The potential shape of the upcoming reform of the Alternative Investment Fund Managers Directive (AIFMD) became clearer this summer. The 18 August letter from Esma to the European Commission gave some strong hints on the outlook for this key text for Luxembourg’s fund industry.
“This is potentially transformational in terms of the variety of topics raised, the philosophy behind these suggestions and the tone used in the letter,” commented Chrystelle Veeckmans, Partner in Asset Management with KPMG Luxembourg. That said, she thinks this shouldn’t come as a major surprise as it is “another iteration of the campaign regulators have been pursuing for the last four to five years.” The experience of working with AIFMD has informed how UCITS is viewed, with a desire to align the way all funds are regulated.
Luxembourg well-placed
The letter featured no fewer than 19 suggestions for reform, that Veeckmans suggests have been influenced by the experience of regulation during the pandemic, as well as concerns about the implications of Brexit. Ultimately the European Commission will take the final decision on how to proceed with AIFMD reform, but this letter will be highly influential.
It remains to be seen how much impact this will have for Luxembourg, but Veeckmans thinks the Grand Duchy should be “well placed” to benefit. Much of the work is around increasing substance and processes, and this would likely see greater emphasis on the work happening in Luxembourg. It is possibly significant in this context that the financial services portfolio at the Commission has just been given to the Irishwoman Mairead McGuinness. Ireland is the EU’s second largest cross-border fund hub after Luxembourg, and would also be significantly affected by a reform.
Three categories of reform
The 19 suggestions can be grouped into three broad categories, Veeckmans suggests: harmonisation across the EU to avoid regulatory arbitrage; enforcing a solid delegation framework; and themes addressing challenges such as liquidity, digitalisation, the role of depositaries and more. A common theme of the comments is a desire to reduce systemic risk. The concern is that some member states’ regulators work more actively to reduce these risks than others, hence why ESMA is seeking to oversee these regimes centrally.
The first proposal has a bold headline: “harmonisation of AIFMD and UCITS regimes”. For example, it talks about AIFMD offering a more “granular” approach to challenges such as risk management, liquidity management and delegation of activities, and that this difference “creates divergences in supervisory/regulatory outcomes”. The Paris-based regulator also sees harmonisation as a chance to reduce complexity for market players and supervisors. There is also a call to align UCITS management company reporting with AIFMD rules.
Substance
ESMA is concerned that national regulators have different interpretations of what activities AIFMs and UCITS management companies can perform, and the regulator would like to clarify this. For example there are questions on how rules can be applied to discretionary portfolio management or investment advice on assets not covered by MiFID, such as real estate.
The extent of delegation of functions across border (particularly portfolio management) and requiring sufficient “substance” in fund hubs such as Luxembourg has been a concern for Esma for a number of years. These came to particular prominence with concerns that UK-based asset managers could potentially use these arrangements to circumvent the barriers being erected by Brexit. “This is something that Luxembourg, for example, has tackled with local regulation – namely CSSF circular 18/698 – while other member states are lagging in this regard,” Veeckmans noted.
“ESMA has also observed an increasing use of secondment arrangements” says the note, pointing to staff from consultancies and group offices working in EU member states on a temporary basis. Similarly, so called “white-label” service providers that provide a platform to set up funds for others are also seen to offer wiggle-room to enable substance rules to be circumvented. ESMA would like to close these loopholes definitively.
As well as these main themes, there are efforts to clarify the rules regarding depositaries, the creation of a new framework regarding loan origination for debt funds, and tidying up of AIFMD reporting and data use. There are also areas more related to general housekeeping such as amendments to definitions and adapting to increased digitalisation.
Can Luxembourg cope?
Does already stretched Luxembourg have the human resources capacity to deal with this? “It will be a challenge but UCITS have inherent scalability, unlike AIFs which are more heterogeneous and require a substantial breadth of knowledge for them to be run effectively,” said Veeckmans.
It remains to be seen to what extent the Commission will take up these suggestions, and whether these ideas will be dealt with in one or several EU directives or regulations. It appears unlikely that there will be a first text before the end of the year, but if the fund industry thought that the wave of post-financial crisis regulation had passed, they will need to think again.