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FOCUS ON INVESTING, MANAGE COMPLIANCE THE CASE FOR AN INDUSTRY SOLUTION IN REGULATORY REPORTING

IN ASSOCIATION WITH:

While such reporting represents a non-core function of the adviser, it nonetheless requires extensive management focus, significant resources and global risk

expertise. But given the pace and complexity of new regulations, is this something individual firms should be taking on alone? Or is there a more efficient, flexi-ble, scalable and cost-effective solution for the industry?

Against that backdrop, the SEC just enacted the Investment Company Reporting Modernization Rule (the Modernization rule) on October 13th, 2016 and its corresponding Form N-PORT. At the time of this writing, firms are racing to understand the implica-tions of the new reporting requirements, which extend

much of the scrutiny and reporting burden that private funds have to contend with, to Registered Investment Companies (RICs). Much of the rule and the new requirements were expected—requiring significant investment in the data, technology and reporting capa-bilities of these firms—but some new requirements for complex calculations mean that serious technologi-cal and quantitative horsepower, previously reserved for portfolio management, is also being extended to reporting—which will be under regulator and public scrutiny. The SEC estimates that the industry’s cost of complying with the new requirements in the modern-ization rule will exceed half a billion dollars in the first year alone.

The pace of regulation in financial services over the past six years “has to be experienced to be appreciated—or believed,” says the head of compliance for the asset management

arm of a global bank. Consider the firm’s experience.

Prior to Dodd-Frank, “regulatory reporting” for the asset management group “was not even a full-time job—not for a single person,” recalls the executive. Any asset management forms and filings were merely minor pieces of someone else’s day job—there was no

HYPER-COMPLIANCE: WELCOME TO THE NEW NORMAL

INTRODUCTION New regulations governing the financial services industry are being implemented at a

breakneck pace. In moves to reduce overall risks in the marketplace, actions by myriad

agencies and jurisdictions the world over are forcing industry participants to devote an

ever-increasing proportion of their budgets and managerial focus to regulatory reporting.

2 | FOCUS ON INVESTING, MANAGE COMPLIANCE

dedicated team. Today, however, just asset management requires a team of nearly 40—all dedicated on regula-tory reporting as a full-time job. Recognize also, says the executive: this is merely the asset management layer of the compliance work. For the firm as a whole, “there is yet another layer of group-wide compliance.”

By no means is this to say such regulations are unwar-ranted. As the executive explains, “As a large global player, we also benefit from more rigorous reporting. We are, after all, heavily invested in other funds, and now we are seeing more disclosures relating to our own counterparties.” Regulation may undoubtedly increase the costs of doing business—“significantly,” says the executive. But overall, he concludes, “there is a net ben-efit to the financial markets.”

Still, new regulations are being written “some-where in the world almost every day.” So keeping up, he says, has evolved from a part-time, background annoyance to a “full-time, resource-intensive, highly specialized discipline.”

Compliance at Light Speed Welcome to the era of “hyper-compliance—the new normal,” says Dan Connell, EY executive director, FSO Advisory, “where firms face wave upon wave of new regulations from multiple agencies across myriad jurisdictions.”

Consider hedge funds, private equity (PE) and reg-istered investment companies. Four years ago, such firms were required to file “about six” reports per year, says Connell. Typically, this might mean four quarterly summaries, a comprehensive annual financial report

and then an annual tax return. Certainly, some would need to file an additional report or two based on some specific transaction, holding or similarly major event, but such reporting was relatively limited.

Today, post-Dodd-Frank, asset management firms and funds could be required to file in excess of 60 reports per year. This is in addition to stricter require-ments for threshold-based reporting, the so-called “wider net,” explains Connell, and includes additional ongoing periodic filings. These filings and regulatory frameworks include:

• Forms PF, CPO-PQR, NFA-PR, AIFMD Annex IV, TIC-S, TIC-SLT, TIC-B, SEC 13F , BEA, ADV, N-PORT

• Solvency II, Basel III, EMIR

• Derivative transaction reports

• Short-selling reports (European Securities and Markets Authority (ESMA))

Overall, financial services firms have arrived “at an era of vastly more rigorous reporting,” explains John Sampson, EY executive director, FSO Advisory. Regulators are setting remarkably “higher standards.” Moreover, each agency is developing its own highly prescriptive formulas. Accordingly, firms will find it difficult to develop any one-size-fits-all solutions, says Sampson, instead being required to “follow the precise rules set by any given regulator.”

