Vanguard Asset Management, Limited

BACKGROUND ON VANGUARD

The Vanguard Group, Inc. (“VGI”) began operations in the USA in 1975 and is headquartered in Valley Forge, Pennsylvania, USA. Today VGI (together with its affiliates) operates in Europe, Asia, Australia and Canada. Vanguard Asset Management Limited (“VAM”) (a wholly owned subsidiary of VGI) is based in London and provides services throughout the European Economic Area pursuant to the Markets in Financial Instruments Directive (“MiFID”). As at 31 December 2016, Vanguard collectively managed approximately €3.85 trillion in assets under management (“AuM”) of which just over €110 billion was managed by VAM.

VGI is owned by certain of Vanguard’s US domiciled mutual funds, which in turn are owned by the investors in those funds. This mutual structure aligns our interests with those of our investors and drives the culture, philosophy and policies throughout the Vanguard organisation worldwide. We have an unwavering focus on investor value and costs and a stated intention of cutting the cost of investing.

Vanguard’s mission is to take a stand for all investors, to treat them fairly and to give them the best chance of investment success. It is our belief that investment success is based on four key principles, being: (a) clear and appropriate investment goals; (b) suitable asset allocation using broadly diversified funds; (c) minimising costs; and (d) maintaining perspective and long-term discipline.

RESPONSE TO QUESTION 1

We appreciate the opportunity to respond to the EBA’s discussion paper on a new prudential regime for investment firms. As detailed further below, we do not think that the current regime under the EU Capital Requirements Directive and Regulation (CRD/CRR) is appropriate for asset managers and we are fully supportive of a separate proportionate regime to take into account the specific risks associated with investment firms. We support an activities based approach to identifying risk to ensure that all investment firms are subject to the same rules regardless of their size.

We support the proposal to redesign the regime to distinguish between investment firms that are: (a) systemic AND bank like (class 1); (b) not systemic and bank like (class 2); and (c) very small and non-interconnected (class 3). In order to ensure appropriate categorisation of investment firms, it is very important to have strict criteria to differentiate between the three different categories of investment firms, based on the relative risk of the activities they undertake.

The guidelines on the criteria to determine the conditions of application of Article 131(3) of CRD in relation to the assessment of other systemically important institutions (O-SIIs) – EBA/GL/2014/10 of 16 December 2014 were created to identify systemically important institutions. The key drivers for a systemically important institution are balance sheet exposure and business models which give rise to systemic risk, credit risk and market risk. Investment firms which are not engaging in bank like activities should not meet the criteria of the guidelines.

Asset managers do not engage in activities that would expose them to systemic risks and therefore should not be categorised in the same way as G-SIIs and O-SIIs. Asset managers do not trade against their own balance sheet and do not engage in bank like activities. In previous examples where an asset manager’s business has no longer been viable, there was no significant impact on the European financial system.

Asset managers act as agents to their clients and are subject to fiduciary duties to act in the best interests of investors. Asset managers also have well established procedures to allow them to be wound down in an orderly manner without any external adverse effects. A separate prudential regime for investment firms other than G-SIIs and O-SIIs is therefore appropriate to allow firms (such as asset managers) to apply the rules in a proportionate manner depending on the activities they carry out.
We believe that the current regime under CRD/CRR is not appropriate for asset managers and we support the proposal to redesign the regime for investment firms that are not deemed to be systemic and bank-like. We support the EBA’s proposal to have a separate prudential regime based on the inherent risks in the business of investment firms and not to apply an adapted version of a capital requirements regime designed for large international banks.

Asset managers do not present the same risks as systemic and bank-like firms (see for example the findings of the Financial Stability Board as to the mitigants to systemic risk presented by asset managers and investment funds in its Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities of January 2017) and therefore should not come under the same capital requirements as credit institutions. A new prudential regime, however, will need to appropriately consider the wide distinctions between the range of investment firms and we believe this regime should be applied on a proportionate basis. Indeed, asset managers’ activities are completely different from those of banks and insurance companies, but also other investment firms, such as proprietary trading firms. Asset Managers act as agents on behalf of their clients and do not use their balance sheets in transactions between their clients and the market. In addition an asset manager will not ‘fail’ in a way that may require regulatory intervention or that causes a systemic risk to European financial stability. These differences require a separate regime to assess and address risk within the investment firm universe.

While we fully support the proposal for a separate set of harmonized rules for investment firms and understand the principle that firms that pose more risk should attract higher capital requirements, we do have some concerns with a number of the proposals set out in the EBA’s discussion paper.

We object to the example of “an extremely large portfolio manager” as possibly coming within the definition of systemically important and therefore subject to more onerous capital requirements, particularly where premised on size of assets under management. Size is not an accurate indicator of risk and therefore should only be relevant after an indicator of systemic risk, such as excessive leverage, has been identified. It does not follow that the larger the firm the greater the risk and therefore the greater the need for capital. Indeed, one could argue that larger asset managers are likely to have more comprehensive and sophisticated systems and controls in place to ensure that idiosyncratic risks do not spread to the wider financial markets. In these circumstances it would be inappropriate to apply a higher capital requirement to large asset managers in comparison to other Class 2 investment firms.

