Speech by Andrew Bailey, Chief Executive at the FCA, delivered at London Business School Annual Asset Management Conference.
“It’s a great pleasure to have the opportunity to be discussing such an important subject, not just in finance but in society at large. I will try to cover the waterfront of asset management from the perspective of a regulator. The FCA regulates the sector for both conduct and prudential purposes, and I am also a member of the Bank of England Financial Policy Committee which has the macro-prudential responsibility.
That’s a pretty extensive waterfront.
One of the important structural shifts post the financial crisis has been away from intermediation of financial activity on bank balance sheets towards the non-bank sector and particularly asset management. The balance had gone too far the other way before the crisis, incentivised by weak capital and liquidity standards in bank regulation, and particularly to hold relatively illiquid assets in so-called trading books – a contradiction of terms if ever there was one.
The combination was toxic – relatively illiquid assets backing bank deposits, where the capital standard was inadequate to cover changes in the value of the assets. What could possibly go wrong? At the heart of this was a very simple issue – the most simple issues are often the most powerful – a bank deposit is a contract where the depositor expects the full return of the money plus interest. The bank acts as principal by taking the funds onto its balance sheet and has own funds or capital liabilities to buffer the losses and enable it to return depositors money in full. Ten years ago with the regulatory standards of the day it didn’t work out.
Since the crisis bank regulation has strengthened, as has risk management in firms, and there has been a progressive shift in the balance of financial intermediation towards non-banks. In terms of assets held, so-called other financial intermediaries (OFIs) – basically if you are not a bank, an insurance company, a pension fund or in the public sector, you are in this category – account for a 30% share, which is 5 percentage points more than in 2011. And, most of this growth is in the asset management part of the so-called OFIs.
A similar pattern can be seen in international capital flows. US dollar credit flows to emerging market economies have pretty much doubled in the last ten years, and most of that increase is accounted for by market intermediation rather than bank lending.
There are many welcome elements of this growth in the relative use of market-based finance. At the heart of it – back to my simple but powerful point on bank deposits – is that market finance involves an agent not a principal relationship, in which changes in asset values are not buffered by capital liabilities. In the area of liquidity and maturity transformation, the structure is also not the same, but as I will come on to, what governs behaviour in market-based finance is the expectations of investors, and they are harder to observe and not necessarily stable over time.
The post-crisis period has also been characterised by what we could call abundant global liquidity, which has been a deliberate product of central bank policy on quantitative easing. One of the intended effects of that policy is to cause investors to seek greater yield by increasing duration. It is no surprise therefore that we have seen curve flattening in risk free markets and a reduction in credit spreads in other markets. This was in the plan.
It’s therefore important that as macro-prudential regulators, who naturally should focus on the tail of the distribution of possible outcomes, we focus on the risk that could arise from a snapback in yields. To be clear, I think that that so far markets have adjusted well to the start of a pretty gradual turn in monetary policy in some countries; so far so good. But if there were to be a snapback in yields in conditions where duration risk has increased, there are risks if investors, for instance, think that global liquidity conditions could tighten rapidly. In principle, and I hope in practice too, asset management and other investment funds can act as a shock absorber with losses being distributed across the system, and with many investors being in for the long-term and able to ride out the shock.
What could go wrong then? Let me come back to what is and is not known about the expectations of investors on the liquidity – in this case market-based liquidity – of their investments. It is reasonable to assume that one of the influences on the expectations of investors in this respect will be the structure of the fund in which they invest, the terms and conditions. Let me highlight two areas here which receive our attention.
First, the structure of open-ended funds, and the degree to which they could be required by their terms to rebalance and reduce asset holdings in stressed conditions, and in doing so amplify market movement by acting as forced sellers in a falling market. This risk is most pronounced where the fund is holding illiquid assets and promising high frequency – even daily – redemption to investors.
We had this experience with open-ended property funds following the EU referendum nearly two years ago. Many funds chose to suspend redemptions, making use of a safety valve that is foreseen in agreements between asset managers and their investors. The safety valve was to suspend redemptions until conditions stabilised. In that case, the shock passed and the funds were able to stabilise and resume normal operations. Our supervisors reviewed these suspensions across the value chain. While suspensions generally operated without major disruption, there is room for improvement. Their more detailed findings are available on our website.