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key realization within this new normal is that more and more regulators will be “requir-ing deeper disclosure,” often as a means of guiding additional compliance rules. As

EY FSO Advisory Principal Michael Barnes explains, “They’re essentially outsourcing their data collection wish list to the industries under their watch—and now they’re in the analysis phase.”

As the form, frequency and depth of reporting increases, regulators are in turn using these vast caches of data to identify potential “trouble spots,” in turn developing rules, limits and controls as they see fit. So much intensive reporting, says Sampson, “means that regulators will have deep insight into the full spectrum of practices, which will be used to expand focus, rule-making and enforcement.”

In addition, more and more regulators will, in turn, share this data with other regulators—worldwide. Note, for example, that much of this added statutory filing stems from cooperation among G-20 members. Memorandums of understanding among agencies relat-ing to post-global-financial-crisis agreements can be expected to generate a wide range of additional report-ing requirements.

All of this data gathering, sharing and analysis, says Barnes, “leads to an exponential increase in the scope of the mandate, along with the required detail, speed, form and frequency of compliance reporting.” For financial services firms, says Barnes, “it’s a dramatic increase in risk and cost.”

Rules Beget More Rules In general, “regulators are using what they learn from data collection to write still more rules,” says EY Principal, Managed Services, Michael Fox. “Regulations to come can be expected to be even more hard-hitting and to cover virtually every aspect of money manage-ment, mutual funds and financial services.”

Consider the evolution in reporting requirements for registered investment advisers (RIA) and funds, an area where the SEC is in the throes of expanding its requirements. One key change is in the works: whereas firms were formerly able to report consolidated posi-tions by form of investment, new rules promise remarkably detailed and granular requirements—for example, information on a CUSIP-by-CUSIP level.

As the SEC finalizes reporting rules and require-ments, it also is gaining knowledge and experience from analysis of many months of expanded report-ing. Knowledge so gained, says Sampson, “is in turn being used to develop additional rules for hedge and private funds,” including “enhanced enforcement on existing regulations.” More than likely, says Sampson, “this means Form PF and related reporting is likely to become much more granular and cumbersome” in the future.

The same pattern is being repeated across the whole of financial services. Mutual fund reporting today, for example, though extensive, tends to focus on aggregate positions. However, as Sampson explains, regulators are looking to gather more and more data. Soon, registered investment companies will need to file Form N-PORT.

[Regulators are] “essentially outsourcing their data collection wish list to the industries under their watch—and now they’re in

the analysis phase.”

—Michael Barnes Principal, Regulatory Compliance,

EY

REGULATORS ARE GATHERING DATA AT AN ACCELERATING RATE—LEADING, IN TURN, TO STILL GREATER REGULATION


N-PORT, says Sampson, is a monthly form requir-ing “more frequent reporting and more detailed information on liquidity, derivatives, risk, returns and counterparties.” Its scope includes market risk, collat-eral/borrowing and counterparty risk. Overall, says Sampson, “this is a remarkably demanding, data-inten-sive report—one that is indicative of the current trend across reporting regimes.”

In addition to collecting increasingly granu-lar data for funds, regulators are beginning to request

financial information on asset managers themselves. For example, recent changes to the National Futures Association’s form CPO-PQR will require asset man-agers to supplement existing quarterly funds reports with current ratios and expense ratios for either the asset manager or its parent company. While there is no related capital requirement, impacted entities will need to maintain documentation supporting the balances that they report to regulators.

“Regulations to come can be expected to be even more hard-hitting and to cover virtually every aspect of money management, mutual funds and financial services.” — Michael Fox

Principal, Managed Services, EY


The above merely scratches the surface of the breadth and depth of likely expanded reporting requirements still to come. Bear in mind that the infrastructure required

to do reporting with this level of granularity, trans-parency, frequency and auditability is not only nonexistent, but it also will be remarkably expensive to develop.

A key driver of cost is the lack of standardization across regulatory bodies. As Connell explains, instead of conforming to industry norms, each regulator “tends to come up with its own highly structured data request.” As a result, “this forces common classification standards that are inconsistent with how firms look at their own data,” creating new, significantly higher record-keeping and compliance costs.

