Major upcoming regulatory initiatives for 2022

Introduction

This OnPoint summarises the panel discussion on the key regulatory initiatives affecting the asset management industry in the EU and the UK. It covers AIFMD II, the next steps in regulation of ESG, and upcoming regulations on crypto assets. The discussion took place on 6 December 2021 between Patrick Goebel (partner, Luxembourg), Cyril Fiat (partner, Paris), Richard Frase (partner, London), Angelo Lercara (partner, Munich) and Ciara O’Leary (partner, Dublin). 

Background

The capital markets union (CMU) is a plan to create a single market for capital. The aim is to get money – investments and savings – flowing across the EU so that it can benefit consumers, investors, and companies, regardless of where they are located. The main objectives are to accelerate the recovery of the COVID-19 downturn and to finance the green and digital transitions.

On 25 November 2021, the EU Commission adopted a package of measures. Within this package, three initiatives will be of particular interest to the asset management industry: 

• Review of the Alternative Investment Fund Managers Directive (AIFMD)¹ – A consultation (the Consultation) was launched on 22 October 2020 by the EU Commission to undertake the first reform of AIFMD. The Consultation was closed at the end of January 2021 and the first draft of a proposal of a new Directive amending AIFMD has been circulated.
• Review of ELTIF – The regulation on European long-term investment funds, a product regulation aiming to provide safe access for retail investor to alternative investment asset classes was also kicked-off. The market has had a mixed response to this regulation.
• Review of MiFIR – the regulations of markets in financial instruments will be amended – trading rules will be adjusted to deliver more transparency for all parties on capital markets.

Alongside to these CMU initiatives, the EU Commission is turning its attention to digital transformation and published in September 2020 its digital finance strategy. This includes a proposal of regulation on markets in crypto assets – MiCA (defined below) – and another regulation on digital operational resilience for the financial sector – in DORA (defined below). These regulations will also have an impact on the asset management industry, albeit crypto assets qualifying as financial instruments will not fall within the scope of MiCA but continue to be regulated by EU securities law, namely, Prospectus Regulation, MiFID, UCITS and AIFMD. In addition, certain national initiatives can be observed which run in parallel to the initiatives of the EU Commission.

Following the UK’s departure from the EU (and the end of the "transition period") on 1 January 2021, the UK is free to follow its own legislative and regulatory path, including in areas such as Environmental, Social and Governance (ESG), the regulations governing managers and developing regulations for crypto assets. Notwithstanding Brexit, the strong interconnection between London and the major EU financial centres cannot been ignored and financial market participants will need to pay close attention (i) to how these EU’s initiatives impact market participants with operations in both the EU and the UK and (ii) how the UK will develop its own regulatory regime outside of the EU throughout 2022 and beyond.

1. SFDR: Where do we stand now and what will be the major steps in 2022?

General development at EU level

SFDR has dominated 2021 and this dominance is going to continue throughout 2022 and 2023. The main operative provisions of the Sustainable Finance Disclosure Regulation² (SFDR), took effect on 10 March 2021 and the initial aim of the legislation was to address the twin objectives of increasing transparency of sustainability-related disclosures and harmonising disclosures for the benefit of end investor.

However, it can perhaps be seen as being more akin to a labelling regime, with market participants seeking to categorise their products as either Article 6, Article 8/Light Green or Article 9/Dark Green as opposed to focussing on the initial objectives behind the legislation.

A key challenge for market participants has been and remains how to accurately classify UCITS and AIFs under SFDR. as either Articles 6, 8 and 9 products. Issues regarding classification continues to create challenges for asset managers owing to the somewhat nebulous concept of "promotion" of environmental or social characteristics pursuant to Article 8 of the SFDR. Although the EU Commission issued some Q&A³ in an attempt to clarify certain priority questions pertaining to the SFDR that the ESMA had raised, several issues and questions remain.

