Luxembourg fund industry wary of watchdog's focus on 'delegation'
Luxembourg's fund industry is wary of being caught in the crosshairs of a European regulatory battle over the use of 'delegation' by asset managers in the wake of Britain's vote to leave the European Union (EU).
The practice, employed by many Luxembourg-domiciled funds, of delegating functions such as investment management and risk management back to a home country has attracted greater scrutiny from regulators concerned about a 'race to the bottom' on standards, as countries compete to attract fund managers setting up new European bases after Brexit.
In July, the European Securities and Markets Authority (ESMA) issued guidance on investment fund relocations from the UK.
This guidance warned against the creation of so-called "letterbox entities" through excessive delegation and conferred "strict conditions" on outsourcing to third countries located outside the EU.
The regulatory focus on delegation has left many fund managers "deeply worried", according to a survey by UK trade body The Investment Association – and any attempt to rein in the practice would have huge implications for Luxembourg, where delegation forms the backbone of the fund industry.
Despite being the second largest fund domicile hub in the world, Luxembourg largely outsources investment management to other financial centres. The UK alone managed £350 billion (€398 billion) on behalf of fund ranges in Luxembourg in 2016, according to the Investment Association.
There are mutterings in the industry that any changes to the rules on delegation would benefit larger European countries such as France, which, since the Brexit vote, has been pushing for the wholesale relocation of financial firms from London – rather than the bulking-up-of-operations approach preferred by Luxembourg.
"Political elements may not necessarily totally be absent here," said Freddy Brausch, Global Co-Head of the Investment Managers Sector for Luxembourg at law firm Linklaters.
"[But] I don't think the industry, at large, is in a position – and is willing – to give up something that works."
Industry experts say ESMA's guidance has not, in itself, rewritten the rules on delegation, with Braush rejecting the notion the guidance represents a "fundamental challenge" to the practice.
"In the future, it should remain an acceptable way to operate, where delegation is needed to make good use of specialist skills where they are, including in third countries," he said. "The model should be preserved."
Luxembourg's financial regulator, the Commission de Surveillance du Secteur Financier (CSSF), said in July that the principles were "in line with the CSSF's practice".
However, ESMA's guidance arguably went further than the existing rules on delegation for retail funds under UCITS legislation, as well as for alternative funds under the Alternative Investment Fund Managers Directive (AIFMD) – raising questions as to whether the regulatory body, based in Paris, may have overstepped its authority.
"The version of the text that has been published for me is fine – they haven't crossed any lines," said Charles Muller, a partner at KPMG specialising in investment management.
"But I know the initial discussion was to go further and to create more stringent conditions for delegation.
"The delegation principles are in the European texts – in UCITS and AIFMD – so any changes to these principles need to be done at the same level."
As a result of the guidance, asset managers in Luxembourg should consider hiring a senior manager to oversee portfolio-management functions, one industry source said, to head off any future accusations of insufficient investment oversight.
A particular area of concern for Luxembourg is the scope of the guidelines.
ESMA suggests extra scrutiny should be applied by regulators when activities are delegated to a "third country", which would include the UK once it leaves the EU in 2019.
"This is the first time we see there might be the view of some that, if you delegate to non-EU players, you should probably have a closer look," said Marc-André Bechet, Director Legal & Tax at the Association of the Luxembourg Fund Industry (ALFI).
The Luxembourg trade body said ESMA's guidance, issued in the context of UK relocations, could apply to a broader set of asset managers, including those from Switzerland, the US and Asian countries.
"Because the opinions are issued in the context of UK firms considering relocating in the EU, other stakeholders that aren't UK entities relocating to Europe may ask themselves whether they must look at these guidelines, this opinion," said Bechet.
"On a broader picture, one may assume these guidelines obviously give an indication of what the European authority is expecting (one) to do, generally speaking."
While ESMA's guidance is unlikely to shift current standards dramatically when applied in Luxembourg, the principles have created a sense that delegation is now in the sights of Europe's regulators and could get caught up in a bigger political fight over the spoils of Brexit.
(Hannah Brenton, firstname.lastname@example.org, +352 49 93 728)