Supervision of Investment Funds – From a Global Debate to a Balanced European Regulatory Framework
This morning, 21 March 2023, Verena Ross, Chair of ESMA (European Securities and Markets Authority), provided an interesting and insightful keynote speech entitled “The macro-prudential supervision of investment funds – from a global debate to a balanced European regulatory framework” at the ALFI European Asset Management Conference 2023, noting in particular how the remaining vulnerabilities of Open-Ended Funds (OEFs) are being kept under close scrutiny at the global level.
Important EU reforms already underway
Verena Ross set out the important EU reforms already underway to tackle the systemic risk posed by investment funds, in particular those arising from liquidity mismatch and excessive leverage. She presented the recent market developments in the investment management sector and gave an overview of ESMA’s views on current vulnerabilities. This was followed by an update on the ongoing regulatory agenda for the investment management sector at both international and European levels, with a particular focus on financial stability and macro-prudential supervision. Finally, Verena Ross wrapped up by sharing some comments on what ESMA expects market participants to do.
Elevated credit and interest rate risks
According to Verena Ross, cooperation between competent authorities has been efficient during times of crises, with increased exchanges of information and intensified monitoring of liquidity and valuation issues. In 2023 the economic environment remains uncertain, so there is no room for complacency. She highlighted how risks remain elevated, noting that high credit risk levels are particularly a matter of concern for bond funds investing in the high-yield segment, whose portfolio quality is at a five-year low, now having a rating between BB– and B+ on average. Using the liability-driven investment funds (LDIs) event in the UK as an illustration of how such risks can materialise and noting that risks faced by LDIs are not specific or unique to them, Ms Ross highlighted that any leveraged entity with concentrated directional exposures could be subject to similar stress, especially if large shocks materialise very quickly. In an uncertain and fast-changing environment, and with scarce liquidity an exogenous event can trigger simultaneous peripheral events, which may become correlated and as a consequence systemic.
Moving on from credit risks to interest rate risk, Verena Ross noted that further spikes in interest rates could result in large mark-to-market losses, triggering investor outflows and forcing the manager to liquidate some of the bond holdings, thereby amplifying in turn the downward pressure on bond prices.
The right regulatory framework
After exploring the credit risk and interest rate risk and associated vulnerabilities, Verena Ross noted that the right regulatory framework is required to address the remaining vulnerabilities in the fund sector. She reminded the audience of the achievements already made in the regulation and supervision of the investment management sector at both global and European levels stating that:
“In 2008, following the Global Finance Crisis, the G20 provided regulators with a roadmap where no financial product, no market and no territory with a potential systemic impact should remain without appropriate regulation and effective supervision. This roadmap resulted in the development of an unprecedented wave of new regulatory reforms such as AIFMD, EMIR, MiFIR and CRAR in Europe. Since 2011, the European System for Financial Supervision (ESFS), which encompasses the ESRB, the European Supervisory Authorities (ESAs) and National Competent Authorities (NCAs) has been the framework for financial supervision in the EU. However, despite the progress made in strengthening the overall framework, the Financial Stability Board (FSB) issued new policy recommendations in 2017, to address structural vulnerabilities in asset management activities.
These vulnerabilities included the potential mismatch in OEFs between the liquidity of fund investments and the redemption frequency of fund units. The FSB tasked IOSCO to deliver recommendations, which were published in 2018. Similarly, at the EU level, the ESRB published a Recommendation on action to address systemic risks related to liquidity mismatches and the use of leverage in investment funds. In this context, it should be noted that work is still ongoing at the international level with a particular focus on the vulnerabilities in OEFs from liquidity mismatches. Last year, both the FSB and IOSCO took stock of the effectiveness and implementation of their respective recommendations. Their reports acknowledge the progress made by authorities, but lessons learnt since then, including during the March 2020 turmoil, indicate that certain further policy enhancements are still necessary.”
According to Ms Ross, these enhancements will include greater use of existing policy tools, such as Liquidity Management Tools (LMTs) and enhancing the availability of OEF-related data for financial stability monitoring. She noted that the FSB is expected to adopt its new recommendations in 2023 and IOSCO is working, at the same time, on guidance on price-based LMTs (e.g. swing prices and dilution levies).
