ILA/PwC Fund Day – best attended yet

A sold-out ILA/PwC Annual Fund Day attracted a record 230 people. The conference focused on major fund governance challenges, giving overviews and practical pointers addressing key topics. Highlights were two panels featuring senior CSSF staff, plus updates on AML procedures, sustainability, delegation management, liquidity risk, due diligence, board effectiveness and more.


CSSF’s Marco Zwick on fund regulation challenges

Online regulatory filing, liquidity regulations, closet index tracking, and, of course, this year’s FATF visit were all discussed in the opening session: an interview with CSSF director Marco Zwick.

Streamlining how industry players interact with the CSSF is a priority, to boost efficiency and make data easier to manage and understand. They have big plans to develop the E-Desk Portal which went live in November. This seeks to make it easier to file applications and reports, with functionality such as instant messages pointing out if information is missing, and the ability to track the progress of a file. 


Liquidity, closet trackers, reform of circulars

After last year’s fund blow-ups, ESMA has been looking again at liquidity risk management. However, Mr Zwick believes: “this problem is not triggered by the regulations themselves–I would simply call it the result from fraud.” As for liquidity stress tests, he said the results of the ESMA version “were not bad” in relation to Luxembourg, and that the CSSF was also conducting a similar process. However, he questioned the practicality of conducting these tests on every fund. 

Another question that has resurfaced relates to so called “closet index tracking” where ostensibly actively managed funds in practice employ passive strategies. Mr Zwick said “the CSSF has not so far identified this as a massive problem,” nevertheless he asked boards to be vigilant. He pointed out that on occasions–such as during market stress–taking a passive stance for a short while might be acceptable practice. Yet this needs to be decided by fund boards and disclosed to investors. 

There are no plans for major new circulars this year, There will be some updating and tidying up of existing rules, particularly around AML within circulars 18/698, 17/650 and Regulation 12-02. Also the 02/77 investor protection circular is set for a make-over. Mr Zwick noted with satisfaction that many of these frameworks have become globally respected standards that other jurisdictions have followed.

FATF: a challenge for Luxembourg

Which led the discussion to major topic of the year: the FATF 4th round of mutual evaluations into AML/CTF rules and procedures Luxembourg, which will take place in October/November this year. “Given how important this is, preparation is an exercise for the whole of Luxembourg and not just the CSSF or financial sector,” Mr Zwick said. The challenge is particularly great as the FATF has identified the global asset management, private banking and trust company sectors to be at particular high risk of money laundering. Of course these three are specialisations of the Luxembourg financial sector.

So far the CSSF know the names of the people from the FATF Secretariat who will be leading this review, with more details to follow when their scoping note is published. Meanwhile, the National coordinator at the Luxembourg Ministry of Justice has been appointed: substitut principal Michel Turk.

Testing AML/CFT effectiveness

Unlike when the FATF came a decade ago, this will not be just a technical review of legislation and regulations, but will study the practical effectiveness of these rules. Boards find themselves at the centre of these discussions, with Mr Zwick expecting some directors to be questioned by the FATF team. “They will not be looking for perfection, but they will want to see examples of how you handled challenges, if you asked the right questions, whether you are clear about risk assessments and so on,” he said.

He also pointed out that individual companies’ risk assessments would ideally be in line with the national and the fund sectoral risk assessments. The private banking and funds paper have been released recently and should be studied. “If your risk appetite is radically different from the national risk assessment then this could lead to more questions,” he explained.

Engaging with industry

More broadly Mr Zwick says the CSSF will seek to engage with the local industry, giving feedback on AML/CFT procedures via conferences and other forms of outreach. Also, to gauge the state of the market they will conduct their third AML/CFT questionnaire in February this year–a similar approach was adopted to the previous two exercises. In particular, take aways from this will be discussed at a conference planned for March-April. Data from these surveys and external audits will also inform the CSSF’s risk based approach to regulation. 

Boards also need to act wisely regarding the register of beneficial owners, he said. For publicly distributed funds with thousands of shareholders, it is in line with the EU directive and national law that board members should be listed as beneficial owners. However, for small funds where a few real beneficial owners exist and can be identified such as for dedicated investment funds for example, “boards should not accept to be listed on the register when the beneficial owner is clearly known. Otherwise you would be helping to circumvent the rules,” he warned.

He offered reassurance on the roles highlighted in the AML Q&A issued at the end of last year. Both the “responsable du respect” and the “responsable du contrôle” roles are a fleshing out of existing practice: that rules are understood and acted upon. In both cases an individual needs to be named for each.

Yet overall, he finds “a lot of things go well” but that more effort is still needed. He recommended that boards be particularly strict. “If internal control functions don’t raise issues and but external ones do then we have a potential problem and this leads to more questions from us and it should raise questions by board members as well,” he noted. 