Is this structure appropriate? The question for me is not really about the appropriateness of open-ended funds per se, but rather offering daily redemption in illiquid assets which also cannot be valued daily. I would observe that funds with longer redemption periods did not experience the same issues in this most recent stress situation. There is a lesson here about maturity transformation in a market liquidity context. More broadly, we have to watch that these sorts of feedbacks do not amplify price moves in markets out of line with more fundamental drivers and in ways that could disturb financial stability.
Exchange traded funds
My second case is related and concerns exchange traded funds (ETFs) which have grown substantially since the crisis. The secondary market liquidity of ETF shares is dependent on market makers and authorised participants (so called APs).
We know relatively little – as we have not experienced a stress since this structure grew so rapidly – about the capacity and willingness of APs to execute their function in stressed conditions where they may be under pressure to tighten their own risk limits. The result could be unexpectedly large discounts for ETF investors selling their holdings relative to the estimated value of the underlying assets, and possibly a need to suspend fund dealings. As with open-ended funds, this could have the potential to amplify shocks to market conditions which are already under stress. We have no easy way of sizing this risk, but we cannot ignore its potential given the rapid growth of ETFs.
In setting out these potential risks, I don’t want to forget the message that the global financial system is more resilient than it was prior to the financial crisis. A lot has been achieved in the last ten years. But our job is to be watchful to the build-up of risks and vulnerabilities in the system, their potential consequences and to take action where appropriate. The structural shift in financial intermediation towards market-based finance means that the vulnerabilities and channels for stress to impact the financial system will be different. A common theme running through the two cases I have described, open ended funds and ETFs, lies in what level of continuous market liquidity conditions investors expect, and thus the liquidity transformation they accept. We must be careful to ensure that there is not a material misalignment between investor expectations and market conditions, and particularly how those expectations may adjust, or not, in stressed conditions. And, I would emphasise that this is not just a job for regulators. It is a job for firms too; indeed, first and foremost it is a job for firms to stress test their structures and responses.
I want now to move on to asset management in the UK and the issues we face.
Over £8 trillion of assets are managed in the UK, and that is nearly £1 trillion more than a year ago. The UK’s asset management industry is the largest in Europe and the second largest in the world. The majority of clients are UK-domiciled, but the industry manages around £2.6 trillion for overseas clients, of which European clients are the largest proportion at around £1.4 trillion and US clients next at £0.5 trillion. The UK accounts for around 35% of all European assets under management. Split by type of management, the proportion of passive management has gone over 25% of the total under management in the last two years. Six years ago it was just over 20%.
Looked at from the point of view of clients, we tend to divide them into two categories. Individual consumers account for around one fifth of assets under management. Institutional investors such as pension funds and insurance companies account for the remaining four fifths of assets under management.
Over £8 trillion of assets are managed in the UK, and that is nearly £1 trillion more than a year ago. The UK’s asset management industry is the largest in Europe and the second largest in the world.
As you will undoubtedly appreciate, there are strong forces of change affecting asset management in the UK, some of which are global in nature, others are UK specific. We set out these forces of change in our latest FCA sector views publication which covers the wide landscape of FCA responsibilities.
Among these forces, let me start with Brexit. As you will be well aware, there are a number of possible outcomes from the EU withdrawal negotiations. For asset managers the key issues are delegation of activity, passporting of funds and segregated account arrangements for EU clients. I start from the position that today we have arrangements in place which work well for the benefit of all clients, and there is every reason for all parties involved to seek to put in place arrangements post-Brexit which preserve the benefits.
As in any other global industry, asset management supply chains are international. A car produced in a factory in Sunderland will have been assembled using parts imported from several different countries. Just so in asset management. A global macro fund, for example, may be located in one jurisdiction, while the management of investments held by the fund may be delegated to a number of jurisdictions, where local portfolio managers are closest to their markets. Few would argue nowadays that all of the parts of an automobile should be sourced solely within the country where it is ultimately assembled. I do not believe it would be any more sensible to require a fund to be managed solely within its domicile. The truth is that delegation is a well-established global norm, underpinned by strong standards and regulatory cooperation. It is not dependent on EU membership. There is no reason to disrupt a system that clearly works effectively.
