LUXEMBOURG FUND SPECIALISTS from a variety of firms discuss the incoming cyber regulations known as DORA, as well as the evolving challenge of tokenisation and cost reductions in asset management.

European fund providers are set to face a stern test of regulatory compliance thanks to the arrival this year of the Digital Operational Resilience Act (DORA), which entered into force in January.

Digitalisation offers asset managers great rewards in terms of efficiencies and closer customer engagement. But the greater connectivity involved heightens risks from cyberattacks and potentially creates greater vulnerability to failures of infrastructure

As EU regulators seek to boost the industry’s resilience to these scenarios, DORA’s biggest impact is the increased involvement of the management body in ICT (‘Information and communication technology’) governance, says head of industry affairs at the Luxembourg Funds Industry Association (ALFI) Gildas Blanchard.

Before DORA, digital resilience was an operational topic that never really reached the boardroom. But now the responsibility of directors and senior management is a central tenet of the regulation, asserted panellists at the recent Funds Europe roundtable held in Luxembourg.

The second major impact is the governance of operational relationships between asset managers and their ICT service providers, Gildas added. “Every firm must map and identify their value chains to identify those service providers that support critical functions and to be clear about which ICT tools are at hand to perform them. The asset management industry relies heavily on third-party providers and the arrangements with each one of them need to be assessed to identify where there is a compliance need. This is not a one-day process since you cannot brutally reverse an arrangement which is already in place. It will take time.”

The final impact, said Blanchard, is organisational. Firms need to establish an independent function for ICT risk management. “This is a control function – but it does necessarily need to fall under risk or compliance. The open questions are: who is going to undertake the task? What existing or new function will be involved? How will independence be ensured? There is some thinking to do to implement an efficient and value-adding organisational model.”

DORA and the detail

According to chief executive officer for M&G Investments Micaela Forelli, Europe Asset Management Operations, is without doubt the most detailed ICT regulation yet seen and places the EU at the forefront globally of regulation designed to cope with operational risks. It has made it complicated for asset managers who run global teams spanning the EU, US, UK and Asia.

“Typically, IT providers will not have an understanding or even the visibility of this giant regulation and this means firms need multidisciplinary connections, both inside the company itself and along the full length of the value chain,” said Forelli.

M&G Europe started this process two years ago, she said. “Given the scale of our organisation and the complexity of the regulation, we needed to make an early start at mapping our services and at remediation measures. We benefited from the hiring of ICT specialists here in Europe that are able to decrypt and decipher the meaning of the regulation so that we could work in an agile way and in line with budget.

“We welcome what’s coming but it will have a huge impact on ManCos [management companies] and investment firms.” Investment funds managing associate at law firm Linklaters Luxembourg, Marie-Christine O’Mahony said more training for directors and managers was needed – particularly as ultimate responsibility lies with them. She said time was of the essence, too.

“There are two batches of draft technical standards and everything comes into effect on 17 January 2025. This does not give much time for the second batch of standards to be finalised and for everyone to make the necessary adjustments. There are also some grey areas for which additional guidance would be welcomed – such as whether DORA would capture a situation where a Luxembourg Ucits management company/alternative investment fund manager would delegate portfolio management services,” said O’Mahony.

For asset servicers, operational resilience has always been an important consideration, said State Street’s Luxembourg head, Riccardo Lamanna. “DORA is something we welcome. In today’s market, asset servicers also operate like platforms, integrating different providers on platforms based in the cloud. We provide mobility services supported by a strong technology environment which means DORA has a a direct impact on us. But we are also a critical service provider, which means we have to think carefully about what our clients expect from us.”

Considering that the majority of asset-servicing technology infrastructure is based on a global footprint, said Lamanna, asset servicers need to understand how regulation in, say, the US compares with the demands of DORA in the EU. “There will be gaps and even if there will be no substantial differences compared with what we do today, there will be much administrative work,” he added.

Right proportions

Henning Swabey, head of growth at fintech firm fundcraft, highlighted the pressure on smaller firms across the value chain – including asset managers and infrastructure providers – and raised a concern about the level of proportionality stemming from the EU’s DORA regulation.

“It is good to have a regulator ensuring firms are careful with their data and their business partners to protect their clients. A firm is only as strong as its weakest link. But fundcraft is a young organisation and organisations of similar age will likely not yet have a global compliance team in place, and they will have board members less experienced than others at supporting regulations of this scale. Firms may even lack access to training and/or a network of experts that could provide some cost-sensitive guidance.”