Looking at the whole of regulatory activity, Connell contends that the impact is driving far more than mere changes in the ways businesses approach compliance. Instead, says Connell, “this is becoming a major distraction,” to the point where companies are being forced to change their fundamental strategies and practices. For example, says Connell, “activities that make sense for investment purposes are being curtailed because of their compliance burdens.” Compliance needs “are draining management focus and distorting business strategies.”

New Business Risks New rules are being written to measure and ultimately decrease systemic market risks. But ironically, in addition to increasing operating costs, so much added reporting introduces an assortment of new business risks. Already mentioned is the risk of a relative decrease in the abil-ity to focus on the core business of investing. Another is a potential loss of agility, as firms will need to weigh a wide range of compliance metrics and issues before redi-recting capital or applying new strategies.

Firms will also run the risk of filing mistakes driven by inconsistencies in their own formulas and reporting. Large firms in particular, says Connell, “have been fil-ing reports and disclosing information to investors since their inception.” But owing to factors such as the size,

ACCELERATION IN NEW REGULATION LEADS TO NEW RISKS AND COSTS

“Activities that make sense for investment purposes are being curtailed because of their compliance burdens.”

—Dan Connell

Executive Director, Technology Solutions, EY

HEIGHTENED COSTS AND RISKS INCLUDE:

Costs• Increased headcount

•� Significant outlays (both Capex and Opex) for new software/systems

• External expertise/regulatory interpretation around the world

Risks• Loss of management focus

• Increased likelihood of “errors” in reporting, likely triggering fines

• Decisions driven by compliance, not markets, limiting strategies and returns


scale and geographic scope of operations, “inconsisten-cies are bound to occur.” And in financial services, says Connell, “we have seen myriad examples of these incon-sistencies across reports triggering hefty fines.”

Another key problem stems from the structure of the trust industry. Again because of scale, geo-graphic diversity and a range of instruments in use, even medium-size firms often must use multiple insti-tutions to accommodate their holdings. However, as Barnes explains, “each of these providers, typically asset servicers, may be using their own definitions and classifications, and problems will arise when identical positions are categorized differently depending upon who is holding the security.”

In general, more reporting leads to a higher like-lihood of perceived shortcomings or failures. An increasingly active regulatory environment may also have the impact of discouraging firms from using strat-egies or instruments that regulators deem too risky, that otherwise fall out of compliance favor, or that sim-ply trigger a new host of reporting requirements by introducing a new product or jurisdiction to the port-folio. The risk here, says Fox, “is that firms will make more of their decisions based on regulations—not on investment criteria.”

NO ROOM FOR HIGHER COMPLIANCE COSTS

Related research shows that the industry has little room for absorbing higher compliance costs. Many new regulations and associated costs are landing just as the sector is facing pressure to preserve its margins. For example, an EY/Forbes Insights survey1

of 100 asset managers found that 61% of firms say they are feeling significant pressure to reduce fees and are taking significant steps to reduce costs.

Margin pressures in the business overall make the rising cost of compliance an even more difficult pill to swallow. As an industry executive interviewed for this research explains, “To deal with fee compression, we’re squeezing costs. But while we’re cutting back nearly across the board, we find we are having to add to our headcount in compliance.” The situation, the executive explains, “is a source of frustration.”

1 Asset Management 2020: Status Quo vs. Transformation, Forbes Insights, June 2016

61%Percentage of firms that are feeling significant pressure to reduce fees and costs.

http://www.forbes.com/forbesinsights/ey_west_coast_asset_mgmt/index.html


s regulatory hurdles proliferate, every individ-ual company is forced to expend an increasingly significant proportion of resources on compli-ance. This leads not only to lower margins

overall but to significant redundancy throughout the industry in an area that is not a competitive differentiator.

The costs of doing it alone can be staggering. Not only is there a steep learning curve and enormous ini-tial and ongoing investment, but firms will also need to maintain a state of perpetual awareness and continuous response. The new normal is not only a source of dra-matically higher costs, but also a drain on management focus and the core mission.

A better way forward is for financial services com-panies to work together to develop an industry-based solution. A compelling idea is to build a compliance model using a trusted third party. Multiple industry par-ticipants could join together, hiring a third party with expertise in systems and regulatory compliance to create a specialist enterprise working on behalf of its sponsors. Core attributes of such an enterprise would include:

•��Specialization “Compliance,” says Sampson, “would be the entity’s

sole focus.”