The SFDR mandated the European Supervisory Authorities (ESAs) to draft regulatory technical standards with regard to the content and presentation of disclosures pursuant to articles 8(4), 9(6) and 11(5) of SFDR (RTS). The RTS were initially due to apply from 1 January 2022, but the EU Commission announced on 25 November 2021 that the application of the RTS⁴ would be delayed until 1 January 2023. Without the technical guidance of the RTS, it remains challenging for financial market participants to ensure that they are accurately categorising financial products (defined under the SFDR to include AIFs and UCITS) pursuant to SFDR. The Taxonomy Regulation which enters into force on 1 January 2023 will add a further layer of complexity as it requires additional pre-contractual and website disclosures as well as disclosures in periodic reports.

The focus for 2022 will continue to be classification, with many stakeholders grappling to source the information and data required to fulfil the granular reporting requirements which will come into effect in 2023.

Developments in Germany

The coalition agreement between Social Democrats, Green Party and Free Democrats has a strong climate and energy focus, detailing steps such as phasing out the use of coal ideally by 2030, and a significant expansion of renewable energies. It is challenging to predict whether any gold-plating measures will be added in the next transposition measures in Germany. It is notable that the German financial services regulator, BaFin⁵, watching developments with interest.

Notwithstanding the SFDR and Taxonomy Regulation, BaFin published a draft guideline for sustainable investment funds as part of a public consultation process in the late summer of 2021. The guideline sets out how UCITS and certain AIFs must be structured in order to qualify as "sustainable" or to be marketed as "sustainable" in Germany and aims at preventing 'greenwashing'. "Greenwashing" greenwashing refers to the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally friendly, when in fact basic environmental standards have not been met. The guidance only applies to German UCITS and AIFs which are marketed to the retail market. It is not intended to affect the SFDR nor Taxonomy Regulation. The SFDR and Taxonomy Regulation focus on disclosure and transparency regarding the integration of sustainability risks and adverse sustainability impacts as well as sustainable investment objectives and do not contain any further quantitative or qualitative standards, which according to BaFin leaves a gap. Consequently, BaFin proposes certain thresholds and requirements that UCITs and certain AIFs must comply to be called sustainable or to be marketed as sustainable.

Developments in France

At a first look, the SFDR and the so-called AMF Doctrine⁶ may be perceived as conflicting or confusing, but on closer examination it is noted they have different focuses. The AMF Doctrine’s application is limited to UCITS and AIFs managed in France or marketed to retail investors in France. The AMF Doctrine requires that a financial product being sold as "green" to French retail investors must meet a higher standard than that required under the relevant provisions of SFDR. The AMF Doctrine includes different categories of product, but these categories are not based on, nor linked to the SFDR classification. The AMF Doctrine sets different types of what it is generally called 'buckets'. These buckets are linked to the way extra-financial criteria on the UCITS or the AIF are communicated to investors, and depending on the 'bucket', different minimum investment restrictions (referred to as 'approaches') will need to be applied.

Developments in the UK

The UK has adopted a different approach to ESG compared to the EU, by not "on-shoring" the SFDR nor the Taxonomy Regulation and focusing specifically on the recommendations of the Task Force for Climate-related Financial Disclosures (the TCFD) and its associated report.

In June 2021, the FCA⁷ launched a consultation setting out proposals for enhancing climate-related disclosures by asset managers, life insurers, and FCA-regulated pension providers⁸.

Conceptually, the FCA’s proposals for climate-related disclosures only apply to UK-authorised firms. A UCITS or an EU AIF which is marketed in the UK would not be caught by this regime if it is not managed by a UK manager. Small UK managers are exempted and there is a timetable for larger managers (i.e., managers with assets under management exceeding £50 billion) who must start with disclosures on 30 June 2023.

There are no specific requirements for pre-contractual disclosure, which distinguishes the UK TCFD regime from SFDR. There are a series of categories which are descriptive: (i) not promoted as sustainable; (ii) responsible and sustainable; (iii) sustainable aligned; and (iv) sustainable impact where the impact is deliberately focused on actively achieving sustainability, while the other categories are a sort of on the scale upwards, including transitioning which is second from bottom. As the UK’s intention is not to do something completely different from SFDR, the FCA has provisionally mapped these categories onto article 6, article 8, and article 9 in SFDR. It may be expected that the FCA will align these categories with SFDR as closely as possible. UK firms are sensitive to the idea that they might have to operate under two similar but different regimes and there may be an element of that in due course but that is certainly not something which the FCA is particularly keen on achieving.

