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Making sense of regulatory change

2014 Regulatory Field Guide

PART 1: KEY REGULATORY EVENTS FOR 2014

Mercurial regulatory change over the past five years has posed challenges for global asset managers, and 2014 will finally bring some certainty to the industry with the implementation of several important regulations. In the US, after almost four years of preparation, the Foreign Account Tax Compliance Act (FATCA) comes into force. In the EU, the controversial Alternative Investment Fund Managers Directive (AIFMD) will be fully live in July. Globally, the movement of over-the-counter (OTC) derivative transac-tions into central clearing will progress this year. In this first part of BBH’s Regulatory Field Guide, we identify key regulatory issues that will impact asset managers’ busi-ness models in 2014 and offer guidelines to manage the new regulatory complexities.

FATCA ......................................... 3-4

OTC Clearing and AIFMD .......... 5-7

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Executive SummaryRegulatory change has been a constant challenge for global

asset managers since the onset of the 2008 financial crisis.

This regulatory activity is chiefly concentrated in the North

Atlantic, specifically the US and Europe. Given the severity of

the financial crisis in the region, this is understandable. Overall,

there have been four themes to the post-crisis North Atlantic

regulatory push:

• Increased investor protection• Increased market harmonization• Increased transparency• Decreased systemic risk

Policymakers have approached these themes with literally dozens of regulatory initiatives and proposals. Beyond the sheer volume of change, the other main challenge of navigat-ing the post-crisis regulatory agenda is dealing with regula-tory uncertainty. Much regulatory work remains unfinished, which makes it difficult for asset managers to fully assess the effects of regulatory change and sufficiently plan for the future. However, this year, some uncertainty will dissipate as some of the larger regulations are implemented.

In the US, after almost four years of preparation, the Foreign Account Tax Compliance Act (FATCA) comes into force. In the EU, the controversial Alternative Investment Fund Managers Directive (AIFMD) will be fully live in July. Globally, the move-ment of over-the-counter (OTC) derivative transactions into central clearing will progress this year. For most global asset managers, these regulations will impact their operating models and product strategy.

Despite the implementation of the above regulatory initiatives, there remain major pieces of regulatory change outstanding. Thematically, the key issues policymakers will address in 2014 include:

• Money market fund reform • The evolution of the UCITS framework

• The investment product complexity debate • The systemic importance of asset managers

Finally, unlike the North Atlantic regulatory agenda’s focus on boundary setting, the Asian regulatory agenda is focused on market liberalization and product opportunity. The key regu-latory focus in the region includes the continued expansion of China’s Renminbi Qualified Foreign Institutional Investors (RQFII) program, and the race to create a regional cross-border fund alternative to UCITS, which is currently the preeminent cross-border vehicle in the region.

As this era of increased regulation persists, we must keep a close eye on developments. To assist asset managers in navi-gating the world of regulation, we present our two part 2014 Regulatory Field Guide. Part one discusses key regulatory events in 2014 and part two focuses on the regulatory devel-opments that lie on the horizon.

Throughout the two papers, BBH will share its perspective and outlook on the regulatory landscape to help global asset man-agers take a step back and consider what the next year holds for regulatory change, and what the longer-term implications are for these new rules.

For more information on regulatory trends and developments, please click here to read previous GlobalView articles and BBH industry publications.

Sean M. Tuffy

Vice President, Head ofRegulatory Intelligence

sean.tuffy@bbh.com

+353.1.603.6316

@SMTuffy

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Key Regulatory Events for 2014Several major regulatory projects will come to fruition this year. For many in the industry, it is the culmination of years and long hours of working groups and project meetings. Each of the three major pieces of regulations coming into force—FATCA, OTC Clearing, AIFMD—will affect global asset managers and the industry differently, but all regulations will, in their respective ways, reshape organizational behavior and industry parameters for years to come.

FATCA

The US Foreign Account Tax Compliance Act’s (FATCA) broad effects, impending deadlines and administrative guidance lags still concern the financial industry. Enacted to combat tax evasion by US persons using offshore accounts, FATCA requires ‘foreign financial institutions’ (FFIs), including non-US banks and investment funds, to identify and report information on US account holders to the US Internal Revenue Service (IRS). FFIs have much incentive to comply with FATCA; failure to participate triggers a punitive 30 percent withholding tax on both US source investment income and US securities sale proceeds. To comply with FATCA and its complex rules, global financial institutions with American investments must effect major changes to their accounts onboarding, withholding and reporting capabilities.

