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Specific regulatory issues

Shadow Banking

In April 2011, the Financial Stability Board published its note on shadow banking. The FSB released the note following the commitment made by the G20 at the Seoul November Summit to look at shadow banking. It is broadly described as credit intermediation involving entities and activities outside the regular banking system. The note recognises the advantages of shadow banking, for instance the fact that it provides market participants and corporates with alternative source of funding and liquidity, but also a source of systemic risk.

The reports considered three main themes.

  • Clarifying what is meant by the shadow banking system,
  • Setting out potential approaches for monitoring the shadow banking system,
  • Exploring possible regulatory measures to address the systemic risk and regulatory arbitrage concerns posed by the shadow banking system.

The AMIC responded explaining it believed that a key step in the ‘shadow banking’ discussion was to clarify the type of activities understood under the term ‘shadow banking’. Moreover the AMIC wanted to ensure that recommendations of regulatory reforms take into account the current regulatory developments and its impact on the asset management industry; and avoid regulatory overlaps. The Council also recommended a global approach in the definition and identification of shadow banking issues.

The FSB approved the initial recommendations at its July Plenary meeting and submitted its final recommendation at the G20 Autumn meeting.

The European Commission published in April 2012 a Green Paper on shadow banking. The AMIC responded to the Green Paper on 15 June 2012, and shared its concerns regarding the definitions of the term ‘shadow banking’ and its potential effects on the asset management industry.

On 18 November 2012, the Financial Stability Board (FSB) published its three consultative documents regarding “Strengthening Oversight and Regulation of Shadow Banking”.  The AMIC responded to the consultation on 14 January 2013.

On 7 April 2014 the AMIC responded to the FSB/IOSCO consultation on the assessment methodologies for identifying non-bank non-insurer Global Systematically Important Financial Institutions (‘NBNI G-SIFIs’).

On 29 May 2015, AMIC’s Market Finance Working Group (formed in December 2014 to address industry concerns about regulatory focus on shadow banking) responded to a second FSB/IOSCO consultation on a methodology to identify NBNI G-SIFIs. AMIC welcomed the FSB/IOSCO’s willingness to refine its approach following the first consultation, but cautioned against including asset management companies as potentially systemically risky entities alongside investment funds.

Credit rating agencies

On 5 September 2014 the AMIC responded to the IOSCO consultation paper on Good Practices on Reducing Reliance on CRAs in asset management.

On 27 October 2010, the FSB released at a global level its principles for reducing reliance on credit rating agency (CRA) ratings. The European Commission published in turn a new consultation on the issue of overreliance on CRAs on 5 November 2010. The consultation, which came to an end on 7 January 2011, aimed at promoting better due diligence and considering internal risk management models. It also called for changing the role of ratings in the current regulatory policy in light of their potential impact on investors’ behaviours.

The main themes of the Commission consultation paper are:

  • Reducing overreliance on external credit ratings (by suggesting the use of internal credit risk assessment process and of a mix of alternative measures, either in the case of capital requirement calculation than investment policy decisions and risk management purposes);
  • Enhancing sovereign debt ratings (among others, one of the proposals is to reduce the assessment time period from one year to six months and increase the number of documentation disclosed by rating agencies );
  • Enhancing competition in the credit rating industry (by encouraging the ECB to issue ratings);
  • Proposing civil liability of CRAs; and
  • Elimination of potential conflict of interest due to the “Issuer-Pays” Model

The AMIC is of the view that reforms, while desirable, need to be well conceived in order to maintain the public-good aspects of credit ratings and to avoid unintended consequences such as increased costs and reduced access to capital markets. Credit rating agencies provide an assessment of the creditworthiness of a corporation or security, based on the issuer's quality of assets, existing liabilities, borrowing history, and overall business performance. Credit rating agencies offer the issuing company the opportunity to use and communicate non-public information externally, without disclosing its precise content. This is a critical aspect of a functioning international capital market.

The current regulatory framework is so reliant on ratings that significant changes can only be conceived to take place over time. Mandates to use ratings have become part of the fabric of financial markets, and cannot be unwoven instantaneously. Many institutional investors are legally obliged to hold only securities of some minimum rating, or may have to hold larger reserves when investing in bonds of lower ratings. Ratings are also used in private contracts, for example to define the investment objectives of bond mutual funds. Accordingly the AMIC believes that regulatory use of ratings has exacerbated pro-cyclicality in the financial system as a whole. However, in order to reduce private reliance on ratings, credible alternatives or substitutes should be developed, particularly for institutions that lack resources to assess independently the number of available fixed income instruments.

