Coming out on top

The concept of “regulatory arbitrage” – gathering much pace during the last decade – has become one of the premier philosophies driving realignment between European and Asian financial centres, striving to attract the biggest share of business from fund houses and wealth managers.

When looking at which centres will win asset flows and new set-ups of investment hubs, there are a large number of inter-related factors to consider. These include reputation, regulation, perception, transparency, quality of life and taxation.

Further fuelling the debate have been attacks – some say politically motivated – on Switzerland, the Caribbean and other “offshore” centres by US authorities and their associates in the G20 and OECD, keen to increase their tax take in a post-crisis, deficit-burdened environment.

This US and European pressure – including the heavy-handed draft Alternative Investment Fund Managers Directive (AIFMD) – appears to be encouraging the migration of much investment business to European centres, although this can sometimes be the first stage of a move further East.

London too is suffering some defections by hedge funds, particularly to Switzerland, from groups trying to escape the expected AIFMD regime. And Switzerland, under threat from Singapore and other heavyweight competitors in the private banking and funds sphere, is fighting tooth and nail to keep its share of business and attract London’s malcontents.

“We only want business today if it is clean,” says Ray Soudah, founder of Zurich’s best known M&A consultancy, Millenium Associates, commenting on the post-secrecy Swiss landscape. His belief is boutique banks, which previously thrived on tax and secrecy-led solutions, will fade away or be swallowed up by bigger players, which will re-shape the wealth management landscape.

“The smaller Swiss players will be wiped out. There are no niches left for them and the time for re-invention is over,” says Mr Soudah.

His colleagues in the closely-knit Swiss business circle, keenly aware of a threat from the East, are working proactively to attract new business, even if it means hunting on their rivals’ doorsteps. A government led initiative, the Swiss Business Hub, has overseen the opening of three offices in China, one in Singapore and the latest addition in South Korea.

Each country is judged according to 13 criteria, including GDP, bilateral trade with Switzerland and appeal to Swiss exporters. South Africa, for instance, has been downgraded, whereas most Asian locations are in the ascendancy, with wealth management identified as the key area for growth.

But there is difference of opinion as to whether the Swiss strategy will prove successful. “The US and Asia are both looking at Switzerland. The US doesn’t like it one bit, and they will do something about it,” says the former boss of a leading Swiss asset management group.

“But the Asians are a lot more tolerant and relaxed. They are quite happy for Switzerland to carry on doing what Switzerland has always done. They don’t see it as a threat.”

Room to grow

Smaller banks think they can still grow and their country can yet absorb assets and staff numbers to keep Switzerland at the centre of the wealth management world. “Switzerland has made it clear that the country is ready to welcome a move from asset managers from other European locations,” says Serge Ledermann, chief investment officer at Banque Heritage in Geneva.

“The country has the capacity to absorb this in terms of infrastructure, labour force and real estate. It’s no secret that the authorities want to develop the legal and tax framework so that it will be no problem for hedge funds to relocate to Switzerland.”

He believes ongoing consolidation among institutions in both Zurich and Geneva will create space for new actors to enter the country. At the same time, possible restrictions on remuneration of top staff in listed companies, may drive talent to smaller private banks, reckons Mr Ledermann.

However, some Zurich power-brokers have a less positive prognosis. “All countries in the world are short of money and need more tax take,” says a former board member of a major Zurich private bank. “Naturally, those countries with the largest deficits are attacking Switzerland. But our problem is that Switzerland was never designed to have a central government. We are left with part-time government members, not qualified for political tasks, who have been forced to defend the country from sustained attack from global heavyweights. What we are seeing today is the UK and Germany putting up taxes and increasing regulation. So hedge fund groups and other funds will move to Switzerland, but are the Swiss able to keep them there? Probably not. Many will move from Switzerland to Singapore. The cleverer ones will move to Singapore straight away.”

Currently, Switzerland, and Geneva in particular, is one of the most difficult places to relocate to, says Sophie De Ferranti, managing director and head of Global Wealth Management at recruitment consultancy ValensGoldberg. “The international schools are full and you can’t find appropriate housing. It’s a really saturated market,” she says.

