outlined in their 2019 Work Programme (published on 23 October) that they will continue to coordinate the work on supervisory cooperation between NCAs and this includes the development of MOU templates.

In my view, these comments should give industry comfort that the required level of work is on-going to ensure that the necessary MOUs will be in place by the end of March 2019.

• Another risk concerns the settlement of Irish securities post Brexit. At present, Ireland has no indigenous securities settlement systems infrastructure with all Irish equity transactions and a proportion of ETFs settled through the CREST Central Securities Depository which is operated out of the UK.

In the event of a hard Brexit and the UK exits the EU, the UK operator will no longer be able to passport in and service the Irish market. As a result of this, a solution needs to be found to ensure the continued settlement of Irish securities. In this regard, the Central Bank continues to have extensive engagement with the Department of Finance, market participants and a number of European Stakeholders with the objective of mitigating the risk of any service disruption.

I would draw your attention to the statement by the European Commission on 13 November which states that “should no agreement be in place, the Commission will adopt temporary and conditional equivalence decisions in order to ensure that there will be no disruption in central clearing and in depositaries services”.

Let me be clear when I say that the Central Bank’s work in this area will not relent so long as the risk of a no deal scenario and no transition period remains. However it is equally, if not more important, that you in industry play your part.

As highlighted by the Central Bank’s Director General of Financial Conduct, Derville Rowland, in a recent keynote address , “in all scenarios, effective contingency planning will be critical and must continue in order to mitigate impacts as they arise”. To expand on this, responsibility ultimately rests with each individual firm to ensure they can continue to operate in compliance with applicable EU laws and regulations. If you are unable to do so then you must look at what options are best for your clients.

Brexit – engagement with existing supervised firms

Notwithstanding the above, I would like to take this opportunity to discuss the work that the Central Bank has undertaken with our existing supervised entities on their Brexit preparedness.

In November 2017, our supervision teams wrote to firms across the MiFID and fund services sectors, requesting that they submit details of their Brexit plans. Specifically, firms were asked to provide analysis of the impact of Brexit on their business model and operations, financial resources, and legal and regulatory structures.

Following analysis of the responses, common risks were identified across both sectors which include: continued access to a Central Securities Depository, UK market access, macroeconomic effects, investor impact, staffing and GDPR. Details of the common risks were communicated to all firms and, where supervisors determined that the plans of individual firms were insufficient, we requested those firms to re-evaluate and re-submit their plans.

At a minimum, we have required firms to consider and address the common sectoral risks, in addition to any other risks already identified by the individual firms. As well as analysing contingency plans, supervisors continue to work with firms to understand the risks arising from continued political developments. To summarise, this ongoing communication between regulators and regulated entities will be critical as we navigate the risks associated with Brexit.

Brexit – changing landscape

Moving on, I am conscious that there are only four months to go before 29 March 2019. With that in mind, I would like to speak briefly about the changes that are beginning to take shape within the Irish asset management sector today.

Since the UK voted to leave the EU on 23 June 2016, we have seen a notable uplift in the number of firms seeking authorisation from the Central Bank. This has included a number of firms operating business models in the capital markets and investment banking space that are new to Ireland.

As these new firms are authorised, the Central Bank will be responsible for the supervision of new risks, including market conduct risk and wholesale credit risk. While I acknowledge that the impact on the Irish domestic economy may be limited, the impact that these firms will have on a pan-European scale may be much greater.

In preparation for the ongoing supervision of these firms we have recently established a new division within the Central Bank, the Investment Banks and Broker Dealers Division. A number of these new firms will fall within the SSM supervision model and over the coming months these firms can expect a high level of intrusive engagement both from the Central Bank and SSM.

We will seek to ensure that these firms stand up their operations as agreed with the Central Bank, put in place strong and robust risk management processes and demonstrate their independence from any group or parent company in another jurisdiction.

In 2015, the Central Bank introduced the revised Client Asset Regulations (“CAR”). The CAR was introduced following a number of firm failures which resulted in the loss of client assets. The rules were developed based on the make-up of the industry at the time, mainly retail. With the arrival of wholesale banking activities, we now need to amend the CAR to cater for these business types. This work has now commenced and we aim to consult on any changes in 2019.

In addition to the above, we can also expect considerable growth in the fund services sector with a number of management companies progressing with their applications for authorisation, including some large global names.

Throughout our engagement with these firms, we have given a clear message that all firms relocating must demonstrate that they have the staff necessary to carry out their functions and this means full time staff dedicated to the management company.

Although many of these firms will continue to rely on delegating activities such as portfolio management, I am pleased to see that our message is getting across and that firms approaching us for authorisation are looking to setup a real business in Ireland with an appropriate level of resourcing.

In my view, this trend of increased substance will continue and with our supervisors now looking to assess how firms have implemented and embedded the key CP86 requirements into their arrangements, it is timely for existing authorised entities to critically assess their resourcing requirements in this new world and start to put in place any necessary changes.

Moreover, it is interesting to note that many large entities are looking to setup operations in more than one jurisdiction and this means that close relationships with other NCAs and Central Bank participation in supervisory colleges will become increasing important as we as regulators will need to find tools and mechanisms to get a holistic view of the supervisory risks from an EU27 perspective.

Brexit – Transitional Period

Before I move on from Brexit, I must acknowledge the fact that we could still be presented with a transitional period from March 2019 until the end of December 2020.

In one sense a transitional period will give industry more time to prepare for Brexit but we must not lose sight of how quickly this time will go by. For those firms who have not yet made their plans, I would say that you will need to engage with us early in the transitional period and to be planning for at least a 12 month period from initiating your plans to being set up and running, irrespective of size.

