IMF Report’s Implications Filter through into FMA’s Workload
New Priorities Set for New Zealand’s Financial Markets
Issues raised in an International Monetary Fund (IMF) report on New Zealand dating from 2017 have percolated through into the to-do lists of the Annual Corporate Plan 2019/20 and Strategic Risk Outlook 2019 published this year by the Financial Markets Authority (FMA). Of note regarding the FMA’s ambit of duties, custodians and wholesale asset managers were singled out for closer regulator attention by the IMF in its Financial System Stability Assessment (FSSA).
At present, in relation to legislation that the FMA oversees, wholesale asset managers are not covered, nor even defined, by the Financial Markets Conduct Act 2013 (FMCA) and its Regulations. By contrast, custodians are already subject to substantial legislation and regulations designed to control their sector, although they are not yet regulated under an FMA licensing and supervision regime such as it applies to supervisors and retail investment scheme managers. For example, in its Strategic Risk Outlook 2019 (p. 10), the FMA notes that it supervises custodians under the AML/CFT regime (Anti-Money Laundering and Countering Financing of Terrorism Act 2009, Clause 130).
The IMF’s headline FSSA formed a major part of the subsequent output from the organisation’s 2016 visiting review of New Zealand’s financial system under its ongoing Financial Sector Assessment Program (FSAP). The FSSA was primarily concerned with regulation of New Zealand’s banking and insurance sectors, and thus the Reserve Bank of New Zealand was the forefronted regulator. However, the FMA came in for mention in respect of the IMF’s observations and recommendations for potentially increasing its regulatory reach across New Zealand’s financial markets.
At the time of the FSSA’s publication in May 2017, the FMA singled out areas of particular interest in its responding media release, stating: “The IMF has, as expected, put forward some recommendations for further enhancement of the regulatory regime for consideration. These recommendations touch on a number of areas including supervisors, custodians, the wholesale asset management sector and issues around conduct in the insurance industry. The FMA is considering these proposals alongside its fellow regulators, the Reserve Bank, MBIE and the Treasury.”
The IMF Makes Key Recommendations
So what does the IMF’s FSSA actually recommend that the FMA has since adopted as part of its current workload? As an opening gambit, the report gives the IMF’s high level overview of the FMA’s role in New Zealand and what it needs to be working on next. Thus it is stated (p. 7):
“The reform of securities market regulation significantly improved the framework, but further enhancements are required. The review of the regulatory framework was instrumental in implementing key reforms, including the establishment of the FMA as conduct regulator. The new regime governs how financial products are offered, promoted, issued and sold, and introduces licensing for providers of certain products, including managers of retail funds. The regulatory perimeter could be reviewed to include wholesale asset managers and custodians, whose activities will become more relevant as the asset management industry matures, bringing potential new risks. There is also a need to enhance conduct regulation in the insurance sector.”
More detail was afforded the theme of regulating custodians and wholesale asset managers later on in the report, wherein point 35 under the section headed Capital Markets records (pp. 33-4):
“The overall regulatory framework for asset management is well developed, but there is scope to consider broadening its perimeter. The provision of custody services does not require a license in New Zealand and, therefore, falls outside of direct supervision by the FMA—or by any other authority. The government could usefully require that these entities be subject to licensing and supervision. Also, wholesale asset management activities are not covered by the FMC Act. This sector may not be significantly larger than the retail sector, but there is insufficient data to assess its risks.”
The essence of these passages was summed up in the FSSA’s Table 1. 2016 New Zealand FSAP: Key Recommendations, subsection Financial Stability and Financial Sector Resilience (p. 8):
“Expand the FMA's regulatory perimeter to include licensing and supervision of custodians and appropriate oversight of wholesale asset managers.”
FMA licensing and supervision of custodians, as explicitly recommended by the IMF, would migrate such entities into the kind of highly specified and regulated legal territory presently occupied to various degrees by licensed supervisors and retail investment scheme managers under the FMCA and the Financial Markets Supervisors Act 2011.
The IMF did not go so far as to recommend that the wholesale asset management sector should be licensed and supervised by the FMA in much the same the way that the supervisory and retail investment scheme management sectors are, but left things more vaguely worded as “appropriate oversight”, perhaps tempered at this stage by the concession regarding “insufficient data to assess its risks”.
The IMF’s proposed timeframe for implementing the key recommendation concerning custodians and wholesale asset managers was ranked “ST (short-term) = 1–3 years” in the report. The FMA’s current interest in custodians and wholesale asset managers falls within this timeframe.
How has the FMA Responded?
In its Annual Corporate Plan 2019/20 and Strategic Risk Outlook 2019, the FMA has responded in various ways to the question of extending its authority further over custodians and wholesale asset managers.
Taking the Strategic Risk Outlook 2019 first, the FMA has classified custodians and wholesale funds under “Investment Management”, along with entities it already licenses and supervises, including retail funds, KiwiSaver, superannuation, supervisors, licensed independent trustees, and discretionary investment management services (DIMS) (p. 10). By implication, custodians and wholesale asset managers belong in the set of regulated entities they are included with.
In the expanded chapter on investment management, the strategy notes, “Although we only license retail fund managers and not wholesale, we recognise that wholesale and retail investment management are interdependent” (p. 17).