•��Deep knowledge of the rules and requirements Experts at the entity would be well versed in both

global regulatory intent and industry practice. In particular, such an enterprise would be in a strong position to identify and implement best practices.

•��Scalability Such an entity would be in a strong position to antici-

pate regulatory changes, adjusting resource allocation and focus as new rules are implemented.

•��Sophisticated software Such a firm, says Barnes, “would have the ability

to assimilate or normalize massive data flows from multiple sources and in various formats.” Individual firms themselves would have less work to do in data sourcing, normalization, aggregation and enrichment

as those steps, plus QC and report generation, take place within the new entity.

•�Agnostic (to jurisdiction) A key challenge is finding a way to meet specific

demands of each regulator as efficiently as possible. As Barnes explains, consider U.S. Form PF and ESMA’s AIFMD Annex 4. “There’s an approximately 80% overlap in the underlying data elements—so report-ing could piggyback on each.” Overall, an industry solution “would understand not only the formulas demanded by the regulators, but also those in use by the industry, and be in an ideal position to serve as the liaison or interface.”

•�Objectivity Such a compliance entity would need to be under-

stood to be objective and conscientious. “Regulators would need to know they can trust the work of such an entity,” says Sampson. Moreover, “their work must be readily auditable and transparent.”

•�Advocacy Working on behalf of multiple or possibly many

dozens of individual firms, the enterprise could also deliver the benefit of wielding considerable credi-ble influence with regulators regarding existing and developing rules.

THE INDUSTRY NEEDS TO CONSOLIDATE ITS EFFORTS

[A compliance-focused enterprise] “could provide a strong sense check, so that firms don’t attract unwanted

regulatory attention—or at the very least are better prepared to explain why their

situation is unique.”

—John Sampson Executive Director, Regulatory Compliance,

EY


The above list is by no means the end of the poten-tial benefits. As Sampson explains, such an enterprise would also be in a particularly strong position to help individual institutions gauge how they stack up to the industry at large across key variables being monitored by regulators.

When regulators study a set of filings, for example, they typically see a classic bell curve of results. Then, says Sampson, “they pick a low point that isolates 5%,

10% or 15% of the total, and write the regulation to bring those [laggards] into line.” Financial services executives “do not want to see their circumstances outside the curve,” says Sampson. So a compliance-focused enterprise monitoring multiple clients as well as the industry as a whole “could provide a strong sense check, so that firms don’t attract unwanted regulatory attention—or at the very least are better prepared to explain why their situation is unique.”

THE SHIFT FROM ARTISANAL TO INDUSTRIAL

Increased regulatory reporting in the asset management industry will transform firms’ compliance approach from “artisanal” to a “factory model.”

Historically, compliance was staffed to deal with complex issues, face off against regulators and provide a front line of defense in managing the firm’s risk—all artisanal tasks requiring deep expertise. But facing many of the same factors that drove the industrial revolution—increasing demand, rising regulation, greater need for con-sistency and modularity, rising cost pressure—artisanal-mode compliance departments are struggling to cope. Specifically, compliance departments today are finding themselves dealing with high volumes of routine work, where inconsistency and inaccuracy, more than nuance and interpretation, are the likely pitfalls.

In a world of high-volume reporting needs, artisanal compliance departments cannot keep up. Traditional regulatory reporting requirements meant that each firm could allow only certain employees to master the intricacies of developing and filing a specific report. This resulted in a series of artisans, all sourcing their own information and reporting in their own peculiar way—with all the thought and care that you might want in a high-quality product, but none of the consistency or auditability that you want in a mass-produced good.

In our post-industrial economy, we see segmentation of production. Factories respond to high demand, using processes that emphasize consistency, modularity and cost efficiency. Factories operate at high vol-umes, with optimized processes, purpose-built technologies and specialized workforces. Artisans, in stark contrast, produce goods that have a niche demand. Their emphasis is on nuance, creativity and innovation, at low volumes, by hand, individually, at high unit costs.

This same equilibrium will define a post-global-financial-crisis compliance department: there will be a high volume of routine tasks in which quality will be determined by accuracy, consistency and auditability (i.e., reporting) and a low volume of nuanced, complex tasks in which expertise, creativity and proactivity will determine success (e.g., first line of defense, rule interpretation, interacting with regulators, etc.).