The US government is using intergovernmental agreements (IGAs) to implement FATCA globally. IGAs were initiated to address FATCA’s conflicts with local laws, then expanded to incorporate alternative means of achieving FATCA goals through simplified procedures, coordinated implementation, and gov-ernment-to-government information exchange. FFIs domiciled in non-IGA countries must forge a binding agreement with the IRS and adhere to FATCA regulations. FFIs domiciled in IGA countries may not be required to contract with the US IRS, but must adhere to IGA terms and local rules enacted to support FATCA.

To ensure compliance, FFIs must develop or outsource FATCA-specific capabilities in three core areas:

• Account due diligence• Withholding• Information reporting

Account Due DiligenceStarting 1 July 2014, FATCA account due diligence will affect all US and non-US based institutions. Its complex standards will deviate significantly from existing ones, imposing an ongoing mandate to track newly issued identifying numbers, as well as changes in account holder circumstances. Changes in those

FATCA IGAsAs of February 2014, the following jurisdictions have formally signed intergovernmental agreements with the U.S.

• Bermuda• Canada• Cayman Islands• Costa Rica• Denmark• France• Germany• Guernsey• Hungary• Ireland• Isle of Man

• Italy• Japan• Jersey• Malta• Mauritius• Mexico• Netherlands• Norway• Spain• Switzerland• United Kingdom

Stephen VescioSenior Vice President Global Tax Services stephen.vescio@bbh.com +1.617.772.6818

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circumstances must be reviewed to determine their effect on the account holder’s FATCA “status.” Institutions will also be required to scrutinize many entities to the extent of their US owners, introducing the need to retain and logically track much more accountholder data.

WithholdingBeginning 1 July 2014, FATCA withholding may be required in the case of FFIs’ noncompliant accounts. Institutions will thus need to either build or re-engineer withholding systems and change operating models to accommodate both an increase in regulatory scope and FATCA-specific processing logic.

Information ReportingFATCA reporting is required for certain 2014 calendar year amounts, and all affected financial institutions must report under FATCA. In fact, FATCA requires far more information report-ing than the current nonresident tax regime, including account balances and other amounts not in the scope of existing U.S. tax reporting rules, such as non-US source payments and sale proceeds. Institutions will need to capture 2014-onward tax amounts paid to FFIs’ US and non-FATCA compliant account holders, which are FATCA’s “persons of interest”

Beyond significantly altering the US nonresident tax landscape, FATCA has triggered nations worldwide to consider the effect of global financial account holdings on their residents. Recently, the United Kingdom implemented an exchange of information regime with Crown Dependencies. Similar information exchange mandates are also being considered in an ongoing Organization for Economic Co-operational and Development (OECD) initiative.

It would behoove institutions to ensure they understand tax information reporting requirement changes, fully assess FATCA’s effects on their business, initiate building or buying in compli-ance solutions, and engage with service providers, counter-parties, and depositories to ensure coordination and mitigate unintended withholding effects.

“ The increase in recent regulatory reforms has expanded financial firms’ reporting burdens, making data management strategies a key institutional priority for years to come.”

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OTC CLEARING AND AIFMD IMPLEMENTATION

OTC ClearingIn 2009, the G20 committed to improve transparency and reduce risks associated with the derivatives market. Last year, the US, through the Dodd-Frank legislation, made great strides in moving over-the-counter (OTC) derivatives to central clear-ing. This year, European regulators will take similar actions. The European Market Infrastructure Regulation (EMIR) is the EU’s response to the G20’s commitment on derivatives. EMIR applies to any EU entity that has entered into a derivatives con-tract and applies indirectly to non-EU counterparties trading with EU parties. EMIR introduces three key requirements:

• Central clearing for all eligible OTC derivatives,• Reporting of all exchange traded and OTC derivatives to

a trade repository,• Risk mitigation requirements for non-centrally cleared

derivatives.

EMIR obligations are being phased in over three years. While certain risk mitigation techniques took effect in 2013, most of the requirements have yet to come into force. Trade report-ing that lets regulators monitor systemic risk buildup in the derivatives market will be rolled out in the first quarter of 2014. Despite initial uncertainty about the reporting deadline, coun-terparties must begin exchange-traded and OTC-derivative

reporting by 12 February 2014. The increase in recent regula-tory reforms has expanded financial firms’ reporting burdens, making data management strategies a key institutional priority for years to come. EMIR specifically requires details on both the parties themselves and their to-be-reported trades. EMIR reporting entails disclosure of 85 fields of data. Information on any derivative contracts concluded, modified or terminated must be reported no later than the working day following the transaction event. To manage these new, complex reporting duties and ensure accurate, timely data filing, firms must know their responsibilities and have effective strategies in place.