Fundcraft, founded in 2021, is heavily invested in digitalising operational infrastructure for alternative investment managers and positions itself as a disruptor for firms still wedded to legacy tech. “When you consider the additional level of bureaucracy involved with DORA, it is a very different challenge for us than it will be for older, global organisations, that might be relying on databases and systems dating back to the previous millennium.”

He urged policymakers and influencers in Luxembourg to be mindful of proportionality. Do not over-regulate, do not become too costly, he said, else there is a risk that innovation from startups and newer market participants in Luxembourg might be hindered if the barrier to entry becomes too high.

Lamanna added: “This is the second largest financial centre in the world and we all have a vast interest in keeping this alive, as does the Luxembourg government. There is no room for complacency, nor for mistakes. If a failure happened in Luxembourg, everybody will point their finger at us, which would not be the case if a failure happened elsewhere. The stakes are high in Luxembourg and we do need to make sure that the balance is right.”

Fund tokenisation

To what extent DORA may be a business inhibitor for some firms remains to be seen. But tokenisation – whereby traditional assets and funds can be distributed more fluidly through digital tokens – should be a business enabler for asset managers. But are firms clear about the direction of tokenisation and what is needed to make it a reality?

According to fundcraft’s Swabey, there are two practical ways that tokenisation can be implemented: first, at the portfolio level, where assets inside a portfolio are tokenised; and second, at the investor level, where a token provides access to a fund, potentially creating a direct line between the investor and the distributed ledger technology that tokens run on, and the various assets inside of a portfolio.

“If you look at the benefits of tokenisation – such as shared access, an immutable source of truth, and real-time data – there are other ways of getting this right without tokenisation, meaning that there is the potential for the industry to disrupt the disruptors before they make an impact,” said Swabey.

Tokenisation has often been called a solution looking for a problem. Swabey’s view is that the best application of tokenisation is in distribution and secondary markets. “That’s where I see a true practical application across all kinds of asset classes, whether alternatives or vanilla Ucits funds, and money markets funds,” he said. “There aren’t many firms that have had a tangible effect yet. There are opportunities but then there are also questions around integration and interconnectedness. And we must consider ownership of the technology: is it owned by a private equity group or is it co-owned by members, and what does that mean about whether it can be used as an industry-wide utility? Ultimately, it’s a question of whether we can trust the provider.”

M&G’s Forelli believes tokenisation could revolutionise operations by reducing costs and making reporting easier, as well as creating real-time access to assets. M&G is involved in

several industry initiatives, but she agreed interconnectivity is a question.

“There are a lot of players looking to open up their own ecosystems to explore tokenisation and sometimes this is done in parallel with each other, and other times it is a lone initiative. Whatever the case, I see asset managers more as followers in this advancement,” said Forelli.  But she also said that asset managers have a duty to support tokenisation

because of its potential to democratise access to investment markets. “We really need to be backing it because tokenisation could boost distribution generally and especially in the arena of private assets where a whole new world for retail or mass affluent investors opens up. They will obtain asset classes that have so far been inaccessible to them.”

Improved ELTIF appeal

Democratisation of private assets is also expected to be facilitated by the European Long-Term Investment Funds (ELTIF) 2.0, for which a set of re-appraised rules came into effect in the EU on 10 January 2024. The new rules are designed to improve the appeal of ELTIFs for fund managers, who in turn could help private assets spread to smaller investors and boost Europe’s smaller companies and economy.

Linklaters’ O’Mahony said there had been much interest from clients – and interesting questions about investment eligibility and restrictions for ELTIFs. The draft regulatory technical standards (RTS) were finalised in December 2023 and submitted to the EU Commission. “This version of the RTS led to many additional questions from the industry, and there has been a lot of pushback,” she said. “For example, if you want the ELTIF to be open-ended so that investors are able to get out of a fund on their own initiative, then the RTS are imposing minimum notice periods which could be as long as a year. So, retail investors would have to put in a redemption notice a year ahead of time – yet for other types of funds the redemption notice period could be much shorter. This is a huge difference and it also has people question the best way to manage this operationally.”

O’Mahony said she was hopeful that push-back will result in improvements to the RTS. “Luxembourg’s financial regulator (the CSSF) is approving ELTIF 2.0 applications, which we welcome, while knowing that the fund documentation will have to be adapted when the final RTS are endorsed. Market players are very interested in the ELTIF’s features, including the possibility to market to retail investors and use the marketing passport,” O’Mahony said.