Compliance teams should retain their expert artisans for all the complexity that comes with our new normal. But for the rest—the high volume, routine work—send that to factories optimized for measurability, predict-ability, accuracy and cost.


Firms today may feel they are keeping up with regulatory churn. But as regulations continue to pile up, so will costs and, as Fox explains, anxiety. “When firms rely solely on their own

resources and perspectives,” says Fox, “executives will always have to wonder whether their interpretation of the regulations is correct or whether or not something they’re doing will place them in the regulatory ‘crosshairs.’”

Barnes believes that companies will begin to migrate toward an industry solution in three waves:

•��Wave one will be composed of leading fund com-plexes and other firms wanting to avoid standing out in the crowd but who are unwilling or unable to continue building so much compliance and reporting infrastructure. Note also, says Barnes, that among this group, “the growing costs of com-pliance are more visible in the compensation of these executives—so they will tend to be driven towards innovation.”

•��Wave two will consist of industry leaders who, upon seeing the ongoing efficiency and success of such a model, will move swiftly to take advantage of the opportunity. “Noting its effectiveness along-side their own increasing compliance costs, others won’t wait long before adopting a similar strategy,” says Barnes.

•��Wave three will likely consist of slower-moving, maybe historically safe, firms. For whatever reason, perhaps driven by the failure of a large or influential industry participant, the market experiences a surge into “regulatory overdrive.” Suddenly, says Barnes, “all filers need to move rapidly to overhaul their capabilities,” which will lead more firms to see the wisdom in a more consolidated industry solution.

Certainly, there are potential drawbacks to any con-solidated industry solution. For example, firms may fear becoming a captive customer, thus locked in to increas-ing costs over time. Alternatively, they may fear that their strategic data may become accessible to competitors.

While these may be legitimate concerns, Connell says that in practice, such fears are overblown. For example, says Connell, “there will be multiple entries in this field—it will evolve into an industry of provid-ers.” Moreover, he contends, “providers will certainly be careful not to share insights into individual activi-ties—as that would do enormous harm to the value of the model.”

The Future: Already Here The concept is compelling. So compelling, in fact, says Sampson, “that we are already building these capabili-ties.” Specifically, he continues, “we are working with several large fund complexes, building the critical mass and developing the most efficient processes.”

As such, EY is already learning a great deal about making the model work. The starting point, says Barnes, is “understanding a firm’s footprint.”

The initial questions include: •Securitiesormarkets—whereandhowdoes

the client gain its exposures? •Regionsorcountries? •Customers—wheredotheyreside?

The basic insight outline above leads to the development of a regulatory road map. EY can now: •Identifytherelevantregulatorsandregulations •Scopetherequireddataelements(instruments,

risks, compliance, etc.) •Buildalignmentbetweentheclientdata

environment and the “utility” data model •Developaruleslibrary(todeterminerouting

of episodic and periodic reporting) •Runtheprogram,reviewandrefine

The concept is still under development, but as Sampson maintains, “we are very confident that this is the solution that will work for the industry.”

GETTING THERE: THE THREE WAVES


METHODOLOGY

The industry is experiencing an unprec-edented increase in required regulatory filings. This is a global phenomenon that is still accelerating, with those closest to the

industry seeing no slowing in sight. It is essential for firms to maintain full compliance

with any and all such regulations. However, this steep and continuously expanding learning curve represents a remarkable drain on any single organization’s man-agement focus, capital and operating resources.

A better approach is for the industry to pool resources to address this non-differentiating reporting burden. Working with a trusted and qualified third party, a solution could be developed that protects each individ-ual firm’s unique data, but at the same time presents an efficient, timely, scalable, accurate, auditable and contin-uously up-to-date approach to industry reporting.

Such a solution is already becoming a reality for a handful of industry leaders. But given such a vast array of compelling benefits, it is time for more firms to explore its potential.

CONCLUSION

This report, developed by Forbes Insights, is based on interviews with both industry executives (anonymous by choice) and the below-mentioned EY executives:

• Michael Barnes, Principal, Regulatory Compliance• Dan Connell, Executive Director, Technology Solutions • Michael Fox, Principal, Managed Services • John Sampson, Executive Director, Regulatory Compliance

Forbes Insights is grateful to all those who participated.


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EDITORIAL

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RESEARCH

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