There is, of course, a more general point here which is important. Financial markets are by nature global not regional in form, and there is a very long history to this. Likewise, we tend naturally to think in terms of global regulatory approaches wherever possible. We are a very active participant in, and supporter of, the work of IOSCO. We work closely with other European Union authorities in this endeavour, and I am sure we will continue to do that post Brexit. Our common interests in effective markets and outcomes for consumers will not suddenly vanish. Moreover, global arrangements like delegation provide ready evidence that the basis exists for a successful model of mutual recognition of regulatory standards which supports continued open markets. As a public official, I take no position on the pros and cons of Brexit. But I do take a strong position that Brexit does not need to be an excuse to restrict trade in financial services, and that to do so would be a mistake for all sides.
Moving on, the next big issue on the landscape concerns changing demographic patterns and the interaction with macroeconomic conditions. I quite often say that if I could put Brexit to one side, hypothetically to be clear, this is the biggest issue that we face at the FCA. And that is because it pulls together a number of very big trends, namely an ageing population, persistent very low or negative long-term real interest rates, and increased costs of care in old age, to name three. Asset managers are very much in the forefront of these issues because increasingly you are providing the means of saving for old age, and the choices for consumers are becoming more complex at a time when – over quite a long period now – the responsibility for those choices has been increasingly transferred to consumers. This is an important reason why at the FCA we have a strong focus on the conduct issues that can arise.
To give a prime example of an issue that we face, the growing number of people reaching retirement could lead to a shift in the balance of assets under management from accumulation–orientated products to decumulation products, including a variety of income drawdown strategies, some of which are likely to be relatively complex.
Closely allied to these demographic trends is the decline of defined benefit pensions and the growth of defined contribution schemes and other retirement income products. This is leading to a range of changes in the sector. The big point that I would draw out is that there continues to be a major shift towards placing more responsibility for decision making onto individuals. We have seen that happening for some time in the accumulation phase of saving for retirement. Now, we are seeing the similar change in the decumulation phase as people exercise choices over when and how they draw pensions. Given the implications of an ageing population, low real interest rates and the cost of old age, it seems to me that greater choice makes sense in terms of individual circumstances and preferences. But it places a responsibility on industry to provide products and the regulator to establish conditions in which those choices can be made securely and confidently.
Developments in regulation
For the final part of my remarks, I want to move on to developments in regulation. This can sound like a laundry list, and a long one at that, something I am going to try to avoid by focusing on three areas: the market study that we have conducted; recent European legislation; and technology. As a list it also serves as a pretty good illustration of the breadth of the FCA’s interests and responsibilities.
The market study was conducted under the FCA’s powers as a competition regulator. These are quite unusual powers for a financial regulator by international standards, but I regard it as something where the UK has set a very good example, and we take competition very seriously. We have identified several drivers of weak competition in a number of areas of the asset management sector. Some investors are not well placed to find better value for themselves, and can be relatively insensitive to the price of asset management products and services. Such investors struggle to protect their own interests and through this to drive competitive pressure on asset managers to deliver good products and services at competitive prices. To help mitigate this, we have issued final rules on governance remedies focused on asset managers as agents of their underlying investors. The proposed changes strengthen the duty on asset managers to act in the best interests of investors.
We have issued final rules on requiring asset managers to pay any profits they may earn when dealing as principal in the units of dual-prices fund without putting their own capital at risk (so-called ‘risk-free box profits’) back into the fund. We have also revised guidance published on changes to make it easier for asset managers to move investors from more expensive share classes to cheaper but otherwise identical classes.
As part of an overall package, we have also published a consultation paper with proposals to improve clarity over what a fund is offering (what it aims to do, how it intends to do it, and how performance is shown) as we believe that a lack of clarity is another reason for weak competition. The proposals aim to help investors, and their advisers, make use of better information to choose the right funds. This incorporates the work of our fund objectives working group. The group has included a wide range of stakeholders including asset management firms and investor groups. We are grateful for the time and expert input of this group.
Taken together, our remedies seek to address both demand and supply side problems in the asset management market which, if addressed, should lead to greater competition and innovation in this market in the interests of the consumers it serves.
The market study also highlighted the importance of clear disclosure of what asset management services cost through the presentation of a ‘single charge’. MiFID II and the Packaged Retail and Insurance based Investment Products Regulation (PRIIPS) have recently introduced greater disclosure of all costs and charges, including transaction costs. Consumers should now see the full costs and charges, expressed as a single fee, for most transactions in investment products. This is a significant step forward, though we will be conducting some work to evaluate how effective these measures have proved in practice. In any case, how the new information is presented will be as important as the disclosure itself if it is to help consumers make more informed choices. To better understand this, we conducted behavioural testing. We have published the results of the testing. The findings show that different disclosure techniques yield meaningfully different outcomes for consumer engagement. Firms should consider the results when thinking about how their disclosures are working.