M&G Investments launched its first ELTIF in November 2023 to widen access to private credit. “We were keenly waiting for the new rules,” said Forelli. “ELTIF 2.0 is a significant step for our industry, making our proposition to deliver the benefits of private markets in a regulated, easily accessible vehicle, possible. In our case, and by offering a diversified portfolio mixing liquid and illiquid corporate credit, it allows for retail investors to gain access to an asset class such as private credit that, traditionally, has only been available to institutional players.

“We see the asset class growing and very appealing for investors, and it is a nice diversification play for retail clients now that rules lower the minimum investment level.” She agreed some clarifications were needed. But she added “it was very helpful to see the regulator step in immediately in January to say they are confirming the rules as we understood them”.

At the same time, M&G Investment’s is explaining ELTIFs to institutional investor clients. “It’s going to be a very interesting couple of years ahead for us as we go into this new avenue.” With the right financial advice and full understanding of the asset classes beneath, Forelli envisages offering these funds to a wider range of retail investors across Europe provided the frequency of redemption periods can be minimised to the current monthly window. But for now, she said, the ELTIF remains a vehicle aimed at the mass affluent.

Counting the cost reduction

Ongoing regulatory pressures and the need for technology investment have both taken place as the industry has tried to reduce costs and increase automation levels over the past two decades, with service centres like Luxembourg crucial to this. The panel considered the success of measures aimed at making asset managers more profitable while also lowering fees for investors. Simply put, has the funds industry succeeded in reducing its costs and creating greater value for shareholders and for investors?

Ideally it would all come down to numbers, says Blanchard. “If you look at the averages you see a clear decreasing trend in cost. And at the same time, you have a product that is fundamentally changed and has much richer features. We are not talking about the same funds as 15 years ago. “Yet, from an academic perspective, it is important to draw attention to the fact that this remains a measurement challenge. Indeed, what we really try to measure is the final and effective cost through funds, managers, geographical regions, etc to the end investor. This figure, unlike other costs statistics, is not easily comparable notably because of the diversity of distribution models and framework. It might be tempting to draw conclusions when you look at the figures beyond averages – but they are not necessarily the most objective conclusions in terms of overall cost from the end investor’s standpoint.”

The market is trying desperately to reduce its production costs though, says Lamanna and while it is difficult to prove that costs are reducing, it is an achievement in itself just to make sure costs don’t go up. “We don’t really know if the cost has gone down, but the relative complexity of the process has gone up. So there has been an incredible improvement in efficiency just to keep pace with regulation. If you don’t improve, then your costs will go up.”

Consolidation is also helping to bring costs down, said Lamanna. “While in the past asset managers were merging simply because they wanted to have a wider offering, mergers now are about having one front-office application and one risk-management platform. But this has to be effectively implemented and we are seeing firms delegate more to providers to consolidate their services. “For example, more asset managers are outsourcing their trading or their middle office. Why would an asset manager spend time, money and sophisticated resources to do the execution on the market? Just give it to someone who does this by profession and that is well integrated with the system. This will bring down the cost and will force rationalisation of the system environment for asset management.”

Forelli said traditional asset managers had reached the “efficient frontier”. “Here in Luxembourg, the cost of doing business is growing not only due to regulatory demands but also due to the need for greater robustness and scalability. At M&G in Luxembourg, for example, we now have 65 people – up from about 10 in the early days. It’s an investment that makes us scalable and productive.”

The focus from the EU legislature on costs makes this an important topic for market players and thus for us law firms, said Linklaters’ O’Mahony. “As an example, there is a prescribed way of disclosing costs for ELTIFs making it easier for investors to compare them. From a more practical angle, if you’re not able to bring costs down, the question is whether you will survive. Decreasing costs seems to be the trend we are seeing, although the intensity may depend on the type of fund and whether it is user-intensive or has multiple complex strategies.”

In Swabey’s view, the cost reduction debate comes back to regulation, operational complexity and legacy technologies. “The industry has seen new rules come in that make sure firms are reducing costs while investors are still protected,” he said. “The industry is increasingly interconnected through technology and platforms, not just internally across different units but also with their clients and other members of the ecosystem. The more we can collaborate, the more we should be able to reduce costs. I’m a strong believer that technology will be our friend on this. The challenge is how we implement the technology and ensure that it has a practical solution in terms of reducing the cost of manufacturing, distributing and administering products because we’re all here ultimately to improve returns for our clients to help them meet their financial goals.”

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