The COVID-19 pandemic has resulted in unprecedented disruption to daily life as well as significant upheaval in both the real economy and the financial markets. That said, unlike the 2008 global financial crisis, this crisis does not stem from asset quality or credit concerns and, despite sharp increases in market volatility initially, the UK regulator, the Financial Conduct Authority (FCA), has indicated that UK markets have been, broadly, operating in an orderly fashion. Nonetheless, the current situation is anticipated to cause significant economic damage and a global recession that may well be more severe than that experienced after the global financial crisis.
Alongside other financial institutions, UK, as EU-based, asset managers are having to deal with the impact of COVID-19 across all aspects of their business operations. Recognising the significant challenges that financial institutions are facing, the FCA has stated that it wants to see firms continue to operate and will be flexible in how it regulates them. That said, the regulator has also made clear that it expects firms to take all reasonable steps to meet their regulatory obligations to protect consumers and market integrity; provide strong support and service to their customers and clients; and manage their financial resilience and liquidity. A number of key issues arise for asset management firms, including the following:
Operational challenges: With many employees, including portfolio and risk managers, working remotely from home, daily compliance monitoring and supervision becomes a challenge. Firms will need to ensure that the increase in remote working does not compromise their operational resilience or cyber security and will need to enhance relevant systems and controls if necessary. As many asset management firms rely heavily on third party service providers, ranging from custodians to technology providers, they will need to be vigilant in continually assessing the service levels of those service providers which are themselves under increased operational and compliance pressures.
The FCA has sought to address certain operational challenges in relation to fund administration and has set out its expectations in relation to regulatory requirements in the current environment. These include, for example, its confirmation that virtual meetings with unitholders are permitted to facilitate investor approval where needed, provided these operate in accordance with investor documentation.
Liquidity management: A fund’s ability to manage liquidity may come into sharp focus during the current situation if redemption requests increase as investors seek to cut losses and increase or preserve their cash holdings. This in turn may trigger further redemption requests from other investors for the same reason. To illustrate this with an example, ESMA stress tests estimate that up to 40% of high yield bond funds will face liquidity issues in a severe redemption ‘shock’ scenario.
Funds with fairly illiquid underlying assets, such as property funds, have already had to suspend redemptions, although, so far, these have been triggered more by valuation uncertainty than an increase in investor redemptions. The FCA has recognised that suspensions may, in these circumstances, be an appropriate measure to protect the interests of investors, provided they are implemented in accordance with applicable regulatory obligations. However, with sharp falls in prices across many asset classes, more funds may face the difficult choice of suspension to preserve value for continuing investors or having to sell in a distressed market to satisfy increasing redemptions.
Investment strategies: If asset values fall further, firms may have to consider more extreme defensive measures in order to preserve investors’ cash which may involve a deviation from their stated investment policies. This may require analysis of their investor documentation (including prospectuses and retail customer documents) to identify whether such approaches match customer disclosures and if not, careful consideration of the disclosures required to communicate any changes openly and transparently to their clients. The FCA has also issued guidance in relation to client communications, particularly those with retail investors, and how firms can provide information on the performance and value of clients’ investments without this constituting investment advice for regulatory purposes.
Short selling and market trading: certainly initially, firms were facing a difficult challenge to manage their investments in the context of regulatory action to reduce market volatility which then, in turn, affected ongoing market operations. ESMA lowered the threshold for net short position notifications under the EU Short Selling Regulation from 0.2% to 0.1% of issued share capital and the FCA applied that threshold in the UK. A number of EU member states initially introduced and then extended short selling bans and the FCA followed these in relation to relevant shares. Those bans have now been lifted in certain jurisdictions, which is a positive sign of countries’ growing confidence in market stability and orderly operation.
The UK did not introduce a short selling ban and the FCA has made it clear that its focus is on maintaining open markets and that, consistent with its approach to date, it will only impose a short selling ban on UK shares if it considers that this is appropriate weighed up against the assistance that short selling provides in terms of liquidity provision, effective price formation and risk management.
Reporting requirements: ESMA has issued statements postponing the implementation of reporting requirements under the EU Securities Financing Transactions Regulation (SFTR) and MiFIR to July 2020, and the requirement to provide best execution reports under MiFID II to June 2020. It has indicated its expectation that regulators will not prioritise these obligations until the new deadlines.
The FCA has indicated its support for ESMA’s approach and compliance with it but also indicated its expectation that firms will continue planning to meet the SFTR and MiFIR requirements from the new deadlines. It also expects firms to continue meeting their best execution obligations under MIFID II, but has indicated it will not take enforcement action against any firm provided the required reports are submitted by the new deadline.
More generally, while there may be delays in complying with reporting obligations in relation to trades, the FCA notes that firms should continue to maintain records, monitor calls, and take all reasonable steps to prevent market abuse risks, although it acknowledges that, with current working arrangements, firms may not always be able to record all calls and asks that they consult with the FCA if unable to meet these requirements.
Wider issues: In addition to these operational and business-specific challenges for asset managers, certain industry-wide ‘existential’ issues may also come to the fore during the current situation. These include, for example, the challenges of providing a reliable store of value in extremely volatile market conditions, the collapse in value of certain asset classes and investors’ need for greater liquidity. Firms’ commitment to shareholder engagement and ‘responsible’ investing may also be tested as they work out which companies they should support and allocate capital to: those companies with the best sustainable investing record may not be the companies in need of substantial capital to survive the crisis, and vice versa.
© Slaughter and May 2020
In addition to these operational and business-specific challenges for asset managers, certain industry-wide ‘existential’ issues may also come to the fore during the current situation.