Managing divergence

The pace of regulatory change in sustainable finance continues to be rapid — not just through the introduction of new requirements but also via substantial amendments and clarifications to existing regimes.

Amidst calls for global collaboration, jurisdictions and regions are acting separately and are adopting different approaches. Regulatory divergence is causing issues for cross-border asset managers in terms of navigating different rules, particularly where regulations can have an extra-territorial impact.

Actions for firms:

• Evaluate the firm’s product range and governance framework in the context of new regulation.

• Harness the benefits of a technology-driven approach to capture the high volume of regulatory change, implement new rules, and identify areas of commonality and divergence.

• Carry out a product scoping and classification exercise against relevant disclosure and labelling requirements.

• Implement a common framework across the firm to define which products qualify as “sustainable”, against either a taxonomy or, in the absence of regulation, a best-practice model.

• Embed sustainability considerations across governance structures, the investment function, product governance, remuneration arrangements, compliance, and marketing.

• Review the approach to stewardship and assess whether appropriate technology for monitoring and reporting engagement is in place.

Asset managers continue to play an increasingly important role in financial markets and funding the real economy. According to the FSB, 1 recent growth in non-banks’ share of global financial assets has been driven by investment funds. Therefore, policymakers continue to focus on the asset management industry and potential financial stability risks. The FSB and IOSCO 2 share a priority to enhance the resilience of nonbanks, along with concerns about general market volatility and cyber threats (see Chapter 4).

Liquidity management in open-ended funds (OEFs) is under the spotlight. Money market fund (MMF) reforms are more advanced but slowing, with regulators now taking stock of progress. A few regulators have remaining concerns about exchange-traded funds (ETFs), and a recent area of focus in Europe has been liability-driven investment strategies. Use of leverage, investments in private and real assets, and asset valuation also feature on regulatory agendas.

Actions for firms:

• Tighten up governance arrangements around the use of liquidity management tools for open-ended investment funds, and the fair treatment of all investors.

• Evaluate the effectiveness of the stress testing process by reconsidering the scenarios used and whether they incorporate all plausible external and operational events.

• For ETF managers, review and implement IOSCO's good practices — for example, around the effectiveness of due diligence on authorized participants and market makers.

• Review asset valuation policies and procedures, ensuring they clearly describe roles and responsibilities, distinguish between normal and stressed market conditions, and include a mechanism to identify and remediate valuation errors.

• Consider preparedness for new reporting obligations and revise systems, roles and responsibilities as needed.

• Re-assess due diligence arrangements over index and data providers and ensure that each party's roles and responsibilities are clear.

The way in which asset managers manage risks is a constant theme for regulators, not least within the context of financial stability. Regulators are acutely aware of the threat of any type of disruption to firms and their customers, particularly in times of stress.

Greater reliance on third-party suppliers raises concerns around remaining substance in asset management firms and their oversight of the suppliers (see Chapter 7), but also about the resilience of those third parties. Cyber threats are highlighted as a key risk and technology-led business transformation and recognition of the global interconnectedness of the financial system have led to increased focus on the resilience of end-to-end business operations. And the adequacy of asset managers’ financial resources and broader risk and control frameworks is also under review.

Actions for firms:

• Identify and manage all potential operational risks through effective controls, monitoring and remediation as needed.

• Review oversight arrangements over third-party providers, including policies and procedures, formal agreements, and robust monitoring arrangements.

• Review information security arrangements to ensure there are clear policies and procedures in place to address cyber-related risks, as well as recovery and incident response plans.

• Assess whether sufficient capital and liquidity is held, having reviewed all potential risks to the business, and whether wind-down plans are complete and practical.

Regulators are seeking to understand the impacts of technology for the industry. They want to facilitate innovation, but are also focused on identifying and mitigating risks.

