Conflicts of Interest in Asset Management

Why does it matter?
 

In this first blog, we discuss the relevance of this topic and the first steps that firms need to take to manage the risk effectively:

• While there is a contractual relationship between asset managers and their clients, their interests are not always perfectly aligned.
• Conflicts of interest are expected to exist in asset management. Very rarely can they be avoided altogether. And, even if disclosed to clients, conflicts still need to be managed.
• Because it is extremely difficult and often not possible to fully evidence that the actions of a member of staff were or were not driven by a conflict of interest or other motives, the regulator imposes a higher standard of risk management than on other conduct risks.
• Not all conflicts can be made subject to a preventative or detective control. Regulations give firms flexibility to determine the appropriate approach for managing their conflict risk, depending on each firm’s size and complexity of the business. Regulators recognise that many of the activities that give rise to possible conflicts also provide benefits to clients and that, so long as appropriate mitigating measures are in place, mitigation or disclosure is often the appropriate response.
• Since it is often not possible to prohibit inherent conflict situations from occurring, the regulatory approach is principles or outcomes based with little specific guidance for firms on how to manage conflicts of interest.
• Fines and public censures, such as exemplified in our case studies (see our blog #4), are only the tip of the iceberg of regulatory activity. In most cases, the regulator would not take the resource heavy approach of public enforcement but instead require the firms, identified during non-public supervisory activity, to undertake lengthy and expensive internal remediation actions to address identified gaps or weaknesses in the management of conflicts of interest.

What is not a Conflict of Interest?
 

Asset managers have a duty to consider their clients’ interests first and foremost. Regulation requires the consideration of all conflict of interest risks, not just the material ones. The risk of conflicts of interest materialising needs to be managed, and where possible, prevented, avoided or mitigated.

What makes the management of conflicts so difficult is the broad and diverse range of activities in which they arise, which often - based on a common misperception - results in the front office staff retort: “Everything we do constitutes a conflict, what do you expect us to do?”

While one can have some sympathies with the front office’s stance, it shows that there is a need to clearly delineate conflicts of interest risk from other non-financial or conduct risks. Where conflicts are conflated in a firm’s risk taxonomy with Market Abuse (a financial crime) or overlap with general duty of care or other regulatory requirements, it is unlikely that staff have a clear understanding of the inherent risk.

Clearly defining, articulating and communicating the conflicts of interests applicable to the firm is a key task, as exemplified in the schematic below.

Conflicts Registers
 

The firm’s risk taxonomy needs to be supported by conflict of interest registers that define,  articulate and record the various categories and types of conflicts for each division and activity of a firm, establishing a common and consistent language and understanding of the business activities and the conflicts that are specific to the firm and its business. Actual and potential conflicts need to be identified and articulated.

Some firms may need to review and expand their register of conflicts, to include all potential risks if they have only listed "material" ones and to ensure live conflicts are logged and regularly reviewed.

Due to the diversity of conflicts,  the situations where they arise and the timing and the frequency of their occurrence, a set of different conflicts of interest registers should be combined in one framework to ensure systematic, complete, timely and accurate recording, resulting in effective management. This allows a firm to join the dots between the various conflict generating activities and the key generators of conflict potential. Consistency, alignment, aggregation and standardisation of reporting of the conflicts to senior management, typically best through a single work-flow software, is evidence of effective management of conflicts. An example schematic of such a workflow is set out below:

Depending on the type of conflicts and the volume or likelihood of their occurrence, some registers require each conflict to be recorded, while other registers need to apply a scenario approach to clearly articulate the inherent conflict in daily activities of the firm.

Typically, there are: 

• transaction-based conflicts (specific deals where the firm has a conflict with one or more clients which are most commonly managed via deal logging),
• structural conflicts are unlikely to be identified on a transaction by transaction. They are frequently and often daily occurring situations that carry inherent conflicts of interest that cannot be mitigated individually with controls.
• live conflicts (incidences that require proactive management of individual actual and potential conflicts) and
• personal as well as internal conflicts.

A consistent and comprehensive register and workflow can be key evidence of effective oversight of the risk. The high volume of information requires careful analysis of all conflicts as they are emerging to gain an understanding of where a firm should apply the scarce control resource to mitigate the risk. 
 

Conflicts of Interest Taxonomy
 

Multiple types of conflicts that are specific to the firm should be articulated in a dedicated taxonomy that identifies and delineates all conflict types in distinct categories. It sets out the identified conflicts situations and scenarios.

While most business conflicts need to be managed in the front office or first line of defence, some other conflict categories clearly benefit from centralised and independent conflicts management by the second line of defence or Compliance. An illustrative example of such a taxonomy and typical responsibilities for the management of the risk is set out below: