European firms in regulation limbo

Money managers in Europe are facing uncertainty related to the impact of new rules on their businesses at a time when the coronavirus-induced recession is taking its toll on revenues.

In the next six to nine months, money managers operating in Europe will fall under new rules around investing, trading, clearing and reporting. But managers say they are still waiting on European lawmakers to clarify the upcoming disclosures regulation relating to sustainable investing and post-Brexit trading and clearing rules. European Union leaders and institutions have been preoccupied with fighting the effects of the pandemic and are yet to confirm many requirements that could significantly alter how managers currently operate in Europe, sources said.

Managers operating in Europe are awaiting rules on how they will access the U.K. market for trading and clearing after Dec. 31. Separately, managers operating in Europe will be required by the European Disclosure Regulation to report how their investment portfolios impact the environment by March 31, 2021.

The uncertainty around these requirements is combined with ongoing challenges and comes as money managers' businesses have to weather a recession, sources added.

"We have changed our outlook for asset managers to negative from stable in March 2020," said Marina Cremonese, London-based vice president and senior analyst at Moody's Investors Service Ltd., in a telephone interview. "Back in December, we had a stable outlook despite the long-term pressure that the industry was facing from fees, increasing regulatory and technology costs, and competition from passive funds," she said. "However, at the same it was still a very profitable and not very leveraged industry."

But given the economic uncertainty and volatility in the financial markets, Ms. Cremonese thinks going forward investors will shift toward safer and lower-fee investment strategies, which will further impact money manager revenues, she said.

Sources said the performance of equities and investment-grade bonds — the main return-seeking liquid asset classes in European portfolios — is also expected to be challenged in the third and the fourth quarter.

"We are in the 'lifting of restrictions' phase and there is a very strong rebound underway, but at the same time, we believe it's worth taking a (pause) on what we might see in the second half of the year" in terms of unemployment and economic impact, said Sonja Laud, CIO of Legal & General Investment Management Ltd. in London.

"Chances that regional lockdowns will be reimposed are likely," she said.

Equity markets have benefited from central bank policies, but are not pricing in a slowdown in the current growth, which could decelerate as furlough programs for workers around the world expire, Ms. Laud said.

For example, LGIM has recently reduced double overweight exposure to investment-grade, high-yield and dollar-denominated emerging market debt in its portfolios to overweight. The firm also remains neutral on equities. But Ms. Laud added that if the U.S. struggles to control the coronavirus, LGIM could move its exposure to underweight on equities and review high-yield bonds.

Money managers are not only having trouble navigating markets, but also need to shift attention and resources to regulatory challenges ahead, sources said.

The first deadline is Dec. 31, when the U.K. formally ceases to be a member of the European Union. The U.K. has decided against asking for an extension.

Sources noted that even though most U.K. and global managers have secured licenses to operate in Europe seamlessly after Brexit, they are set to face more issues later this year.

One contentious issue is access for European investors to the London Stock Exchange and London-based clearinghouses after Brexit. How trading and clearing will work between the U.K. and the EU are yet to be clarified by the European Commission, managers say. As permanent equivalence status has not yet been confirmed, global managers with Europe-based clients could be constrained to trading shares and clearing trades inside of the EU in the future.

As Pensions & Investments went to press, the European Commission said it intends to adopt a "time-limited equivalence decision" for U.K. clearinghouses to clear derivatives trades originating in Europe.

Previously, the European Securities and Markets Authority, Europe's financial services watchdog, assured money managers that they would be able to rely on a three-year equivalence period for clearing in the event of a hard Brexit. However, managers are still worried that their clients will be exposed to liquidity risk and price dislocations.

Threats to access when it comes to trading are looming on the horizon for European equity managers with U.K. equity strategies or strategies that feature U.K. equities. For example, Jan Buchan, principal solicitor at Kames Capital PLC in Edinburgh, said that under the EU's existing Markets in Financial Instruments Regulation, EU firms are required to trade on EU-based exchanges. Ms. Buchan said that if LSE does not get the equivalence status, "our Dutch investment firm (Aegon Asset Management) may not be able to trade on the LSE," she said.

She thinks that equity trading is affected the hardest by the lack of agreement on equivalence as it restricts firms from trading on the most liquid venues. When an investment manager in the Netherlands has a choice, they will trade in London due to better liquidity and best execution, which requires managers to seek the most favorable circumstances, she added.

Sources said most buy-side firms have contingency plans for clearing but are yet to implement them, which could lead to market dislocations and IT glitches if they attempt to switch trading venues at the same time. "Large broker-dealers say that clients don't want to be transferred from U.K. accounts to EU accounts until they really have to," said Kay Swinburne, vice chairwoman of financial services at KPMG U.K. in London.

Another potential challenge for U.K.-based managers — exacerbated by the pandemic — is the location and travel of business development, sales and marketing executives post-Brexit. Kieran Fox, director of business development at Irish Funds Industry Association in Dublin, said that firms should consider whether overseas employees based in their U.K. offices require a visa after Brexit.

The next stop for managers is in March 2021, when they have to be ready to report on their investments' impact on the environment under the upcoming EU Disclosure Regulation. However, the new rules are already creating confusion among managers. The first set of reporting is due in the first quarter of 2021, but a separate complementary piece — the taxonomy criteria, which measures the impact and intensity of, for example, carbon emissions on the environment for disclosures — will not be ready in time for the first reporting deadline, sources said. And managers say the basic set of guidelines from the European Commission about the disclosure requirements are also troublesome to meet.

Carlo Funk, head of ESG investment strategy for Europe, the Middle East and Africa at State Street Global Advisors Ltd. in London, said that managers are expected to provide information to investors on how sustainability risk is included in their investment process.

"We are already doing that, so it is not that big of a headache," he said. But he added that regulators also expect managers to show the adverse impact of every single investment strategy on the environment.

For financial products that promote ESG, regulators have yet to clarify whether they want managers to include the taxonomy, which itself has not been finalized.

"The tricky part is that the impact data is not great," he said.

Managers that are working to meet these obligations on time say they must change strategy prospectuses and other forms of investor communication."There is definitely a big movement in the market. If you are not (integrating ESG to meet obligations), you are not following the rules of the game," Luba Nikulina, global head of research at Willis Towers Watson PLC in London, said in a telephone interview.

In the U.K., which is broadly following the EU's rules as well as global standards set by the Task Force on Climate-related Financial Disclosures, the largest risk remains around greenwashing of strategies.

Investors and managers are still questioning at which point a green label is put on the strategy and at which point ESG is considered fundamental to the strategy, Ms. Nikulina said.

High on EU lawmakers' agendas for this year are also green bond standards, sources said.

Ingrid Holmes, head of policy and advocacy at the international business of Federated Hermes Inc. in London, said in a telephone interview that European legislators are also looking to tweak the European financial services regulation to get more private investment into public and private partnerships.

"They are looking at requirements that range from any green bonds having obligatory EU green bond standards ... and using that to underpin revisions to capital requirements (of financial services firm)," she said.