Annex IV reporting came into force on October 31 under the Alternative Investment Fund Managers Directive (AIFMD).
The Annex IV reporting template consists of 41 highly detailed questions with 340 data fields, and requires fund managers to provide a wide range of information including details on instruments traded, assets under management, liquidity, borrowings, stress test results and leverage. For some firms, much of this data had not been previously requested by regulators, which has resulted in them coming under regulatory scrutiny potentially for the very first time.
However, industry experts warn that Europe’s hedge funds and other asset managers have largely underestimated the onerous task of reporting. The failure to understand just how complex it will be to continuously report this information will largely create many challenges for Europe’s firms.
“I think it is fair to say that some investment managers have possibly underestimated the extent of what is being required to fulfill this reporting obligation,” says Rolf Bachner, managing director, product management, BNY Mellon.
Who is to blame?
With this, it raises the question of why these firms have not fully gauged what is required of them when it comes to Annex IV reporting.
On the one hand, the finger could be pointed at the regulator. The Annex IV rules were announced in March 2013, but Europe’s financial authority, the European Securities and Markets Authority (ESMA), did not publish the guidelines on reporting until November. This was more than two years after AIFMD was adopted and less than a year before the first reporting deadline for some managers came into force.
As a result, national regulators, such as the U.K.’s Financial Conduct Authority (FCA), did not publish their guidelines until after ESMA issued their version.
According to Donnacher O’Connor, a partner at law firm Dillon Eustace, which services Irish and international asset managers, custodians and prime brokers, this was not enough time for firms to meet the overhauling rules.
“A significant amount of preparation was required for managers to be in a position to report, and there is a lot of work involved in preparing these reports. So there were, and still are, some timing issues,” says O’Connor.
Due to a lack of clarity, this in turn has also presented difficulties for Europe’s depositary banks.
“The Annex IV process has not been an easy exercise for us largely because the regulators have not fully engaged with the industry on providing the granular guidance necessary to complete the required reporting in a timely manner,” says State Street’s Shane Ralph, head of depository oversight services for the EMEA region.
Moreover, the regulators are perhaps also failing to understand the complexity for firms to report new products and deliver new information for the first time. “It will be a huge challenge to report on products that have not previously been subject to regulatory reporting, and it will not be easy communicating this challenge to the regulators,” says Ralf Menegatti, product owner, asset management EMEA, at regulatory reporting firm AxiomSL.
On the other hand, part of the blame can also be centered on the firms themselves, which have not only underestimated the massive costs in implementing systems and collecting data efficiently and effectively, but also how regulators will treat the information delivered to them.
Menegatti adds that most firms have failed to anticipate the effort required to deliver files and quality reporting to the regulators. “The Annex IV reporting requirements is the part of the directive where people really have to lay their cards on the table and be transparent. In my opinion most people have underestimated the effort required,” he says.
Furthermore, according to Hugh Stevens, head of private equity and real estate fund solutions at BNP Paribas Securities Services, the industry largely failed to identify the running costs of Annex IV reporting after the first wave.
“Speaking to people in the market…the costs don’t end after the first wave of reporting. This is because the costs come from the collection of data from various systems. For large managers the costs of setting up the infrastructure could be in the millions,” Stevens says.
Is Annex IV outsourcable?
Many firms have chosen to outsource their regulatory reporting obligations to their fund administrator as it will house much of the data that must be included in the reports. But under this relationship, the fund manager is still legally responsible for reporting.
A number of fund administrators have been partnering with regulatory reporting tech firms to meet this demand. For example, Confluence, a tech vendor, partnered with Mitsubishi UFJ Fund Services in October to provide Annex IV reporting solutions.
O’Connor believes fund administrators will most likely to take the lead in supporting Annex IV reporting, largely because they are capturing the AIF trading and account data that forms the basis of much of the quantitative-based reporting. “We see the managers working in collaboration with the administrators, and in some cases, third-party service providers who bring all the reporting together,” he says.
According to a Global Custodian/Viteos hedge fund outsourcing survey of U.S. and U.K. firms last year, 67% of respondents said they use a principal fund administrator for all of their regulatory reporting requirements.
Some banks such as BNP Paribas Securities Services, State Street, and Societe Generale Securities Services (SGSS) have launched their own reporting service in which they combine information they already have stored with information that is sent to them from the asset manager.
