The Investment Association’s (IA) Funds Regime Working Group first published its proposals for the ‘Direct2Fund’ (D2F) model back in June 2019. These came as part of a package of proposals aimed at enhancing the competitiveness of the UK funds industry, with an eye to the post-Brexit regulatory landscape. The model would enable end investors to transact directly with funds, removing the Authorised Fund Manager (AFM) as counterparty to the deal. This, the IA has argued, would bring with it a number of benefits and the proposal is gaining momentum with implications for AFMs, investors and depositaries.
The proposal
The traditional model in the UK at present is that the AFM acts as principal, and that the investor’s cash, when invested in a fund, goes through the AFM’s bank account. This can leave the investor at risk of losing money if the AFM encounters difficulties such as bankruptcy and presents a degree of systemic risk. The current model can prove burdensome from an administrative perspective, and is arguably also overly complicated: although the arrangements are set out in fund prospectuses investors may nevertheless be unaware that the AFM is performing this role. The current model is also something of an outlier internationally, with other jurisdictions following something closer to the Direct2Fund approach.
In the proposal, cash from the investor would go directly to the fund’s issue and cancellations bank account. The AFM would then have the choice to act as agent or principal. Under the current system, the CASS rules help to mitigate credit risk from the consumer but the proposed model would essentially remove this risk. The risk of contagion or systemic risk would potentially also be better mitigated, as the bankruptcy of the AFM would not risk harming the end investor. In so doing, the Direct2Fund model has the potential to enhance the protections available to client cash. It is argued that this approach will help ensure the best outcomes for investors, businesses, the asset management industry, and the economy.
Benefits of the model
The simplified D2F model has additional benefits owing to its relatively uncomplicated nature. Its proponents argue that it reduces the administrative burden associated with the current system, thereby reducing the costs incurred by firms as they seek to comply. Reduced complexity has advantages for end investors as well: the IA argues that the simplified system will be more cost-effective and easier to understand.
Looking outwards, the Direct2Fund model has implications in terms of how the UK funds industry could be positioned internationally: bringing the UK model more in line with other jurisdictions, could further help simplify the system and reduce complexity.
There are a number of technical questions to be addressed as the D2F continues its journey from idea to reality. These were set out in a letter to the IA from the FCA on 07 December 2020, which the Association responded to in February 2021. These included questions relating to the assets and liabilities of sub-funds and collection accounts, and the segregation of assets within umbrella funds. The FCA also sought further details on the benefits and costs of the proposals and on the implications for preparation of regulatory reports.
There are also important considerations to be addressed in terms of the role of the depositary. This includes how depositaries will carry out their responsibilities in terms of COLL and FUND rules and how they will fulfil their cash monitoring duties.
What are the next steps?
A likely roadmap has been shared by the IA which sees the first funds adopting the model in 2023. However, there are a number of steps that will need to be taken to ensure that the full details of the model are fully thought through, and these have been pushed back somewhat by the FCA, noting the focus on other key initiatives. Interactions with existing regulation will also need to be considered in more detail to avoid issues such as duplication or creating overly burdensome requirements. For example, ISA rules will need to be reviewed by HMRC to ensure that they can support funds using the D2F model. HM Treasury meanwhile, will need to review OEIC regulations to ensure they are sufficient to enable the FCA to adopt the new rules.
A public consultation had been expected in 2021 with subsequent changes to rules expected in 2022. However, these targets may have been pushed back somewhat. The aim had been for the first funds adapted to the Direct2Fund model to be up and running in 2023.
While the changes the IA has proposed may appear to be a somewhat technical evolution of the plumbing of the funds industry, they should be seen within a broader strategic context. By creating a more streamlined and efficient model, its supporters hope to further enhance the competitiveness of the UK funds market. So while it has been pushed down the priority list for consultation – for now – the issues it seeks to address remain timely and relevant.
NatWest Trustee and Depositary Services view
- We support the proposals in principle, particularly when viewed through the lenses of investor protection and enhancing the competitiveness and efficiency of the UK as a funds domicile.
- We are engaging with the IA on the D2F model and await the publication of the consultation paper.
- We are speaking with clients in order to understand broader market sentiment and clients’ views as to the benefits and potential challenges of implementing the model within the timeframe floated by the IA.