Although reporting obligations have been causing a stir for market participants, central clearing is without doubt the key component of EMIR. Central clearing is an essential element in the effort to reduce counterparty credit risk in the OTC deriva-tives market. Historically, OTC derivatives have been cleared bilaterally. In the new clearing model, a central counterparty (CCP) will stand between the parties to the trade, shielding each from the risk of the other party’s default. The CCP effec-tively becomes the buyer to the seller and the seller to the buyer. To cover a clearing member’s potential future default, CCPs will demand more frequent collateral posting of higher-quality assets. This could have serious implications for collat-eral management and market liquidity, which has been chris-tened the “collateral crunch.” The new clearing environment will impact portfolio decision making, and, to circumvent new clearing costs, managers may turn to equivalent products offer-ing the same exposure.

Niamh GibsonAssistant Vice President Market Intelligence Group niamh.gibson@bbh.com +353.1.603.6364

KEY 2014 EMIR DATES

12 February 2014 Reporting deadline for all derivative contracts entered into from 12 February 2014

15 March 2014 National competent authorities to authorize CCPs

12 May 2014 Reporting deadline for all contracts open as of 16 August 2012 and still outstanding as of 12 February 2014

15 September 2014 ESMA to submit draft technical standards on the clearing obligation to the European Commision

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Not all trades are eligible for EMIR clearing. In 2013, the International Organization of Securities Commission (IOSCO) issued final rules outlining margin requirements for uncleared trades, which will be phased in beginning December 2015. However, margin requirements for cleared swaps are expected to commence toward the end of 2014. Given the timing discrep-ancy in the margin requirements, trading in uncleared trades will likely far outnumber cleared trades until the requirements are synchronized in 2015.

Similar to the reporting obligation, some ambiguity surrounds the timeline for EMIR central clearing, which is scheduled to take effect in mid-2014, however this timetable is beginning to unravel. The more likely scenario is that central clearing will start in 2015. While the initial G20 target date for clearing was the beginning of 2013, few countries met this deadline. Nations that have adopted central clearing include India, Japan, Singapore and the US.

AIFMD Implementation The Alternative Investment Fund Managers Directive (AIFMD) entered into force in July 2013, but most industry participants will tackle it in earnest starting this year. AIFMD allows both EU and non-EU managers transition periods. For the former, that period ends in July 2014; for the latter, July 2015.

In the cross-border fund industry, the three major jurisdic-tions—Ireland, Luxembourg and the United Kingdom—have announced AIFMD application deadlines in advance of the EU manager transition period’s end. The application dates for AIFMD authorization are:

• United Kingdom: 22 January• Ireland: 21 February• Luxembourg: 01 April

Between now and July, affected asset managers will need to:

• Change service, outsourcing and custody/prime brokerage agreements;

• Formally appoint a depositary, a new requirement for many alternative funds;

• Review their remuneration packages to ensure that they meet AIFMD requirements;

• Confirm their readiness to comply with the transparency and reporting requirements.

For most of 2014, the asset management industry will respond tactically to the AIFMD, focusing on ensuring compliance with the directive. However, after the regulation is fully imple-mented, the industry will examine some strategic questions in response to the AIFMD.

AIFMD TIMELINE

July 2013

AIFMD Implementation Date, Passport made available to EU AIFMs

Jan. 2014 UK deadline for AIMFD applications

Feb. 2014Ireland deadline for AIFMD applications

Apr. 2014Luxembourg deadline for AIFMD applications

July 2014End of AIFMD transitional period for EU AIFMs

July 2015ESMA to reports on extension of passport to non-EU AIFs and AIFMs

2016Possible extension of passports to non-EU AIFs/AIFMs

2017Review of AIFMD by EU Commission

2018

ESMA to review passport regime and possible end of all national private placement regimes

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ConclusionThe implementation of this regulation trio – FATCA, OTC Clearing, AIFMD – brings a conclusion to several years of debate and preparation. Looking the trio, each has a key deliverable that will hit in the next 2-4 months.

• FATCA: Asset managers need to ensure that they have registered their FFIs by 25 April 2014. • OTC Clearing: Under EMIR, asset managers need to ensure they are reporting appropriately, including being prepared for the

May 2014 back loading reporting date. • AIFMD: EU asset managers need to ensure that they receive AIFMD authorization by 22 July 2014.

Though these regulations all have separate policy goals, they are united by a common element: each has extraterritorial implica-tions. This demonstrates the global nature of the asset management industry, and how increasingly the regulation of the indus-try is becoming global. This extended dimension of regulation means that industry participants must pay as much attention to regulatory developments abroad as at home. Equally, it underscores the need for international regulatory cooperation so that the rules in one jurisdiction do not conflict with the rules in another.

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