Alternative Investment Fund Managers Directive (AIFMD) – Level 2

The European Parliament ECON Committee agreed on a final text to the AIFM Directive which would include clauses on asset stripping and remuneration as well as a compromise on marketing passports. The agreed text was set to impose a passport system and registration, reporting and capital requirements on companies. It also included depository liability, capital requirements and rules covering leverage use. The main regulatory component is an obligation for EU-based managers of alternative investment funds to register and disclose their activities. This includes divulging investment strategies and accounting practices to investors and regulators, Hedge fund managers would also be forces to retain minimum capital requirements and ensure these assets are secured in depository banks.

Controversially, it allows non-EU hedge funds and private equity firms to market to investors across the EU without having to seek permission from each member government. Parliament had pushed for a marketing passport to be granted to non-EU players. But under a compromise with member states, MEPs agreed that managers will obtain passports only if the non-EU country they are located in meets minimum regulatory standards and has agreements in place to allow information sharing. Initially only EU AIF and AIF managers will be able to obtain a passport with those based outside the EU having to market through the current national private placement regimes. After an opinion from ESMA and the adoption of implementing legislation by the Commission, the passport would then also become available to non-EU AIF and AIF managers.

In addition a new clause was inserted to ensure that fund managers will have to obey the same rules as those for bank managers to remove incentives for excessive risk-taking.

Although the Commission’s very first proposal had already dealt with regulating depositories’ liability, MEPs felt that too much leeway was being given to depositories to delegate this liability. To this end, MEPs inserted a clause stating that if a depository legally delegates its tasks to others, then it must provide a contract which allows the fund or the fund manager to claim damages against the entity which received the delegation. This should ensure that at no point in the chain will liability be irretrievably lost. MEPs also secured a requirement that the AIF investors concerned are closely involved with the potential delegation of liability.

CESR published a call for evidence on level 2 measures. The AMIC made some general comments on the implementing measures. In particular the response highlighted the value of the alternative investment industry to the investors, the AMIC believes that maintaining diversity of investment is crucial. There was concern that investors would lose the ability to design optimal portfolios and there was a risk that overly burdensome regulation results in addition to the reduction in the quantity of funds available, also in the reduction in both the variety of funds and also the quality of funds which EU investors can access.



Revision of the provisions on diversification of collateral in ESMA’s guidelines on ETFs and other UCITS issues

ESMA issued its consultation paper on Revision of the provisions on diversification of collateral in ESMA’s guidelines on ETFs and other UCITS issues in December 2013 in response to concerns that the requirements on collateral diversification in the Guidelines, which came in to force on 18 February 2013, were having a significant adverse impact on UCITS’ collateral management policies.

In its response of 31 January 2014 the AMIC welcomes the distinction made between collateral diversification and diversification of assets held by funds – as suggested by ESMA’s approach, but considers that the proposal in this consultation paper is not consistent with a coherent UCITS investor protection policy.

The AMIC response to the paper is available here.

On 26 July 2012 the European Commission launched a public consultation entitled "UCITS Product Rules, Liquidity Management, Depositary, Money Market Funds, Long-Term Investments on a number of regulatory issues related to money market funds, eligible assets, the use of derivatives, and depositary passports". At this stage, it appears that the consultation will form the basis for "UCITS VI", so as to build on the recent UCITS IV Directive and the upcoming UCITS V Directive. The Commission has requested responses to the consultation from interested parties by 18 October 2012.
In the Consultation, the Commission has posed a series of broad, open questions relating to eight different areas of the UCITS regime:
  • eligible assets and use of derivatives: evaluation of the current practices in UCITS portfolio management and assessment of certain fund investment policies;
  • efficient portfolio management techniques: assessment of current rules regarding certain types of transactions and management of collateral;
  • OTC derivatives: treatment of OTC derivatives cleared through central counterparties, assessment of the current framework regarding operational risk and conflicts of interest, frequency of calculation of counterparty risk exposure;
  • extraordinary liquidity management rules: assessment of the potential need for uniform guidance in dealing with liquidity issues;
  • depositary passport: assessment of whether or not to introduce a cross-border passport for the performance of the depository functions set out in the UCITS Directive;
  • money market funds: assessment of the potential need to strengthen the resilience of the MMF market in order to prevent investor runs and systemic risks;  
  • long-term investments: assessment of the potential need for measures to promote long-term investments and of the possible form of such measures (including investments in social entrepreneurship);
  • addressing UCITS IV: assessment of whether or not the rules concerning the management company passport, master feeder structures, fund mergers and notification procedures might require improvements.
In its press release, the Commission specifically mentions that this consultation is to be seen as complementary to its on-going shadow banking work. The consultation aims to further clarify the interaction between the debate on shadow banking and the role of investment funds.