AML procedures oversight overview

Where does the responsibility lie for AML across the relationships between funds, mancos and transfer agencies? Given that they all share this duty it could lead to false confidence that the matter is being handled thoroughly by someone else. Birgit Goldak, a partner with PwC Luxembourg, Ruth Bültmann a non-executive director, and Manuel Dienhart, managing director, transfer agency with Brown Brothers Harriman debated this challenge. 

Whilst adopting a risk-based approach helps target efforts, different players have their own methodologies and sensitivities to each of country risk, investor risk and product risk around AML. “Every entity needs to know its role and obligations to ensure that risk appetites are aligned,” Ruth noted. Birgit agreed, adding this process tends to result in a “spiralling up” of risk assessments to match the highest levels among any given set of partners.

Communication is key, and as Manuel suggested, this is often a question of technology. For example, as a TA he has to keep track of different clients changing preferences over time, and that these will offer differ from BBH’s own assessment. Ruth said that this process requires close cooperation with compliance teams in order to gain strong understanding of the relationship and data, with boards needing to monitor these aspects.

Getting to grips with sustainability 

“There is no such concept as ESG compliance–it is a grid of factors,” explained Nathalie Dogniez, a partner with PwC. For example, she quoted the case of nuclear power, which while it produces low carbon energy, it carries the risk of radioactive pollution. Neither opinion is “good” or “bad”, but a matter of individual preference. She also warned about excessive reliance on data and ratings. While these can help gauge the overall picture, they are inherently subjective she suggested.

Sustainability requires subtle assessments to be made and policy adapted accordingly. For example, the engagement approach sees the asset manager use their role as a shareholder to influence the companies they invest in. This requires on-going communication, on-site visits, and building high levels of trust. 

Nathalie is also wary of companies that refer to the UN’s Sustainable Development Goals in their literature. “These are political goals for states and supranational bodies to follow, not companies. If funds are using these for marketing purposes, boards should challenge this,” she said.  

She spoke about the European Commission’s green investment taxonomy, which seeks to treat this challenge in a granular fashion. The notion being that this approach is more likely to help the client achieve their personal ESG investing goals, but much will depend on how these classifications are fleshed out over the coming couple of years. As for other regulatory moves, Nathalie said she could envisage the Mifid II suitability test being modified to ensure ESG preferences are taken into account just as risk appetite is at the moment. 

Monitoring delegation 

Luxembourg’s cross-border fund hub specialises in the management of delegated responsibilities. Sophie Dupin, a partner with Elvinger Hoss Prussen explained what should be expected of directors and conducting officers in this regard. 

It is a fundamental, ultimate responsibility of the board to understand and define the delegation model being used, she said. This means understanding the relationship between the fund, the fund manager, the manco and the depositary, with respect to where portfolio management, risk management, central administration and marketing are carried out. Compliance, audit, AML, valuation, IT and more all need to be situated and overseen, and this while ensuring adequate substance is deployed in Luxembourg. As well as initial due diligence, this has to be supervised on an ongoing basis.

It is into this framework that executive managers must create and implement appropriate procedures and controls for these relationships. Sophie also talked about the need for well defined “escalation processes” about when new challenging questions need taking to the board for a final decision. On risk, it is also the management’s job to assess and determine this as it relates to each delegate. She suggested that the board should oversee this and approve risk assessments suggested by the conducting officer. 

Board and director effectiveness

How can you be an effective director who contributes to boards that add value for investors? This was the focus of a panel of experienced local corporate governance professionals chaired by Bill Lockwood. They debated 15 questions that sought to stir self-reflection.

For example, they debated whether independence could fade after an extended period on a board. Susanne Van Dootingh said it was important to weigh the importance to taking time to understand the business with the natural human tendency to empathise with a team. She suggested that proscribed term limits on directorships can be a somewhat blunt object. “Personality, education and a willingness to challenge constructively are as important as tenure,” she said. Henry Kelly agreed adding: “the value of term limit guidelines is to make us think about whether we continue to challenge in positive manner.”

Revel Wood commented that there was sometimes social pressure on directors to not voluntarily relinquish mandates. “When this happens people can find their decision questioned but often this is because they simply don’t have the time to perform the role to the required level,” he noted. Monique Bachner agreed. “There can be a stigma when directors resign, but there shouldn’t be. Directors need to be able to move on if they feel this is appropriate, and this should be seen as a healthy development,” she said. 


Overseeing liquidity risk

With the Woodford blow-up, liquidity risk management has come to the fore and was debated by a panel monitored by non-executive director William Jones. One can never be sure if one can sell an asset in the future for a reasonable price, so his key advice was “all you can do is be prepared.”

