How to fix suspended exchange control circular, Regulation 28 – investment expert Nerina Visser. MUST READ!

Late last year, an exchange control circular (15/2020) changed the rules for Exchange Traded Funds by widening access to foreign investments. But, the authorities back-tracked in November under reported pressure from large businesses with a commercial interest in maintaining the status quo. This, in turn, was seen as a blow to savers in pension funds, which are restricted in their ability to invest offshore where the best returns have been enjoyed in recent years. The investment community was asked to submit comments to the proposed changes. Financial services industry expert Nerina Visser has submitted a detailed report on how South Africa can tweak the regulations to ease controls. Her submission has proved popular among many of her peers. Here is the summary of her key arguments – and a link to an in-depth interview with Visser on BizNews Radio. And, for more on this hot topic, scroll to the end of the article for insights from independent financial advisor Magnus Heystek and financial services entrepreneur Magda Wierzycka, who heads Sygnia. – Jackie Cameron

By Nerina Visser*

Considerations on the (suspended) SARB Exchange Control Circular 15/2020

I offer comments and considerations relating to four aspects, as follows:

  1. Macro-prudential limits for institutional investors, relating to the capital flow management framework, vs. investment mandate and regulatory limits, relating to the prudential framework currently applicable to all regulated funds, including retirement funds, collective investment schemes and insurance.
  2. Review of Regulation 28 of the Pension Funds Act of 1956.
  3. The look-through principle as introduced in 2011.
  4. Contrasting listed instruments (exchange-traded) to unlisted investments (being over-the-counter, “OTC”), rather than so-called “active” vs. “passive” investment styles.

1. Macro-prudential limits for institutional investors vs.investment mandate and regulatory limits

Nerina Visser

The basis for having macro-prudential limits as one component of the capital flow management framework, is well- established as part of exchange control regulation. Any changes to the current limits for institutional investors (being 30%, plus an additional 10% for retail assets) should not be conflated with the investment mandate and regulatory limits, relating to the prudential framework currently applicable to all regulated funds.

There are many different investment mandates and regulatory limits – e.g. Regulation 28, CISCA, insurance legislation, discretionary investment mandates, even ASISA fund classification standards – which serve to ensure relevance and prudency as far as different investment objectives are concerned. The types of funds and investment portfolios to which such mandates and limits apply, represent a broad range of the products and solutions offered by institutional investors, and as such we need to clearly differentiate between macro-prudential limits for institutional investors and investment mandate or regulatory limits.

Let us use an example of institutional investor A who manages three different investment portfolios:

  • a retirement annuity fund (subject to Reg. 28);
  • a collective investment scheme (a CIS in securities classified as a “global – general equity” portfolio as perASISA classifications, thus have at least 80% of its investments outside South Africa); and
  • a discretionary stockbroking portfolio on the JSE with the mandate to maintain maximum offshoreexposure.
    Institutional investor – exampleLet us assume that the three portfolios are all equal size (R100m), and that both the RA and CIS portfolios are invested according the maximum limits available* investment mandate or regulatory limit
    + cannot achieve investment mandate without breaching macro-prudential limit ** macro-prudential limitIn this example the institution will not be able to fulfil the discretionary mandate of a maximum offshore exposure, as anything more than 10% offshore in the discretionary portfolio will put it in breach of its macro-prudential limit of 40%.
  • In this case the institution will assist the client in moving the money offshore, whereafter the investment will be managed outside of South Africa, and all peripheral benefits and value-add will accrue to foreign markets.Under the proposed dispensation – if global investments listed on a domestic stock exchange is considered “domestic” for macro-prudential limit purposes – the institutional investor can achieve its required mandate by retaining the assets within the South African capital and investment markets, without breaching any of the various investment mandate or regulatory limits. This is illustrated in the example below:

% allocation

RA

CIS

Disc

Overall

SA equity

45

20

90

52

SA bonds

20

7

SA cash

5

2

Foreign equity

30*

80*

10+

40**

Total

100

100

100

100

AUM

100

100

100

300

* investment mandate or regulatory limit ** macro-prudential limit

2. Review of Regulation 28

There can be no doubt that Regulation 28 of the Pension Funds Act of 1956 requires a substantial review to maintain its suitability and relevance for current investment opportunities and capital market conditions. To mention just a few of the current inconsistencies and shortcomings:

  • The universe of listed equities has shrunk dramatically over the past decade. Allowing up to 75% of retirement funds assets to be invested in this declining pool of investment opportunities is forcing capital to be allocated to a concentrated selection of investments with less and less relevance to the South African economy.
  • Alternative investments have become a very crowded space for a hugely divergent set of investment opportunities – from private equity, to hedge funds, to “any other assets not referred to in this schedule”. There is no specific mention of infrastructure projects, structured products, etc.
  • Foreign exposure is only mentioned in the context of Equities, with no specific reference under Debt Instruments, Immovable Property, Hedge Funds, Private Equity and any other assets. 5% of cash can be held with a foreign bank, but it is unclear if this is to be considered part of the 30% foreign allowance (or 10% additional allowance for the rest of Africa), or not. And what about foreign debt, property or alternative investments? Is that part of the 30% foreign allowance, or in addition to it?
  • There is little guidance on the classification of derivative instruments according to Reg. 28 limits, and how the effective exposure should be included in the aggregate holdings report.
  • The definition of sub-limits based on market capitalisation is outdated and has not been adjusted for inflation / market growth.There will no doubt be many submissions to this task group to justify increasing the 30% foreign limit, especially based on (recent) past performance relative to the domestic investment markets. There are plenty of good reasons why 30% would be deemed to be too low, including the often-quoted fact that both the South African economy and investment opportunity set represents less than 1% of the global options. As such it is inappropriate, even risky, to restrict retirement savings to such a limited scope. But having a limit on foreign exposure is not uncommon – a 2019 study of pension schemes by the Organisation for Economic Co-operation and Development (“OECD”) found that 82 of 84 countries studied had some form of foreign exposure restriction on pension schemes. But a 100% allowance is also not appropriate, so what is the “perfect” answer? The principle of matching assets and liabilities is a prudent one, and one of the roots of limiting foreign exposure. However, this is only applicable to defined benefit (“DB”) funds, or occupational pension and provident funds which serves both pre- and post-retirement members, with a portion of liabilities represented by payment outflows. In

% allocation

RA

CIS

Disc

Overall

SA equity

45

20

22

SA bonds

20

7

SA cash

5

2

Foreign equity – domestic listing

15*

40*

35*

30

Foreign equity – other

15*

40*

65*

40**

Total

100

100

100

100

AUM

100

100

100

300

the case of preservation funds and retirement annuities, where there is only the option of exiting the fund to either another retirement fund option, or an external post-retirement solution, the liability structure is not one of regular annuity / pension payments.

In fact, the biggest “liability” of a young retirement fund member, with at least a 20-30 years’ time horizon until the earliest legislated retirement age of 55, is one of real capital growth, and it is inconceivable that the current Regulation 28 limits, coupled with the pedestrian domestic economic growth outlook, can achieve the required real growth in retirement funds for such a member – this is a significant risk to the current retirement savings system.

Simultaneously, there is a disconnect between pre- and post-retirement regimes, where as soon as the member transfers to a post-retirement investment such as a living annuity, there is no restriction on foreign exposure, yet at this stage the member / annuitant is already in the drawdown phase, resulting in a specific liability stream of regular payments (at least 2.5% p.a. of the invested capital). This inconsistency, and leniency in the lack of liability matching required in some post-retirement savings vehicles, represent another significant risk to the current retirement savings system.

The current Regulation 28 construct does not recognise the realities of either the evolution of the retirement fund system (incl. from DB to DC, and from occupational funds to personal pre-retirement solutions such as RAs), or of the current state of the capital and investment markets and the opportunities it presents.