The AMIC response to the consultation is available here.

ESMA Consultation Paper on recallability of repo and reverse repo arrangements

In its response, AMIC members explain they are concerned in general that ESMA guidelines are setting principles on a key topic already in discussion at other international or European bodies levels. For instance the FSB will make by the end of the year its own recommendations on securities lending and repos based on the extensive work they have undertaken under the G20 work programme. UCITS VI will also look into some of the aspects of collateral management. AMIC members believe there is a need for coherence and consistency in the approach on this topic at all regulatory levels.

AMIC members are also concerned about the limitations proposed in the guidelines, which in effect, affect the UCITS access to the repo market. Restricting the ability of a UCITS to enter into non-recallable repo transactions for instance would ultimately increase frictional cost, reduce the number of counterparties willing to take on the additional risk of fully recallable repo transactions and suppress activity in the repo market. End-investors benefit most when the capital transfer mechanism is as efficient as possible; indeed efficient capital transfer mechanisms create liquidity and liquidity ultimately reduces costs for end-investors.

AMIC members are concerned by the wording of paragraph ‘40.e. Collateral diversification’ of the guidelines on ETFs and other UCITS issues – referred to in point 3.c of the proposed guidelines. The new guidelines from ESMA could be interpreted so as to require such managers to accept collateral which is riskier and may not be as liquid in comparison to their own collateral management policy – and create new market risks.

Finally, the impact of the proposed guidelines should be considered in the context of the increased demand for cash that will result from implementation of the European Market Infrastructure Regulation (EMIR) as currently drafted. If variation margin collateral requirements under EMIR are not expanded to include highly liquid securities as well as cash, the buy-side will have to increase its use of the repo markets to raise the necessary cash to meet the CCPs’ variation margin requirements. Any proposed restrictions on repo transactions would therefore impact the ability of market participants to meet the variation margin requirements under EMIR, and could lead to forced sales of assets to generate alternative sources of cash.
In 2009, the G20 Leaders initiated a reform programme of the over-the-counter (OTC) derivatives markets. In particular, a number of measures were agreed to enhance the transparency and regulation of OTC derivatives, including mandatory central clearing. However, mandatory clearing requirements are only intended to capture standardised OTC derivatives. Non-standardised products will thus continue to be non-centrally cleared and will remain subject to bilateral counterparty risk management.

In 2011, the G20 Leaders agreed to add margin requirements on non-centrally-cleared derivatives to the reform programme. These requirements are expected to further mitigate systemic risk in the derivatives markets. In addition, the G20 believes it would encourage standardisation and promote central clearing of derivatives by reflecting the generally higher risk of non-centrally-cleared derivatives. The consultative paper published jointly by the BCBS and IOSCO lays out a set of high-level principles on margining practices and treatment of collateral, and proposes margin requirements for non-centrally-cleared derivatives.

These policy proposals are articulated through a set of key principles that primarily seek to ensure that appropriate margining practices will be established for all non-centrally-cleared OTC derivative transactions. These principles will apply to all transactions that involve either financial firms or systemically important non-financial entities.

The AMIC Executive Committee believes that the consultation paper is key to the development of the market, and also felt that it would shape the market for the buy-side. In addition to specific and technical responses to the questions posed by the paper, AMIC members made some general comments that they hope will be taken into consideration:
  • As provided for in EMIR regulation in Europe, existing derivative instruments should not be retroactively concerned by new regulation as their economic conditions may just be impossible to maintain with the constraint of a collateral; a grandfathering clause is absolutely necessary to exempt existing transactions from collateral requirements even in case of reset lowering risk (to clear excess counterparty risk or to diminish notional amount, for example).
  • There may be a rush of all stakeholders on collateral due to the fact that all operations will have to be collateralised at once and to a higher degree than eventually required, simply by lack of recognised CCPs. A staged implementation calendar is therefore required.
  • The current wider regulatory agenda is requiring ever more (high quality) collateral, at a time when there is the downgrade of a substantial part of previously reasonable good collateral, and it is widely perceived that the market will suffer from a shortage of high quality collateral.
  • A broad universe of assets as eligible collateral is therefore needed.
  • An international framework is desirable to avoid market fragmentation and regulatory arbitrage.