Go east

Singapore, on the other hand, is more welcoming in terms of living conditions, space and regulatory environment, she believes. Currently, there is such a shortage of staff that Ms De Ferranti is bringing in private bankers to the City state from nearby Malaysia, Korea and Indonesia. She also believes regulation and compliance issues in Switzerland may be driving away potential employees. “It’s a lot simpler in Singapore to get a company registered,” she says.

Luxembourg can be a more attractive lifestyle choice for many in the investment industry, she believes, expecting the Grand Duchy to pick up some of the business which the Swiss may eventually lose. “There are schools and there are houses and it’s equally as tax attractive,” she adds.

As fund domiciles, the first movers, and most pro-active chasers of funds business, both Luxembourg and Dublin are currently benefiting hugely from trends towards regulated, European investments.

During 2009, the year immediately following the world’s worst financial crisis since the 1930s, Luxembourg’s funds industry grew by 18 per cent, nudging what local practitioners call the “magic” 2 trillion euro figure, around 30 per cent of Europe’s €5,200bn total. The year saw €80bn of net new money coming into Luxembourg-domiciled funds, representing 50 per cent of Europe’s fresh collective investment product flows.

Most of this success, according to big cheeses of the kingdom’s investment industry, stems from the Ucits directive. This EU-wide dictat was launched in 1985 and has been the defining legislation guiding the regulation of cross-border funds for the last 20 years. These fast evolving rules define which investment instruments can be used, how communication with consumers is used and how funds are marketed across different countries in the economic bloc.

Not only has Ucits become a brand stamped on products and recognised around Europe as a mark of quality, but it also differentiates funds sold in emerging markets such as Latin America and Asia. Luxembourg’s authorities claim 70 per cent of funds registered in Hong Kong are Luxembourg based.

Alfi, Luxembourg’s funds association, has just opened a representative office in the Chinese territory, from where it will also target fund markets in Singapore, Taiwan and South Korea. European centres like Luxembourg – where financial services represents a third of gross domestic product – and Dublin, hope to profit from displacement of Caribbean business expected after the AIFMD rules are enacted. Alfi says it anticipated the directive and was a chief advocate of Luxembourg legislation passed in 2007, which will allow alternative-style products to be set up.

“We expected migration of funds from offshore centres, back to regulated centres like Luxembourg and Dublin,” says Alfi’s chairman Claude Kremer. “Today, those centres which can hold up regulatory certainty will win out.”

But the economic situation is also a factor in selection of centres by fund operators, claims Mr Kremer. “If somebody is creating a funds hub in Europe and they are looking for a low-risk state with a low budget deficit, these type of factors plead in favour of Luxembourg, regardless of any regulatory issues.”

Rules have also been integrated into the country’s regulatory pallet to live up to investors’ aspirations in Islamic finance, socially responsible investing and microfinance. Islamic products have been earmarked by the country’s finance industry – with full government backing – as the area with greatest scope for expansion, while other countries in the vicinity, notably Switzerland, have been accused as slow off the mark in responding to demand for Sharia-style strategies.

Over the last three years, Luxembourg’s finance minister, Luc Frieden, has analysed the factors which may help his country “become more important in Islamic finance,” and supervised rules being drawn up to put Sharia vehicles on a par with more traditional banking and investment products to give them “legal certainty.”

The minister promises more to come, in a bid to broaden the Duchy’s diversity of available products. But the strategy is already bearing fruit, with Alfi registering more than 30 Sharia-compliant funds, one for each major global player in financial services. Although Mr Frieden and his government colleagues claim it is up to the private sector to deal with competition from other centres, both sides clearly working closely to try and gain both first mover advantage and maintain competitiveness.

Ireland’s regulators receive particular praise from their own disciples for their insistence that because Ucits legislation was designed to democratise financial services, and make fancy high-finance strategies available to the man on the street, all Ucits funds must be capable of being explained to retail customers, even if they are aimed at institutions.