3. Look-through principle must be retained

It is worthwhile to remember the reason why the look-through principle was introduced in 2011. This was in the aftermath of the global financial crisis (“GFC”) in 2008, where investment banks created investment structures, wrapping sub-investment grade securities (e.g. sub-prime mortgages) into notes that received very high investment ratings from credit rating agencies, thereby effectively converting sub-investment grade investments into products that qualified for investment by – amongst others – pension funds.

In South Africa there was a similar experience of hedge funds being wrapped in structured notes, thereby converting hedge fund investments (to which regulatory limits applied) into credit notes, or debt instruments (with much more lenient regulatory limits). The specific purpose of the look-through principle was to avoid using a “wrapper” to effectively change the nature of the underlying investment for the purposes of regulatory or investment mandate limits.

The same principle should continue to apply – you can’t use the classification of the “wrapper” being “domestic” (e.g. a JSE-listed global ETF) to change the nature of the underlying (e.g. foreign equities). This would mean that such a JSE-listed global ETF may be classified as “domestic” for macro-prudential purposes but “foreign” for investment mandates and limits, e.g. Reg. 28, ASISA classifications, etc., as demonstrated in the example in section 1.

The question remains – what constitutes “foreign”? In the case of

  • listed securities – is it the domicile of the primary listing? what about the operational domicile? how do you distinguish between the equity and debt of the same company? when is it “foreign” and when is it “domestic”?
  • unlisted investments – is it about the proportion of the revenue? or of the earnings? or the proportion of operations measured by number of employees?
  • What about debt instruments? Does the currency (ZAR vs. non-ZAR) determine this?Clear guidance would be required to avoid further ambiguity of the interpretation of “foreign”, especially for investment mandates and regulatory limits.

4. Exchange control circular battle: It’s about listed (exchange-traded) vs. unlisted (“OTC”), not active vs. so-called “passive”

A key aspect of the proposed change in exchange controls relates to listings on South African exchanges, i.e. to exchange-traded instruments. The scope thus covers “foreign classified debt and derivative instruments as well as exchange traded funds referencing foreign assets, that are inward listed on a South African exchange, traded and settled in Rand”.

This highlights an important differentiation between listed and OTC investments – the former trades primarily in the secondary market, the exchange, whereas the latter can only transact in the primary market. Exchange-traded instruments of course also have a primary market component, but this is limited to periodic creation or redemption, thus changes in issue size, and this is done by the issuer. Therefore, from the perspective of exchange controls, the SARB would be dealing with periodic tranching of cross-border capital flows, from each approved issuer, thus easier to monitor and manage, rather than daily flows from every institutional investor, on behalf of a broad and diverse range of clients, introducing much more complexity in oversight and monitoring.

Once the securities have been created and listed on the South African exchange, any subsequent activity takes place in the secondary market, in ZAR, on the domestic exchange, thereby capturing much more of the investment value chain locally – stockbroking, investment advisory, asset management, custodian services, to name but a few. If money is getting allocated to offshore investments anyway – which is prudent from a diversification and risk management perspective – we may as well capture more of the value created, locally. We should not under- estimate the multiplier benefit to local financial / investment industry and economy, rather than to the current foreign markets.

To argue that the suspension of this circular is a so-called “active vs. passive” argument, and an attempt by the “active” industry to protect their turf, is a red herring, and opportunistic – after all, there are numerous actively- managed exchange-traded instruments, just as there are index-tracking (so-called “passively managed”) CIS funds. This is great progress on the road to grow and develop the domestic investment and finance industry, and capture more of the peripheral value creation for the benefit of the South African economy, the local market, and ultimately, for the benefit of society.

I strongly support the (re-)introduction of Excon Circular No 15/2020 in its current form, with the necessary clarification on how this is to be applied within the prudential framework, to different investment mandates and regulatory limits, taking into consideration the look-through principle, which is currently only applicable to Regulation 28. Furthermore, a comprehensive review of Regulation 28 is long overdue, and critical to address the growing risks in the South African retirement fund system.

  • Nerina Visser, CFA, is director & co-owner at etfSA Portfolio Management Company, President at CFA Society South Africa. 

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