You should not underestimate the challenge as you will have multiple tasks to complete including the sourcing of office space, hiring or moving staff, repapering clients, not to mention getting regulatory approval.

There will be little sympathy for firms from regulators or indeed their clients if, come December 2020, they have not made the necessary arrangements to continue to service EU27 clients.

For existing supervised entities, this will also give you more time to plan and prepare for Brexit and as supervisors we will continue to engage and challenge you on your preparation over any transitional period that emerges.

Other Key Topics

 At this juncture, let me say a little bit about other matters that are important to us within the Central Bank.

In recent times, the Central Bank has noted a significant rise in the use of outsourcing by regulated firms in Ireland. In light of this, together with the growing international focus on outsourcing and increasing concerns in relation to outsourcing practices, we recently completed a review of outsourcing across the Irish financial services sector.

This work has culminated in the Central Bank publishing a paper last month entitled ‘Outsourcing – Findings and Issues for Discussion’.

In addition to setting out the Central Bank’s findings and observations, the paper communicates our minimum supervisory expectations around the management of outsourcing risk, as they pertain to the areas considered in the survey.

The findings, point to poor governance and controls around risk assessment and management of outsourcing, inadequate monitoring and reporting, failure to consider outsourced service providers in business continuity planning and testing, and a lack of exit strategies. This is of concern to the Central Bank, particularly as many of the findings relate to outsourcing arrangements that were deemed critical or important by the firms in question.

The paper also highlights some of the key risks and evolving trends associated with outsourcing including; sensitive data risk, concentration risk, offshoring, chain-outsourcing and substitutability, which firms must consider and manage as part of any outsourcing arrangement.

Specifically in the context of Brexit and the current pipeline of firms applying to the Central Bank for authorisation in Ireland, a high degree of reliance on outsourcing, particularly intragroup outsourcing, is a common feature of these applications. Many firms seeking to be authorised in Ireland plan to outsource to existing group entities located in the UK. The boards and senior management of any applicant firm must be able to demonstrate to the Central Bank that the new entity will have robust governance, risk management and business continuity arrangements in place in respect of any existing or proposed outsourcing. In this context, I would urge all interested parties to consider the contents of the paper and the expectations set out therein.

The Central Bank plans to hold an outsourcing industry event in Q1 2019. The event, together with feedback sought on this paper, will inform the ongoing discussions around outsourcing trends, key issues and the appropriate regulatory response. Interested parties are invited to make submissions in response to the paper by 18 January 2019. Further details can be found on the Central Bank website.

Moving on, it is hard to believe that MiFID II has been in place for close to a year at this stage.

And while our supervisors have been, and will continue to engage with individual firms to discuss the overall implementation and impact of MiFID II, more specific and detailed work is being undertaken over the remainder of 2018 and into 2019. For example, the Central Bank recently commenced reviews in two key focus areas, namely investment research and product governance, to assess the consistency of application of specific requirements.

At an ESMA level, the continued implementation of MiFID II also remains a key point of focus to ensure supervisory convergence across member states and also with a view to developing appropriate policy responses to shifting market dynamics. An example of this is the work ESMA is carrying out in respect of periodic auctions for equity instruments. A recent call for evidence by ESMA is aimed at developing a better understanding of the way periodic auction trading systems operate, and to assess whether they can be used to circumvent the double volume cap mechanism and other transparency requirements under MiFID II. I would encourage those interested in responding to submit their response by 11 January to enable ESMA to gather information on the functioning of these trading systems.

Another area of interest is the European Commission’s proposals for a new prudential regime for investment firms. The Central Bank is generally supportive of the proposals and considers that the new prudential regime will be more proportionate than the current regime.

The 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 would have the lightest set of prudential requirements applying to them.

On top of all of this, we cannot afford to lose sight of our day-to-day supervision of regulated firms. The majority of our staff are involved in this important work and in 2019, we will continue to challenge firms on the implementation of MiFID II and CP86 while also maintaining a high level of visibility with our firms on the protection of client assets.

Of course with a changing asset management landscape, we also need to move with the times. For example, this year we engaged with our supervised firms to understand the potential opportunities and challenges presented to them and their business models by FinTech. Moreover, the Central Bank launched an innovation hub in April which allows FinTech firms to engage with the Central Bank outside of existing formal regulator/firm engagement processes and to share information on innovation in financial services based on new technologies.

Finally and in line with our forward-looking approach to risk based supervision, last summer we commenced a change project within our Prudential Regulation Pillar. One of the key outcomes from this body of work will be the establishment of the Prudential Analysis & Inspections Directorate. Once launched, the work of this new Directorate will enhance our ability as supervisors, deepen our knowledge of the firms we supervise and also ensure that we can fulfil our regulatory mandate into the future.

Conclusion

I will stop there and summarise with my final thoughts.

At present Brexit day is chiselled in all our diaries for 11pm on 29 March, 2019. However as we all know, a lot of uncertainty still remains. As a result, regulators and firms must continue to prepare for a range of scenarios, including a hard Brexit.

Even with Brexit looming, existing work of the Central Bank will continue at pace. We also remain conscious that a new regulatory environment awaits post Brexit. For that reason, the existing strong relationship that we have with the FCA and PRA will be maintained. This positive relationship is important to us in the Central Bank and we will continue to work with our colleagues in the FCA and PRA whatever the scenario.

In conclusion none of us should expect our lives to get any easier or may I say less interesting in the coming months.

Thank you for your attention.

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With thanks to Adrian O’Mahony, Alan Bonny, Ailbhe Cannon, Lorcan Byrne, Orna McNamara and Suzanne Power for their contribution to these remarks.