Comprehensively regulated asset managers do not engage in the types of activities that give rise to systemic risk and we disagree with the suggestion that the failure of asset managers may have the level of impact on customers and markets as is proposed in the discussion paper. As mentioned above, asset managers act as agents on behalf of their clients and are subject to fiduciary duties to act in the best interest of investors. In addition to this, asset managers are subject to comprehensive conduct of business rules pursuant to the likes of MiFID, the Market Abuse Regulation, the UCITS Directive and the Alternative Investment Fund Managers Directive (“AIFMD”). They are also subject to oversight from numerous entities such as regulators, auditors etc. We do not believe that if an asset manager fails that there is a risk to the market or the European financial system nor do they pose a significant risk to customers. As a result, we do not consider that the revised prudential regime for asset managers should include capital requirements to ensure that these firms can absorb losses arising from correcting harm caused to customers and markets. Rather, we consider that a prudential regime appropriate for asset managers would be one that requires firms to hold sufficient capital to allow them to wind down in an orderly manner when necessary.

Disproportionate capital requirements furthermore may disincentivise asset managers from participating in the Commission’s Capital Markets Union initiative to the detriment of efforts to reduce EU dependency on bank financing and the wider EU economy as a whole.

The EBA opines that prudential requirements for investment firms have to take into account the additional risk associated with holding client money and securities. We note that handling or holding client money and securities can give rise to additional risk and that it is appropriate for a capital requirements regime to reflect these risks. However, asset managers holding client money and/or client assets require regulatory permissions to do so, which in turn gives rise to the need to comply with onerous conduct of business rules regarding how such client assets/money are held. In addition, the assets of clients are typically segregated and held by a third party for the benefit of the clients, as in the case of UCITS and alternative investment funds under the AIFMD. As a result, the failure of the asset manager should not impact client assets.
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RISK TO CUSTOMERS (RtC)

While we agree that customers of investment firms need to be protected, we have some concerns about the K-factors that are proposed in this section. As mentioned in response to question 2 above, we do not believe that the size of an investment firm is an indication of the level of systemic risk. There may be a number of large firms that are not of systemic importance that would be captured by this factor, while other smaller firms that may be riskier to the customer on the basis of the activities they pursue are not. These firms may create a higher risk with other more diversified firms being less risky.

We do not agree with the scalars that are applied to the specific K-factor whereby the amount of any capital requirement should increase in proportion to the scale of the business undertaken. The existing activities of a particular firm should be taken into account rather than just the AUM of the firm. We consider that systemic risk emanates from the combination of leverage and interconnectedness. Comprehensively regulated investment funds do not employ significant leverage and are not inextricably interconnected with other systemically important institutions such that risk emanating from asset managers is automatically transmitted throughout the financial system.

The other K factors of assets safeguarded and administered (ASA) and client money held (CMH) do not take into account how asset managers safeguard client assets. Existing regulation pursuant to MiFID, the UCITS Directive and AIFMD already helps to mitigate operational risk. Asset managers are subject to regulation that controls risk by requiring managers to have appropriate policies and procedures to identify and monitor operational risk. In addition, asset managers do not typically hold client assets themselves. Rather the assets are segregated and held by a third party and are therefore recoverable by clients in the event of insolvency of the asset manager.

RISK TO MARKETS (RtM)
We do not agree that the failure of an asset manager would result in a RtM. Recent examples of failing or stressed asset managers have revealed little to no impact on market access or market liquidity. Asset managers tend to have small balance sheets, employ little to no leverage, and the forced liquidation of their own assets does not create market disruption.

It is also worth noting that asset managers should rarely be dealing on own account. As a result the proposed K-factor of “proprietary trading activities” is therefore not relevant for asset managers.

RISK TO FIRM (RtF)

We do not believe that RtF is particularly relevant for asset managers that are operating an agency model. We understand the rationale to treat a firm that is leveraged significantly as different to a firm which is not. However, we think it is important to distinguish between the leverage of an investment firm and of an investment fund. Asset managers do not take any balance sheet risk with respect to an investment fund and have no ability to use their clients’ assets for their own purposes due to the segregation of assets. In any case, comprehensively regulated investment funds (such as UCITS) are typically not highly leveraged.
ASSETS UNDER MANAGEMENT (AUM)

As discussed above, we do not believe that an AUM figure is a suitable and comparable metric. The risk profile of different managers will depend on a multitude of factors and is not dependent on the size of the asset manager. Using AUM to set capital could lead to unnecessarily high capital requirement for larger managers. In reality, these managers are also more likely to have more robust controls for operational risk.

ASSETS UNDER ADVICE (AUA)

Our concerns regarding size mentioned above are equally applicable in respect of AUA. If AUA is to be used as a metric for operational risk, this K-factor should be adjusted to the specific situation of the firm and the type of customers involved.

