There are few things more disruptive to the investment management industry than instability. Financial institutions are experts in managing risk in their investments. One of the reasons they can achieve this is due to developed processes for anticipating and predicting events – they can rely on their models. Managers expect the same for their operations.
Structured finance, particularly collateralized loan obligations (CLOs), has remained a robust subsector of capital markets even during this year's intense volatility. However, American investment managers in this sector are largely unaware of the existential threat to this market beyond the tumultuous macroeconomic outlook. For many, there is a major disruption in business on the horizon, particularly for fundraising new securitized structures.
There are some key figures to understand about CLOs that really set this scene. First, according to S&P Global's 2021 Leveraged Commentary and Data report, nearly 80% of CLOs are managed by US firms. Additionally, the Federal Reserve reported in 2019 that nearly 75% of US CLO securities, at the time of publication, were issued out of the Cayman Islands. Why does this matter? Not all investors are also based in the US, and European investors could actually be completely shut off from this market.
In 2015, the European Union adopted a modernized regulatory framework that incorporates various Anti-Money-Laundering Directives (AMLDs). One such directive contains a feature that maintains a list of jurisdictions with strategic deficiencies in their regimes that are considered a significant threat to the financial system of the EU – this is widely known as the 'blacklist'. Article 4 of the EU Securitization Regulation prohibits EU investors from investing into vehicles domiciled in a country that appears on the 'blacklist', or are domiciled in jurisdictions that are likely to be on the blacklist.
In early 2022, the Cayman Islands and eight other jurisdictions were placed on the AML blacklist. Since European investors are prohibited from investing in CLOs that are domiciled in blacklisted, or likely to be blacklisted, jurisdictions, US managers will either have to migrate the structure to another offshore jurisdiction or forego continued fundraising from European investors.
The blacklisting of these jurisdictions and the migration of investment vehicles with a European investor nexus creates a serious consideration for all international finance centres: how to help assure stability and resiliency for managers, without compromising innovation.
Managers want their structures to have longevity. It is inefficient, costly, and possibly even a governance concern for a manager to set up a vehicle in one jurisdiction to then later have to migrate it to another. Financial jurisdictions should be stable, predictable, and resilient. Investment managers want to be sure that there will be no significant or disproportionate changes to the structures that they are establishing.
A jurisdiction must be able to address change in a timely and effective way to maintain stability for its investment managers. To be adaptive to change, which often comes quickly, as in the case of the securitization market outlined previously, a healthy collaboration between the government, regulator, and industry is key. When a partnered approach between these stakeholders is present, new regulations can be addressed in a timely and effective way. By adapting to changing regulation without the material disruption the investment managers' fund structures, jurisdictions can provide managers the confidence in the operations they seek. The only volatility managers should be worried about is in prices, not their funds.
This article was first published in Structured Credit Investor.
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