It continues, “Funds under management continue to grow in New Zealand, with KiwiSaver expected to dominate future inflows. As at March 2019, there was an estimated $188 billion of funds under management (FUM) in New Zealand, including retail and wholesale managed portfolios” (ibid).
In respect of custodians, the strategy remarks (p. 19):
“The custody industry is relatively small in New Zealand, and there is significant overlap with supervisor functions. The International Monetary Fund (IMF) noted in its 2017 Financial Sector Assessment Program (FSAP) review that New Zealand is an outlier in not having a regime for the regulation of custodians. We are currently considering whether there is a case for recommending the establishment of a regulatory regime for custodians”
Beneath the heading “Sector risks and harms we want to address”, the strategy speaks of, “Stability of funds – Managed Investment Scheme (MIS) managers have insufficient processes and controls to respond to a liquidity crisis event, which could lead to investor losses” (p. 20).
Just below, under “Long-term opportunities and challenges” the strategy asserts:
“Outsourcing – prevalence of outsourcing of fund management and the lack of regulatory oversight in wholesale funds and custody arrangements mean that we may not have a clear view of some stability risks … Custody – the outcome of our work assessing the case for regulating custody in New Zealand.”
These concerns of the FMA echo the problems that arose with the Woodford Investment Management funds debacle that occurred in Britain earlier this year, whereby both the Woodford wholesale funds affected and the custodial service via which they were offered to retail investors were driven into a liquidity crunch-driven suspension of unit trading.
Moving on to the Annual Corporate Plan 2019/20, under Investment Management, the document effectively reiterates (p. 12) a section of the wording of the strategy (p. 17) in respect of wholesale funds.
Listed within activities for 2019/20, the plan states, “IMF Financial Sector Assessment Program – continuing to follow up on the 2017 IMF recommendations for further enhancement of the regulatory regime, including considering whether there is a case for recommending the establishment of a regulatory regime for custodians” (p. 13).
Work to be Done
It is evident from the passages quoted above that the FMA has moved to incorporate the IMF’s FSSA priorities with respect to custodians and wholesale asset managers into its strategy and workload for 2019-20, with more emphasis evident on custodians at this stage.
Regarding two sectors of New Zealand’s financial markets seen as problematic by the IMF, wholesale asset management appears to the one wherein the FMA will need to undertake greater research and discovery in order to formulate a viable framework for oversight that will deliver enhanced stability of funds and more effective protections for investors.
An existing model to imitate could be the retail MIS regime of the FMCA, including the requirement for independent, FMA-licensed supervision. However, there may be aspects of this regime not readily adaptable or entirely suitable to wholesale funds and their management. Further work will likely be required to develop a fit-for-purpose regime for wholesale funds management licensing and supervision, supposing that is the pathway along which following the IMF’s recommendations leads the FMA.
With respect to the custodial sector, it is much better known and already extensively governed by legislation and regulations, as is evidenced in the following section. A model for making changes in this area could be to assimilate custodians into something like the licensing and oversight regime imposed on supervisors by the FMCA and Financial Markets Supervisors Act 2011, but, once more, the existing regime may not be wholly suitable for custodians and could require customisation.
What is the Present State of the Law for Custodians?
Significant amounts of legislation (FMCA, Financial Advisers Act 2008, Financial Service Providers (Registration and Dispute Resolution) Act 2008) and regulations (Financial Advisers (Custodians of FMCA Financial Products) Regulations 2014) presently apply to custodians. The FMA has provided summary resources (here and here) in this respect in July of this year as well as publishing information sheets in February and October 2015.
There are instances of custodial function wherein the FMA arguably does already regulate to the level recommended by the IMF, for example in the case of a supervisor of a registered MIS. In this case the FMCA’s section 156 (Requirement to have supervisor or other independent person as custodian) requires the supervisor, an entity which is licensed and supervised by the FMA, to act as the custodian of the scheme’s property. However, if the supervisor delegates out the custody function to an external party, then under present legislation the external party is not itself required to be a licensed custodian, which is an area of law that both the IMF and the FMA have signalled interest in reforming.
The View of Trustees Executors
The IMF’s proposed changes to regulation of custodians and wholesale asset managers have been sitting in the background of the FMA’s workload for several years and are now, as expected, coming to the fore. Already PWC has conducted a survey of custodial practices in New Zealand on behalf of the FMA, but the further results of that work have yet to be made public.
Trustees Executors is of the view that the IMF’s key recommendations regarding custodians and wholesale asset managers could be effective in reducing stability risks to the benefit of investors within New Zealand’s financial markets, and looks forward to more substantive guidance from the FMA as to the conclusions that it might reach in this area.
As a licensed supervisor operating under the FMCA, Trustees Executors is well familiar with the current retail MIS regime. In working subject to the FMCA’s section 156, Trustees Executors already functions as a de facto licensed custodian with direct accountability to the FMA.
The IMF has proposed that the FMA’s regulatory perimeter could also be reviewed to include wholesale asset managers, whose activities will become more relevant as the funds management industry matures and develops potential new risks. For those asset managers who do not currently have full supervisory oversight of their wholesale funds, it would not be surprising to see the FMA make some movement in this area. Trustees Executors stands ready to assist with providing input, based on its prior expertise and experience with supervising certain wholesale managers, to developing an effective and practicable supervisory regime for these kinds of funds.