Both Fin Tech and Big Tech receive multiple references in recent regulatory outputs, along with artificial intelligence (AI) and machine learning (ML). Distributed ledger technology (DLT) underpins crypto-assets but is also being put to good use in market infrastructure initiatives, including fund unit tokenization and settlement. Regulators are cognizant of the greater use by investors of social media and online platforms, but recognize the risks as well as the potential benefits.

Actions for firms:

• Explore the possibilities of tokenizing assets and fund units within the guardrails of the existing regulatory framework.

• Track regulatory developments on AI and ML, and consider appropriate use cases within the business.

• Ensure online marketing and adverts are not misleading, and staff have relevant training to comply with the latest regulatory requirements.

• Participate in regulators' efforts to promote innovation, and feedback on potential opportunities and risks.

There has been a notable increase in regulatory efforts to prevent harm to retail investors. New regulatory initiatives have been proposed or implemented to address retail market conduct issues. Alongside traditional themes such as product governance, there is a significant focus on value for money and transparency, which is consistently reflected in new fair value considerations and disclosure requirements. And in addition to focusing on the distribution chain, disclosures and marketing materials, regulators are stepping up efforts to educate investors and protect them from scams.

Actions for firms:

• Review the firm's evolving strategy, culture and purpose to ensure it remains aligned with acting in customers' best interests.

• Review governance structures and MI that is used to consider customer outcomes, and whether good or poor customer outcomes are being evidenced.

• Check whether a target market for products has been defined with sufficient granularity, and whether products are being distributed to that market.

• Ensure disclosures on costs and charges are understandable and consistent with new regulatory requirements.

• Challenge whether products are demonstrably meeting clients' needs and providing value for money.

• Review arrangements with distributors, and whether distributor due diligence is formalized and underpinned by adequate policies and procedures.

• Ensure systems and controls are keeping pace with technology developments efficiently to deliver accurate electronic disclosures.

The way in which firms are governed is a constant priority for regulators, with current concerns including firms’ culture, diversity and inclusion, and the probity/integrity of senior management. Outsourcing of key functions, such as portfolio and investment risk management, concerns around substance in the delegating firm and its ability to oversee the third parties to which it delegates are also core themes.

Controls to deter financial crime are being strengthened due to global regulatory pressure. And as part of firms’ investment processes, many regulators are emphasizing the need for good conduct in wholesale markets, and proper due diligence and stewardship of investments.

Actions for firms:

• Ensure the compliance function keeps pace with growth in the business and that the three lines of defense remain appropriately organized.

• Promote a “speak up” culture and establish an effective whistleblowing procedure.

• Review the composition of the board to check whether individuals can dedicate sufficient time to their role, and whether there is sufficient knowledge, expertise and independent challenge.

• Check the mapping of senior managers' and staff roles and responsibilities against new or changing accountability regimes.

• Review whether there are sufficient resources and expertise at all levels in the business to be able to evidence “substance” and effectively to oversee outsourced functions.

• Review policies and procedures to determine whether appropriate AML due diligence arrangements are in place for higher risk customers.

• Enhance formalized voting policies and capabilities to disclose voting activity in easy to analyze format.

Developing capital markets are opening further to overseas firms and investors, subject to conditions. Various jurisdictions are competing as fund domiciles, with concerted efforts by some to address adverse findings by the global Financial Action Task Force (FATF). Within Europe, the fall-out from the UK’s departure from the EU – “Brexit” – continues to occupy regulators.

Regulators around the world continue to create new fund vehicles or amend existing products, to offer flexibility and compete for market share. Authorities are also aiming to bolster investment from professional investors, and in infrastructure and unlisted companies to assist economic recovery. Regulators are keen, though, to mitigate potential conduct risks and prevent harm.

Actions for firms:

• Factor opening markets and access possibilities into the business and product strategy.

• Monitor the outcomes of jurisdictions' reviews of fund regimes.

• Consider launching new products to take advantage of the evolving range of fund vehicles.

• Implement a robust approach to crypto-assets in terms of investment eligibility and risk management.