By Bruce Davidson, of Altus Ltd.
There has been lots of flag-waving and righteous indignation since the IRS deliberately targeted FS firms around the globe with its FATCA legislation. Product providers are facing up to some scary project estimates as they contemplate the challenge of adapting their systems and processes to apply special treatment to one part of their client and asset base. Meanwhile most people have failed to notice that RDR is having a similar (though probably unintended) impact on non-UK providers.
On the face of it, the FSA has no powers to regulate non-UK firms but, by widening the scope of retail investment products and insisting all advice is explicitly paid for by the client, RDR has effectively outlawed commission payments from offshore providers to UK advisers from the end of this year. That includes offshore bond providers and fund managers alike and, whilst some of the bigger Transfer Agents have recognised this and are working on solutions, others are still unaware that they are impacted and may be in for quite a shock in January 2013 when commission cheques get returned.
A complex challenge
Addressing this urgent challenge is not as simple as just turning off the commission tap though. Payments are still allowed for advice on exactly the same funds to other distributors in Europe and can continue for both non-advised and legacy business in the UK too, at least for now.
Neither is it a case of establishing clean share classes for every fund sold into the UK. Many of these offshore funds are sold infrequently to UK retail clients at levels which do not justify the costs associated with launching and maintaining a new retail share class – typically £10-20K per annum.
Reusing institutional share classes is an option some have explored but there are complications here too. Genuine institutional funds may receive tax treatment which cannot be granted to retail investors and even if they can be opened up more widely, there are practical challenges around minimum contributions and dilution of the scale benefits enjoyed by institutional investors.
A complex solution
The precise solution to this tricky challenge will vary according to circumstance and technology but will almost certainly involve ring-fencing holdings within existing accounts according to their RDR commission treatment. Designing this segregation in software is a significant undertaking but implementing it across a varied distribution and client base is even more difficult.
At the moment the location or MiFID status of an investor has no impact on how the distributors of funds are remunerated. With the advent of RDR this changes and, whilst the business logic is fairly straightforward, most fund managers do not currently capture sufficient information to make the necessary distinctions.
First, the fund manager needs to identify the location of the client. That sounds simple but many offshore accounts are held at an omnibus level and contain a mixture of UK and non-UK clients -whose business now needs to be treated differently for commission purposes. Assuming, the distributors can be persuaded to split out the UK clients into a separate account, the fund manager then needs to know about the MiFID status of the UK clients to identify retail business – information which is not commonly shared today.
Last but not least, they need to establish the advice basis on which each investment transaction was made. Whilst this is not a difficult concept to grasp, it is not something which is currently included in many of the STP trading links to fund managers and would therefore require significant change to systems.
A complex future
The good news is that all these challenges are soluble. The bad news is that there are many more like them on the horizon as Financial Services undergoes a fundamental shift from localised markets to a truly globalised industry.
Even with current technology it is perfectly feasible for a UK investor to buy an offshore bond in Ireland which invests in Luxembourg funds trading Japanese equities. This scenario is precisely the reason why fund managers and transfer agents in Luxembourg and Dublin are busy grappling with the impact of RDR regulations aimed at the UK market.
Right now such scenarios probably involve several manual steps and plenty of local expertise but, with the inexorable rise of the Internet to carry our digitised financial products around the globe in seconds, it will not be long before the whole process can be controlled via a single technology platform which will suddenly need to apply all the right rules at all the right points.
There will be competitive advantage for those who are first to develop a systematic approach to this complex rules challenge and there is more to this than technology. People, Process, Information and Systems will all be impacted by this emerging iceberg of supranational regulation and a successful response will require a whole new way of thinking. The only reliable foundation for this thinking will be robust models which capture the collective understanding of a business and allow it to be deployed much faster and more flexibly than currently.
The fact that a piece of FSA regulation will have such a profound effect on the operations of non-UK Financial Services companies is interesting but so much more significant than just a one-off compliance headline.
Until now even the largest Financial Services organisations have got by with ad-hoc responses to local challenges. As the internet becomes ubiquitous and Financial Services goes genuinely global, this parochial approach will become unsustainable. The winners in this wired new world will be those who design their business for change rather than adapt to as it happens.
RDR, along with FATCA, is just the beginning.