Benjamin Gauthier a partner with PwC Luxembourg, reminded the audience of how quickly this topic has risen up the regulatory agenda. From warranting a few lines in UCITS IV, now EU-level regulators are taking a deep interest in liquidity. Indeed, just before Christmas CSSF circular 19/733 implemented IOSOC best practice into Luxembourg regulations. As well two ESMA documents have appeared related to the stress-tests set to be run this year. Regulators around the world are joining this move, he added. 

Jean-Philippe Blua of BlueBay Asset Management noted that “it is fine to take a degree of liquidity risk if it is properly managed and aligned with the trading position.” With alternative funds, monthly or quarterly redemptions are standard and thus liquidity requirements differ markedly from UCITS, with daily to weekly redemption being the norm. These ideas were fleshed out by Julie Krentz of VAM Group who gave practical examples of how the boards she sits on manage liquidity.

ALFI’s plans to 2025 

Although broadly satisfied with recent performance, Camille Thommes, ALFI’s director general sounded some notes of caution in his presentation. Yes, net assets boomed last year—up nearly 15% in the year to November—but just one-fifth of this was due to new net subscriptions, which was a modest score by comparison with previous years. “The industry is at a critical juncture, and must address numerous political, social, and market trends,” he said. Thus, as well as a tougher geopolitical environment and more activist regulators, there is the pension gap and young investors with a fresh approach to investment, plus low interest rates and the challenge of passive products.

To face this the association will focus on helping the development of four key themes: sustainable finance, assisting with retirement saving (particularly via the EU’s new PEPP), alternative funds, and technological innovation and transformation. These will be fleshed out soon when ALFI publishes its new five-year ambition paper. 

Due diligence over assets

Circular 18/698 codified the due diligence requirements over assets for all types of funds, and this has required many actors to tighten their procedures, noted Sandrine Periot, a partner with KPMG, the panel moderator. 

Daniela Klasen-Martin of the third party manco Crestbridge talked of the need to take a risk-based approach when matching risk with risk appetites. She noted that in the real estate sector due diligence tends to be quite an advanced standard practice, featuring reviews of tax and legal implications, and with the assets inspected on site. For there is also full screening of the counterparties: the buyer, seller, developer and agent. 

This process is more complex with venture capital, as due diligence generally focuses on the commercial side of the projects being supported. Making an assessment of the entrepreneurs can be a delicate task, however. These individuals are often be very young so have little track record, and conducting over-zealous background checks are not always well received. Tobias Ettlin of ONE Group suggested that deploying technology helps due diligence reports to become living, dynamic documents. This enables changing circumstances to be tracked from a data hub, which also offers clear audit trails

CSSF on fund regulation trends

Conversations with Pascal Berchem and Alain Hoscheid, both chefs de service at the CSSF brought the day to a close. In his introduction, interviewer Olivier Carré, a partner with PwC, spoke of how circular 18/698 has been viewed favourably with regulators at the EU level–a reward for the hard work that practitioners put in to become compliant. He underlined the important role boards have over the coming months with the year-end work for many funds, and the subsequent reporting requirements, particularly regarding AML.

Mr Berchem highlighted some of the key moves on substance and governance over the last year. He saw 25 new applications for licences and 72 AIFM licence extension requests, mostly in the real estate sector. These include some large players in the alternative space setting up in Luxembourg for the first time. Brexit is driving much of this activity. He added that the substance being put in these operations in Luxembourg is similar to that seen in other jurisdictions. Risk and compliance functions are generally kept in house, but with internal audit increasingly outsourced.

There has also been a wave (more than 70) of new branches being established, mainly for distribution and marketing activities. Branches pose questions about where ultimate regulatory responsibility lies, and Pascal said that that the ESAs are aware of these potential grey area and are acting. There is move towards the creation of “supervisory colleges” where relevant regulators work together to determine which should have ultimate responsibility. “We don’t know yet how this will evolve, but this should become clearer in the coming months,” he said. This could lead to the requirement for branches to report or this might be just at the level of the headquarters. This could see the CSSF having ultimate responsibility for overseeing a web of relationships.

Mr Berchem also mentioned how at the ESMA level there is some talk of the potential for conflicts of interest on boards of alternative funds, where investment decisions, transactions, valuations and risk management are all overseen by the same people. He suggested independent valuation and risk committees on boards might be the way forward.

Mr Hoscheid then commented on topics related to risk management. He pointed to the expectations of the regulator in relation to formalization of risk related processes. Comprehensive risk profiles (with both a description of risks and a setting of the risk appetite) have to be approved at board level and have to be subject to periodic reviews, notably also following significant market or investment policy change. In terms of regular risk reporting to Boards the CSSF expects at least a quarterly frequency. He also highlighted the need to be on top of liquidity risk management processes, with each entity needing a bespoke approach to address potential vulnerabilities. ESMA will be looking into this in-depth this year, he said, in the context of a Common Supervisory Action on liquidity management for UCITS, with possible publication of related best practice guidelines.