In response to other concerns highlighted by the market study, we are supporting an independent Institutional Disclosure Working Group (DWG). The group is seeking to agree a disclosure framework to support consistent disclosure of costs and charges to institutional investors.
The market study also highlighted issues of conflicts of interest, ineffective competition and a lack of transparency on fiduciary management performance and fees in the investment consulting market. These could result in: inappropriate purchase decisions and possibly too high prices being paid for fiduciary management services; and poor service levels and too high fees for investment consultancy services as a result of ineffective competition. We have referred investment consultants to the CMA, and now await the outcome of their investigation.
As I hope you can tell, this is a very important package of measures which is designed to reflect the importance of asset management to long-term savings in this country.
As I mentioned earlier, in EU regulations we saw a major change in the landscape at the start of this year with the introduction of MiFID II and PRIIPS.
MiFID II is probably the largest single change ever in European financial market regulation. Our initial priority, to be very clear because I know this attracts attention in some quarters, was to implement MiFID II in a way that did not stop the effective functioning of markets. I want to be very clear on that. It does not mean that we disregard rules, but it does recognise that implementing rules in a market that wasn’t functioning would be – at its kindest – getting the cart before the horse. Our supervisors have a programme of work to assess the state of compliance and to evaluate how effective the regulations have been in meeting their aims. In order to undertake that work properly, it is appropriate, as we generally do following major pieces of regulatory change, to allow the market time to evolve and to allow an adequate period of time to pass to make meaningful observations of trends and patterns.
PRIIPS, meanwhile, establishes standard disclosure obligations, including a requirement to disclose transaction costs for retail products under scope. It also introduced a requirement for firms to produce, publish and provide a standardised key information document (KID) for PRIIPS. This was so that investors can make better informed decisions by being able to compare key features, risks and rewards of PRIIPS.
Some firms have told us they have concerns about this directly applicable EU regulation. In response, in January we published a statement clarifying some of our views on the KID. We will continue to engage with firms and their trade associations to consider how their concerns may be resolved so that investors get the full benefit of the Regulation. We will also continue to work with the European Supervisory Authorities, and contribute to the European Commission’s post-implementation review of the PRIIPS Regulation.
I want to be clear that I am concerned about PRIIPS, and I know I am not alone. It carries a risk that it is leading to literally accurate disclosure which is not providing useful context, and there is evidence that funds, for instance from the US, are withdrawing from Europe to avoid the burden. I have also heard concerns about performance projections. We all have to take this seriously.
And so, finally, technology. Technology advances are leading to various changes in the investment management sector. There have been significant developments in straight-through deal processing (STP) and distributed ledger technology (DLT). Asset managers continue to look for ways to increase efficiency in their front and back offices. Outsourcing investment administration processes to specialist providers plays an important part in this. The advent of DLT opens the potential for STP to become even more efficient. Potential benefits include more efficient management of counterparty risk, enhanced reconciliation and lower collateral requirements. As regulators, we will be looking at the ability of firms to oversee DLT, STP and other technology-related outsourcing arrangements effectively. There are also questions around accountability, if interruption to these services results in any losses for investors.
Another area of growth is the increasing use of artificial intelligence (AI). Areas using AI include risk management, compliance, investment decisions, securities trading and monitoring, and client relationship management. Investment managers may well have to increase their technology spends to keep up with AI developments. Supervision of artificial intelligence remains a challenge and may also raise issues of accountability.
Growth of online distribution channels and potential channel consolidation could lead to fewer routes to market being available for asset managers. If online distribution is dominated by only a few online distributors their market power may change the value chain dynamics. This could in turn lead to a reduced range of investment products available to investors. Our platform market study, which will publish an interim report in summer 2018, will shed more light on this area.
This could come across as a pretty daunting list of issues. But, look at it another way, as a description it shows just how important asset management is, and the public policy issues that arise.
Asset management is inevitably affected by the big moving parts of our world today: the importance of retaining open markets for financial services; dealing with the challenges of an ageing population in a world of low real interest rates; technological innovation; the shift towards market-based finance following the financial crisis and its implications; and ensuring the industry provides the best service to consumers.
These are very important issues for the FCA.