“The Irish regulator has guidance notes about how to set out its requirements, particularly about complex products,” says Michael Barr, partner in the Investment Funds Unit at Dublin-based lawyers A&L Goodbody. “They say you must be able to explain your product to the retail public, even if it is aimed at large pension funds, as it is passported around Europe, potentially as a retail product. That isn’t as scary as it sounds, and improves things for the manager, as it prevents later claims of mis-selling.”

But the message from Dublin stalwarts is that they must not rest on their laurels. Peter O’Dwyer, a director at one of Dublin’s leading investment servicing groups, Trinity, says we are currently returning to the days of the early 1990s, when Dublin was in the ascendancy as a home for funds and their service providers. “The government in Dublin is fired up, with new ideas and legislation. For the last five years, the story was about staff retention problems. Now US lawyers are getting really excited about Ireland. Their cultural affinity makes it the most natural platform to create funds for distribution in Europe.”

One new expected challenge comes from a newer EU member, Malta, once seen as a tiny speck of land in the Mediterranean, marooned somewhere between Sicily and Libya, but today building an increasing reputation as a sharply regulated and marketed funds centre.

“Competition will not just come from Luxembourg any more,” warns Mr O’Dwyer. “Malta is always there on the horizon, and it is growing. It is small in terms of infrastructure, numbers of lawyers and accountants, but it is there and people are beginning to launch Maltese funds.”

Naturally, there is some smirking from practitioners in Malta about the problems prevalent in the Irish banking system and the fact that Luxembourg, until recently, had the ignominy of being included on the OECD “grey list.” But the island claims a much lower price of doing business than other European and offshore locations, although the figures are hotly disputed by the Irish.

Andre Zerafa, partner at Vaelletta-based Ganadao & Associates says his jurisdiction typically appeals to refugees from major investment banks setting up hedge funds running between €500m and €3bn, who want to outsource some of the functions to a cheaper, but well regulated centre. Often there is another office in London or Geneva.

“Investment managers are not expected by the regulator to employ 20 people here straight away,” says Mr Zerafa. “But once they have tasted what we have to offer, they start seeing Malta as their hub, rather than having all core functions carried out in London."

Looking forward

The next step for Malta is to attract a major investment servicing organisation, which will immediately start to give Malta a critical mass of funds business.

There are already several smaller, more specialised players such as Praxis and Butterfield Trust on the island. But it is believed regulators have been in talks with custody arms of BNP Paribas and State Street, in order to bring more jobs to the island, as Ucits legislation requires custodians to be in the same domicile as the fund.

“The next building block is the custodian and that is something we have to work on,” says Joe Bannister, chairman of the Malta Financial Services Authority.

Despite the threat from new entrants, Luxembourg expects to continue boosting its share of the European funds sector by one per cent a year. “This is already a very high increase,” believes Alfi deputy director general Charles Muller.

“There is competition around Ucits IV, not just from Malta, which is ambitious, but from Poland and other new European countries,” adding that the UK and France are also stepping up their marketing as financial centres.

“Competition is good as it keeps us on our toes,” says Mr Muller. “But with the market share we have, if the trend continues like this, we will be very comfortable.”

Malta’s growth fuelled by Lino’s plan

Like Ireland, its key EU competitor, Malta did not achieve success as a financial centre overnight. Lino Spiteri, a former finance minister and high-profile politician on the island since the 1970s, when he was a key political adviser to socialist prime minister Dom Mintoff, is widely seen as the Godfather of the country’s growing financial sector.

“Lebanon – which had been the key financial centre for the region – was engulfed in a civil war, and we were ideally situated in the same time zone,” remembers Mr Spiteri. “By 1994, when we were agreeing our package of reforms, we looked at the situation in Dublin, Luxembourg and the Channel Islands. We felt that demand out there was bigger than supply and that Malta could tap into that demand.”

Yet one consultant, working with some major hedge fund clients, says smaller EU countries may be punished by the London regulators if they try and sell funds into the UK. “The FSA will take a dim view of people establishing in a smaller member state because it’s quicker and easier and then passporting products into the UK. Regulatory arbitrage exists as a possibility, but there is not much evidence of it in reality so far.”