Underneath the labelling, there will be two tiers of disclosures. First, there is a consumer-facing disclosure which is the equivalent of a fact sheet, similar to a 'key information document' which will give the investor the key sustainability attributes. Second, there will be a level 2 tier under that, which will have detailed disclosures aimed at institutional and professional investors.

Some of the matters that the FCA and the UK Treasury will be looking at are the treatment of UCITS and non-UK AIFs marketing into the UK. Although the regime does currently not impose any specific requirements for UCITS and EU AIFs, it may dovetail with the funds equivalence regime that is also currently in development.

The FCA and the UK Treasury are also looking at how to deal with the investment chain. Advisers who are between the financial product provider and the investor would also be impacted.

The timetable for of the UK TCFD regime is finalised. Effective from 1 January 2022, rules come into force for asset managers with assets under management (AuM) of more than £50 billion, with first disclosures to be published by 30 June 2023. Subsequent disclosures would be made by 30 June each calendar year. The second phase of application is effective from 1 January 2023, when the rules will take effect for the remaining firms above the proposed £5 billion AuM threshold for both asset managers, with first disclosures to be published by 30 June 2024. Subsequent disclosures would be made by 30 June each calendar year thereafter.

2. AIFMD II

General

Article 69 of the AIFMD mandated the EU Commission to review the application of the scope of the AIFMD by 22 July 2017. As part of this review, the EU Commission published several reports and consultative documents which resulted in the publication of its first draft proposal on 25 November 2021 (the Draft Directive)⁹, which is the starting point of the EU legislative process. In terms of timing, based on previous experience, it is anticipated that an agreement will on the Draft Directive will be reached by mid to end 2022, leading to publication of the final directive in the official journal of the EU in early 2023. Member States will then have 24 months to implement the changes. This means the proposals set out in the Draft Directive, if adopted, are likely to start applying from the end of 2024 or early 2025. Application is not imminent, but firms would be wise to start preparing now.

It is also important to note that the EU Commission is proposing similar changes to the UCITS Directive on delegation, liquidity risk management, data reporting for market monitoring purposes and regulatory treatment of custodians. Below we summarize just a few of the changes based on the current draft of the proposed Draft Directive.

Delegation

Prior to the publication of the Draft Directive, there was a lot of speculation and concern that significant amendments would be made to the existing delegation framework. This was largely as a result the ESMA Opinion on supervisory convergence in the area of investment management following Brexit issued in 2017 and also the August 2020 letter from ESMA sent to the EU Commission¹⁰ stating that, in ESMAs view, there should be additional legislative clarifications in the AIFMD framework in relation to delegation and substance requirements. UK, US and other third country managers doing business in the EU were closely following the initiatives to see if they would result in further measures to regulate delegations outside of the EU. The positive news is that Draft Directive does not propose fundamental changes to the delegation framework, something that has been welcomed by the market. There are three points which are worth mentioning in relation to delegation:

• The first point is substance. The Draft Directive includes a specific requirement that an EU AIFM must have two full-time staff based in the EU. This does not seem now wildly out of line with what is already required in Luxembourg and Ireland which to already have requirements on substance.
• The second point is delegation itself. For the moment, the Draft Directive does not include quantitative controls on what can be delegated (e.g., there is no limitation on the percentage of activities which can be delegated). There are however more onerous reporting requirements where more risk or portfolio management is delegated than retained. The Draft Directive proposes that competent authorities give annual notice to ESMA of delegation arrangements where more risk or portfolio management is delegated to third-country entities than is retained. There are also provisions for ESMA to develop regulatory technical standards on the content and procedures relating to what is reported. There are also proposals for further reviews by ESMA of how this monitoring pans out in the future and it is likely that there will be increased emphasis on monitoring of third country delegation arrangements.
• The third point concerns the requirements under article 20 of AIFMD. Currently, it is not entirely clear what is covered by delegation within the scope of article 20. The Draft Directive specifically says that all functions listed in annex I of AIFMD, including the ancillary services, will fall within the scope of article 20 of AIFMD. This may have some practical consequences, but the full impact will not be known until all the details have been worked through. As an example, annex I of AIFMD includes legal advice and legal services, and it is questionable whether an AIFM will have to go through the requirements of article 20 with a law firm. Another example concerns individual portfolio management and investment advice provided under article 6 (4) of AIFMD and which are generally designated as "MiFID top-up services".

