Local authority funds in the UK face a “fire sale” of up to half their £230bn (€314bn) in assets if they are reclassified as retail investors under a European Directive coming into force in 2017.

Triggered by the transposition of the revised Markets in Financial Instruments Directive (MiFID II), the new rules would do away with MiFID I’s framework allowing asset managers to treat local public authorities automatically as professional clients.

Instead, asset managers would be forced to assess whether public authorities, including the administering authorities behind the UK’s 101 local government pension schemes (LGPS), possessed the requisite knowledge to invest in institutional products.

In a briefing note sent to funds last week, the UK’s Local Government Association (LGA) warned that the LGPS would be “defaulted to retail client status”, leaving them with a “much reduced pool” of asset managers and consultants with which to work.

“Those managers willing to deal with you will offer a restricted range of products, and, due to the extra compliance checks and reporting required for retail clients, those products could cost more,” the note said.

“If, when the Directive comes into force (January 2017) you hold assets in products outside of the scope of those available to retail clients, you may find the manager will eject you from that product, resulting in a ‘fire sale’ of assets.”

It added: “First estimates are that up to 50% of LGPS assets may be affected.”

The LGA said a “fire sale” could be averted if the Financial Conduct Authority (FCA), in charge of drafting the regulation, allowed for a transitional period, during which the LGPS could retain its stakes in institutional products.

Alternatively, it noted, funds could ‘opt up’ and be classified as professional clients, requiring every local authority fund to demonstrate to each of its external managers it possessed the requisite experience, expertise and knowledge so it was “capable” of making its own investment decisions.

It is understood that the Department for Communities and Local Government (DCLG), in charge of LGPS regulation, is working to address the matter.

A source within DCLG said the department would be doing its “level best” to avoid a divestment of holdings, which it said could see asset sales occur at “entirely the wrong time”.

“We really must try to avoid that at all cost,” the source added.

The LGA could not say how long an assessment to opt up would take, but warned funds not to be surprised if the process was not complete if a significant number waited until late 2016 to start the classification process.

The association said it was in discussions with the FCA on ways to make the transition “smoother” for the LGPS, and was also talking with the Investment Association about the development of a standardised process allowing the funds to achieve professional status.

It did not say if the rules would impact plans to create LGPS asset pools but said it was talking with both the DCLG and the Treasury about any potential impact. 

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