Despite a deteriorating eurozone outlook eating away at Luxembourg’s financial services industry, bright spots are on the horizon.
Despite a deteriorating eurozone outlook eating away at Luxembourg’s financial services industry, bright spots are on the horizon.
As the second-largest investment fund centre in the world and the largest in Europe, Luxembourg’s financial sector continues to adopt European Union regulation early, which is helping to draw in hedge funds, particularly those adapted to operate within the UCITS framework. By mid-2011, over 3,700 hedge funds were registered, a total exceeded only by the UK and France.
The size of Luxembourg’s UCITS sector is now a major attraction for hedge funds moving into Europe to earn credentials for eventual distribution beyond the EU while the country’s low public debt and relatively stable economy present advantages in attracting investment fund flows albeit with fierce competition from Ireland, the Channel Islands and even Malta.
Its success as a financial centre, says agency Luxembourg for Finance, is grounded in the social and political stability of the Grand Duchy and in a modern legal and regulatory framework that is continuously updated, allowing it to offer a wide variety of investment fund vehicles. It is also at the top of the World Economic Forum’s global competitiveness index for the prevalence of foreign ownership of companies.
But an impending recession in Europe, and resulting slowdown in demand from the eurozone will dampen exports, with financial services, which accounts for some 28 per cent of GDP according to some estimates, suffering most.
And the outlook for GDP growth over the next year has weakened further, notes Ernst & Young in its most recent economic report on the country. The firm has heavily revised its forecasts for growth – to 1.9 per cent compared with 3.5 per cent in an earlier report. For 2012, it predicts 0.9 per cent growth, revised down from 1.7 per cent.
The revisions take into account that the economy took a much larger hit from the global crisis than previously calculated while the greater than expected intensity of the eurozone crisis too is affecting future growth prospects.
That has certainly spurred officials, such as the finance minister, trade minister and Grand Duke, to market Luxembourg as Europe’s financial centre to high-growth regions such as China and South East Asia. Relocation of offshore funds and gradual recovery of eurozone financial markets will undoubtedly support financial sector growth but sustaining net inflows in the longer term will require tapping into rising savings flows from East Asian and Middle Eastern emerging markets, notes Ernst & Young.
The global financial crisis has not changed the landscape in Luxembourg, says Marc Wenda, product manager, hedge fund services at European Fund Administration. “The crisis simply accelerated trends that were already happening. There’s a higher awareness of risk, not just in portfolio reporting but also in the onboarding of new clients and new funds as well as the due diligence requirements from investors.”
A more near-term bright spot is the push to derivatives clearing. Alternative investment funds that will now need centralised derivatives trading may be encouraged to relocate to Luxembourg because of its early moves towards an ECB-linked securities repository. In October, Clearstream announced that its joint venture, LuxCSD, with Luxembourg’s central bank became fully operational and will serve as the access point to TARGET2-Securities (T2S).
LuxCSD provides the Luxembourg financial community with central bank money settlement prices as well as issuance and custody services for a wide range of securities, including investment funds.
One of the key advantages of Luxembourg is its workforce. Having been a major funds centre for decades, the country boasts a highly qualified pool of staff, mainly from Belgium, France and Germany, as well as locals, who are fluent in the major languages and experienced in all aspects of the funds industry. Over 500 fund promoters are based in the country, and the technological infrastructure also means it is straightforward for businesses based there to sell globally.
But it’s regulation that’s the key. Luxembourg was the first European jurisdiction to allow cross border distribution of funds. So a firm could base itself in the Duchy and sell across several countries from one hub. It’s estimated that 80 per cent of European funds that are sold in three or more countries are domiciled in Luxembourg.
It’s also been quick on the uptake when it comes to integrating trans-national regulations. As one of the first countries to be ready for UCITS I and UCITS II, Luxembourg was also one of the first countries to introduce UCITS III into national law in December 2002, a move welcomed by the local fund industry. In fact, the only barrier holding Luxembourg-based funds back is the speed at which other countries have been introducing the legislation - at present there are still restrictions in some jurisdictions on selling UCITS III funds. And in December, UCITS IV was passed into law.
Since 2002, Luxembourg has become an increasingly important destination for hedge funds, an area that it didn’t see much of prior to that time. An investment circular published by the Commission do Surveillance du Secteur Financier (CSSF) increased the appeal of the jurisdiction for hedge funds, and further moves - such as the abolition of subscription tax for triple A funds that are solely for institutional investors have increased the inflows of funds to the country. The new hedge fund laws didn’t really change anything; they simply formalised the regulation for what had been generally understood in the markets for some years.
However, the fact that there are now formal laws has reassured a jittery market. The downturn of the past couple of years meant some offshore jurisdictions became wary of a flight to perceived quality - countries where the regulations were understood by regulators and governments who remained concerned that some areas of the financial industry were out of control.
While Luxembourg of course experienced some ructions during the downturn, the impact was surprisingly low - due in significant part to the confidence both the industry and European governments had in the strength of the infrastructure of the country. And while there will always be complaints about the favourable tax status Luxembourg-based funds may receive, the mutterings about Luxembourg have been far more muted than in other jurisdictions, such as Dublin.
“For a reason we don’t always quite understand, some people have chosen Luxembourg over countries like Ireland for perceived risk reasons,” says Wenda. “I don’t understand it - as long as the law is enforced, then there is no additional specific danger to the fund. Maybe it is perceived tax stability, which obviously exists in Luxembourg.”
The main issue affecting providers in Luxembourg has been simply keeping up with the volume of new regulations and laws coming through over the past couple of years as governments and regulators have panicked and tried to bring in barriers to further market turmoil. Whether it’s on a cross-border level, such as the European Union Savings Directive or the impact of US laws such as Dodd-Frank, the new International Accounting Standards or local legislation, such as the recent German tax rules, the workload for some providers has become intolerable.
“As a small firm, we were spending more and more of our time and budget on preparing for new regulation,” says one former country manager at a boutique administration firm that has now been bought by a larger player. “There have always been issues with economies of scale, but because we offered a bespoke service we could still manage to give our customers the experience they needed. But with all the changes that have taken place in recent years we couldn’t keep up and it’s worked out for the best for both us and our clients that we are now part of a much larger organisation.”
Consolidation has become the name of the game here. Many of the global players have made acquisitions, while several local names have merged. Further consolidation is expected.
“Some smaller standalone fund administrators may be struggling,” explains Wenda, “but this is due to the existing business being consolidated or merged, or massive redemptions.”
The pension fund market has not been quite so successful. Although the law was changed more than a decade ago to allow pension funds to be launched in Luxembourg, so far only a handful have decided to do so. Taxation is thought to be the reason for this.
“Taxation hinders the creation of cross-border pension funds,” says Stephane Ries, head of relationship management at the Investment Fund & Global Custody Department of Kredietbank S.A. Luxembourgeoise. “Luxembourg acknowledged it could not attract many multinational pension funds and began to focus on getting the assets of those funds into the domicile. Nowadays, if a multinational company is running several pension funds for the benefit of its employees, it can create a single investment fund in Luxembourg in order to leverage off economies of scale in pensions management. Luxembourg has just introduced an exemption from the taxe d’abonnement for these funds, which are also called pension-pooling vehicles.”
One area where large amounts of growth is expected is in the servicing of alternative funds. Sicavs and property funds are expected to become more popular, and the industry within Luxembourg is gearing up to service these different models.
“Business is stable,” explains Wenda. “What we are seeing is that it takes much more time for new projects to go live. The alternative sector, however, remains the growth area.