Liquidity Management

Another change proposed in the Draft Directive which may affect not only the internal organization of AIFMs but also the structuring of AIFs, relates to liquidity risk management. Additional requirements were recommended by the European Systemic Risk Board and ESMA, drawing on lessons learnt during COVID crisis.

Of note, the Draft Directive proposes that an AIFM that manages an open-ended AIF must select at least one appropriate liquidity management tool (LMT) from a list (to be set out in a new Annex V) for possible use in the interest of the AIF’s investors – this is in addition to being able to suspend redemptions. The AIFM must also implement detailed policies and procedures for the activation and deactivation of its selected liquidity management tools and the operational and administrative arrangements for their use.

The Draft Directive also includes provisions enabling the competent authorities to require that an AIFM activates or deactivates a relevant LMT, a power which is expressed to extend to cover non-EU AIFMs. Whether competent authorities will wish to be able to enforce the activation of LMTs – which may not be in the fund documentation – remains to be seen.

Loan Origination

Although the AIFMD’s principal aim is to regulate managers and only indirectly the products, the Draft Directive includes proposals to set a certain number of minimum requirements on loan originating AIFs, that have become an important source of financing - especially for small and medium companies whose post-COVID recovery is now considered of utmost importance.

The proposed amendments include that:

• loan origination will be identified as a new permitted activity for AIFMs as listed in annex I of AIFMD.
• AIFMs that engage in direct loan origination and purchase of loans in the secondary market must add policies, procedures, and processes in place for the granting loans, assessing credit risk and administering and monitoring the credit portfolio. These policies and procedures will need to be put in place at the time the AIF is established and there will be an express requirement to keep those policies and procedures under regular review, and in any event at least once a year.
• new transparency requirements will be introduced to provide information on AIF loan portfolios that will be fed into investor disclosures, and also made in the form of reporting to competent authorities.
• to limit conflict of interest, AIFMs and their staff should not receive loans from loan-originating AIFs that they manage. Similarly, the AIF depository and staff or the AIFM delegate and its staff should be prohibited from receiving loans from the associated AIFs.
• any AIF which engages in loan origination to a "significant extent" - is defined as the notional value of the loan origination being at least equal to 60% of the NAV - must be established as a closed-ended AIF.
• an AIF must retain 5% of the notional value of loans it has originated, and subsequently sold on the secondary market. Note this requirement does not apply where the AIF has purchased the loan on the secondary market and did not originate the loan.
• limits to the extent to which such AIFs may directly originate loans to financial institutions, a proposal likely to be linked to the concerns around financial stability risk.

The Draft Directive proposes other amendments which are discussed in detail in our OnPoint "AIFMD – the EU Commission publishes its proposals for reform of the AIFMD"¹¹.

3. Regulation of crypto assets

General

Crypto assets are broadly defined as "digital representations of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology." Regulation of crypto assets remains high on the regulatory agenda.

As part of the EU’s digital finance package, the EU Commission adopted two legislative proposals in September 2020 (i) a proposal for a regulation on digital operational resilience for the financial sector - EU Digital Operational Resilience for the financial sector (DORA), the aim of which is for participants in the EU financial sector to be subject to a common set of rules to mitigate information communication technology risks; and (ii) a proposal to create a harmonised framework for the regulation of crypto assets across the EU, including a regulation on markets in crypto assets (MiCA). MiCA is intended to create a new EU legal framework for crypto assets that are outside existing EU financial services legislation, and so currently unregulated, as well as to introduce rules for stablecoins.

MiCA provides for a prospectus regime for the issuing of crypto assets. MiCA will apply to any person providing crypto assets services or issuing crypto assets in or to the EU. Custody and administration of crypto assets, operating trading platform for crypto assets, exchange of crypto assets with fiat assets or with other crypto assets, the execution of orders for crypto assets on behalf of third parties, the placement of crypto assets and the reception and transmission of crypto assets as well as the advice on crypto assets will be regulated by MiCA. The good news is that a passport will be granted to provide these services across the EU. Notably, MiCA will not apply to security tokens which generally falls within the scope of the Prospectus Regulation and MiFID.

Supervision of crypto asset service providers will be entrusted to the national supervisory authorities and supervision of significant asset-referenced and e-money tokens will be in the hands of European Banking Authority.

Developments in Germany

The German legislator has already taken certain steps to address crypto assets and BaFin has been very active in issuing guidance in this regard. One of these measures consisted in introducing crypto custody business in the German Banking Act as a financial service resulting companies providing crypto custody business to be authorised by BaFin.

Furthermore, the possibility has been introduced for certain German domiciled institutional open-ended funds (which are the predominant form of investment vehicle for institutional investors) to invest up to 20% of their assets into crypto assets. The aim being to enhance Germany’s position as a crypto assets domicile for institutional investors and more generally boost the crypto assets industry in Germany.

Another important piece of crypto asset related legislation is the Electronic Securities Act, which entered into force 10 June 2021. This act enables digital securities to be issued without the need for those securities to be evidenced by a certificate. The impact is that it is now possible to issue securities using distributed ledger technology (DLT) – for example, blockchain technology. The issuance will take place via electronic securities registers, which will be kept in the form of crypto security registers. The crypto security registers can be maintained by the securities issuers themselves, provided that BaFin has granted those issuers the requisite permission. For the time being, the provisions of the Electronic Securities Act apply only to debt securities. Shortly before being released, a provision was added to the Electronic Securities Act that serves as the legal basis for creating electronic fund units which will be registered in a decentralized register. The draft regulation released by the German Treasury in September 2021 for consultation, provides that the funds' depositaries (i.e. credit institutions and large securities providers) will be required to maintain the crypto register.

Developments in France

France would argue that it is a forerunner in regulation of ‘digital assets’, which includes both crypto assets and tokens. In the last three years there have been several legislative developments that have established a framework for the issuance of mutual tokens, initial coin offerings, and that have also created statutes for the regulation of digital assets services providers, which includes a licensing and registration regime. The licence regime that is voluntary for digital asset service providers, who will be subject to a core set of rules for all services and specific rules for a particular offered service. There is also a mandatory registration regime for digital asset service providers who wish to (i) provide crypto asset custody services, (ii) purchase and sell crypto assets for legal tender and offer a crypto asset exchange service and (iii) operate crypto asset trading platforms.

Developments in the UK

In comparison to the EU and certain of its member states, the UK is moving more slowly in terms of legal and regulatory proposals on crypto assets. Consultations relating to how to regulate crypto assets have been developed. While there is no doubt that regulation will come, the FCA is currently focusing on investor protection and preventing the harms that may come from crypto asset-based scams, which are extensive in the UK at the moment.

Endnotes:

1) Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.

2) Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector, as amended by Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation).

3) See our OnPoint "EU Commission Publishes Q&A on the application of SFDR".

4) See our OnPoint "Application of RTS under the SFDR – further delayed to 1 January 2023".

5) Bundesanstalt für Finanzmarktaufsicht, the German supervisory authority for financial services.

6) Please see our OnPoint "AMF ESG Doctrine: Goldplating SFDR by another name?".

7) UK Financial Conduct Authority, the supervisory authority for financial services in the UK.

8) Please see our OnPoint "FCA Consultation on Enhancing Climate-Related Disclosures by UK Asset Managers".

9) The package of measures is available here.

10) ESMA’s letter is available here.

11) The OnPoint is available here.