ASSETS SAFEGUARDED AND ADMINISTERED / CLIENT MONEY HELD
As mentioned above, the client assets and monies managed by asset managers are typically segregated/held by third parties (such as custodian/depositary institutions) in accordance with strict conduct of business rules. As a result, we do not consider that the amount of assets safeguarded and administered or client money held by asset managers to be appropriate K-factors, unless account is taken of the significant protections afforded to end investors.
We do not think that an uplift factor is necessary for firms which are not leveraged significantly. This would only make sense for investment firms which are dealing on their own account and which have significant balance sheet exposures (i.e. not asset managers).

We would also suggest the option of down scaling factors which would incentivise firms to be well capitalised and to improve their risk management.
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We believe that the FOR should remain part of the capital regime. That said there would be merit in considering whether the current FOR remains sufficient to cover typical wind down costs of an investment firm. We also believe that further clarity around the deductions would be helpful as there are various interpretations in the market on how deductions are made.
We do not believe that being a larger firm or trading financial instruments, including derivatives makes a firm bank-like.

We do not agree that the size of the firm should be a determinate for setting capital requirements. Being a large asset manager does not necessarily mean that it is subject to more risk and large asset managers often have robust controls and procedures in place to ensure operational risk is at a minimum.

Unless investment firms are trading financial instruments (such as derivatives) for their proprietary accounts, an investment firm typically does not have an obligation for the trade. Moreover, often an asset manager will use derivatives to reduce risk through hedging or to gain exposure to an investment index it is tracking on behalf of a fund. The use of derivatives by regulated funds is a fundamental component of prudent portfolio management that provides significant benefits to investors in terms of risk mitigation, lower costs and greater liquidity. Leverage that could raise the potential for systemic risk is not related to the volume of derivatives usage, but rather by the purpose for which a particular derivative product is used and how the purpose relates to specific assets and the overall portfolio. The activities of the asset manager should be taken into account and the risk involved in those activities rather than the size of the firm itself.
We would support a new prudential regime for investment firms which is tailored to the risks investment firms might pose and which is flexible enough to be suitable for the whole range of investment firms.

We think that a K-factor approach (subject to our comments on this approach in general) could be considered appropriate for such firms. In this instance, the proposal must take into account the risks inherent in the business carried out by the investment firm. Similar to the CRD regime, there could be a disapplication of a number of onerous requirements where appropriate in accordance with the risk of the business involved. As mentioned above, we do not think that the size of a firm should be taken into account in the categorisation of a firm as ‘systemic’. In addition, for the reasons set out in our previous responses we do not believe that asset managers would be ‘systemic’.
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We believe that referencing liquidity requirements to the FOR is appropriate. This would ensure that in a stressed scenario, there would be sufficient cash to appropriately wind down the business in an orderly manner.
We believe that this should be kept to the existing definition.
We think that it makes sense to link capital, wind down requirements and liquidity requirements. It should be made clear that the guidance on liquidity relates only to the firm and does not extend to liquidity management of the firm’ assets.
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We generally agree with the proposed approach to addressing group risk within investment firm-only groups. Consideration will need to be given to all relevant entities within the group to get an accurate sense of the capital and risk exposures involved. Nevertheless, it is also important that the revised prudential regime proportionately takes account of geographical and regulatory boundaries so as to ensure that global multinational groups do not inappropriately find EU group entities having to allocate capital resources in respect of the activities of non-EU affiliate companies, subject to separate and distinct prudential regimes. Disproportionate consolidation requirements could impact the competitiveness of EU domiciled investment firm groups.
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We believe that applying CRD-remuneration style requirements would not be optimal and a separate regime would be more suited and proportionate. There are a number of separate remuneration requirements under the UCITS/AIFM rules that now apply to fund managers, which could be applied to asset managers qualifying as Class 2 firms.

Applying CRD style remuneration requirements would fail to account for the distinction between the agency nature of the asset management business as against balance sheet risk of the banking industry. CRD remuneration rules are designed to avoid excessive risk taking by credit institutions that could lead to systemic risk and impact wider financial stability. Any future remuneration rules applied to investment firms should take into account the differences between banking and asset management business models.
As set out in our responses to questions 1 and 2 above, we believe that there should be separate regime for investment firms that are not systemic and bank-like (e.g. asset managers) and it would not be appropriate to amend the CRR to take account of firms that are not systemic and bank like. The activities of asset managers are fundamentally different to firms that are systemic and bank like, and there are a completely different set of risk factors. Accordingly, a separate set of harmonised rules with a clearly defined degree of proportionality (depending on the risk associated with the activities of a particular firm) set out in primary EU legislation would be the best approach and would allow for greater oversight and better regulation. It should also avoid the current situation where the differing National Competent Authorities’ implementation of the EBA’s Remuneration Guidelines suggests a lack of uniform understanding of existing proportionality under Article 94 of CRD.
The current regime is not appropriate for the majority of investment firms as it is aimed at banks and credit institutions that have a much larger exposure to credit risk and market risk. There is a large operational burden on the calculation of credit and market risk exposures for investment firms that do not have a particularly high risk profile in this regard. Unlike banks, asset managers are not principal investors, do not provide guarantees and have little to no leverage. The profit and loss experienced by investors have no direct impact on the asset manager’s financial stability. A separate regime that takes into account the wide range of investment firms would be a more appropriate approach.
Richard Withers
V