However, this too presents problems for the depositary bank because of the scale of the information it needs to collect from the fund manager, its clients, third parties, custodians, and prime brokers.
“When the client is serviced by State Street, we have the majority of the data required for Annex IV reporting, which we source systemically from our books and records; however, due to the comprehensive nature of the data requested, we may also need to gather certain information from our clients and their prime brokers,” says State Street’s Ralph.
So where does this leave the custodian banks that have largely been the go-to venue for outsourcing middle-and back-office functions?
BNY Mellon’s Bachner and Paul North, head of product development, argue the Annex IV reporting cannot be fully delegated to the custodian or a third party because the requirement is so comprehensive.
“A service provider might be able to aggregate the data, put it in the format and send it to the regulator, but it will not also be able to collect and source the data themselves,” says Bachner.
“You have to think about this as more of a process than as a regular packaged reporting service. There are many data points required; these have to be formatted and reviewed and then delivered. It doesn’t necessarily lend itself to a service provider that does custody and accounting,” adds North. “It is not necessarily something that is outsourcable given the complex requirements, the process management side of it, the accountability of it and the delivery of it.”
Increased tensions within the industry
According to industry experts, Annex IV reporting and AIFMD as a whole has the potential to increase tensions between regulators, fund managers, depository banks, prime brokers and sub-custodians.
Firstly, for depository banks that are providing outsourced services, Annex IV reporting is putting increased tension between their relationships with certain prime brokers that are either providing only parts of information required, or refusing to provide data at all.
Regarding the relationship with prime brokers, “I think it has changed,” explains Ralph. “The reporting from prime brokers has been an issue, in which some have said there is certain information that they can’t provide.
“Some U.S. prime brokers are still holding out in terms of certain information that we need. As a depositary bank we understand what the regulators want; it is up to the prime brokers to understand that as well.”
Secondly, AIFMD is a pan-European directive that has resulted in some firms that have traditionally not been considered as alternative funds, such as investment trusts, falling into the regulatory scope, causing increased tension between managers and their national regulators.
“A lot of firms caught by AIFMD would have thought they were already robustly regulated under the Companies Act or the Trust Act, and they didn’t really welcome this additional burden on them,” says BNY Mellon’s North. “I am sure other firms across Europe, such as regional pension schemes, have the same sentiment.”
Thirdly, for custodians and depository banks that charge clients to report on their behalf, AIFMD could significantly change the competitive landscape, according to Chris Collins, director of regulatory responses, Sapient Global Markets.
“You’ve got these issues of reporting and operational inefficiencies in the custodian-fund manager relationship,” says Collins. “Banks and financial institutions are facing the issue of consolidating all their soiled reporting requirements. The cost of these new activities always lies somewhere. Where that pans out, who ends up with the bill and how much it costs is going to be the real test.”
In addition, AxiomSL’s Menegatti argues the directive is forcing fund managers and directors to abandon the multi-jurisdictional organizational structures they have often used.
“AIFMD has completely turned the funds industry on its head. Requirements for greater transparency mean it is no longer profitable for a fund manager in Jersey to use the services of a sub-custodian bank in London and depository bank in Paris, for example,” he says. “Fund managers have also had to follow substance requirements and segregate risk from their fund services company and their custodian. The impact of all these changes cannot be underestimated.”
What is next?
The main issue for the future of Europe’s fund industry is how they will deal with the extra costs of complying with additional regulatory burdens. According to a survey conducted by BNY Mellon and FTI Consulting in July this year, 38% of those surveyed indicated that the costs of complying could force managers to either merge their funds with other firms or close them entirely.
In addition, national regulators are expected to take a tough line on firms that fail to report correctly and in a timely manner. “I have spoken to the U.K. regulator (the FCA) and they said they intend to fine all market participants that deliver their reports late,” adds Menegatti. This in turn will put additional technological pressures on firms in order to avoid costly penalties.
Moreover, there is the very real prospect that AIFMD and Annex IV reporting is just the start, with other reporting and regulatory obligations likely to follow.
“The expectation we have is we are going to see more of this complex reporting coming out in other regulations. This isn’t a one-off requirement; this is an example of things that will follow in other reforms such as money market regulations,” concludes North.
Have Europe’s Managers Prepared For Annex IV Reporting?
The first wave of Annex IV reporting under AIFMD has come into force for some European firms; however, many have largely underestimated the sheer cost and workload required to comply.