Focusing on EU regulations, she noted that the proposals for AIFMD reform (with important changes proposed also in the UCITS Directive) aim at addressing the vulnerabilities identified by global and European bodies. These include inter alia, the development of an EU framework for the design and use of LMTs, harmonised rules for loan-origination funds and the creation of a brand-new reporting for UCITS. According to Ms Ross, the proposals will maintain the European regulatory framework at the forefront of the global regulatory agenda and make the European investment management sector more resilient as well as increase investor protection. Despite these positive advancements in the EU regulatory framework, it was noted that Money Market Funds are still missing in the reforms of the EU regulatory framework. The vulnerabilities that surfaced during the pandemic have demonstrated that legislative changes to enhance the resilience of the money market fund sector are needed sooner rather than later.
Verena Ross then moved on to discuss the two main risks ESMA are actively monitoring - Liquidity and Leverage.
Liquidity risk monitoring
With regards to liquidity risk, she noted that both the UCITS Directive and AIFMD have various requirements in relation to liquidity management which are designed to mitigate this risk. UCITS especially can only invest in a range of assets that are deemed liquid and have to comply with strict counterparty risk limits. With respect to the AIFMD, there are requirements on the fund manager to put in place robust and effective liquidity risk management processes and stress tests, tailored to the specific asset classes and investment fund risk profiles. She noted that at the EU level, liquidity is a risk that is actively monitored by ESMA in the fund sector, especially since 2020, and the Covid outbreak. She highlighted supervisory work carried out by NCAs under a number of initiatives including, the Common Supervisory Action (CSA) on UCITS liquidity risk management, as well as the work on the implementation of the ESRB recommendation on liquidity risks in corporate and real estate funds. Notwithstanding shortcomings were identified by ESMA through these exercises.
The shortcomings were, according to Ms Ross, very much consistent with those highlighted at the international level. The supervisory exercises showed the need to increase the availability and usability of LMTs by investment funds, as well as the sharing of information between NCAs. The reviews of the AIFMD and UCITS Directive are expected to address these shortcomings. Managers are expected to monitor the alignment of their funds’ investment strategy, their liquidity profile and their redemption policy. In addition, managers should put in place accurate assessments and strong controls around the management of liquidity risk. These obligations should also be regularly monitored through ongoing supervision by NCAs. In addition, Ms Ross highlighted one important aspect in better managing liquidity risk is the performance of liquidity stress testing, to simulate the resilience of the fund sector both under normal and stressed market conditions. ESMA issued Guidelines on Liquidity Stress Testing in 2019 to help the uniform application of these tests. ESMA expects the lessons learned from those stress tests to come in useful, now that the macro-economic environment warrants greater vigilance.
Leverage risk
Verena Ross set out how in 2021, ESMA issued Guidelines to NCAs on risk monitoring and the setting up of leverage limits for AIFs. These guidelines were issued in response to the 2017 ESRB recommendation and took into account the framework developed by IOSCO in 2020 for measuring leverage in investment funds. In light of these guidelines, ESMA and NCAs are now performing regular monitoring of AIFs’ leverage, based on a common framework. She provided one example of data-driven supervision in this field as the leverage limit on commercial real estate funds introduced by the Central Bank of Ireland at the end of last year. On 3 November 2022, the Central Bank of Ireland was the first NCA to notify ESMA of its intention to impose leverage limits on Irish real estate funds under the AIFMD. In response to this notification, ESMA issued advice where we supported the CBI initiative and concluded that the proposed leverage limit was appropriate to address the risks created by Irish real estate funds.
Detailed and timely information needed to perform risk monitoring
Finally, Verena Ross noted that it is crucial that regulators, including ESMA, have access to detailed and timely information to perform risk monitoring. With all the regulations developed after the 2008 financial crisis, securities regulators benefit from the unprecedented amounts of data, collected through regulatory reporting, that we are using extensively for financial stability monitoring. She set out how ESMA has developed an advanced system of risk indicators and metrics, with wide coverage (securities markets, investors, infrastructures), building on internal research and the latest quantitative techniques for assessing complex activities (including such issues as market liquidity, interconnectedness, and the systemic dimension of hedge funds). Notwithstanding, she highlighted that there are still some important gaps that need to be addressed and, in that context, ESMA welcomes the review of the UCITS Directive which foresees the creation of an EU-wide reporting regime for UCITS.
Conclusion
It is clear from the keynote speech that the regulatory framework on investment management has been significantly reinforced over the last 10 years and that some further regulatory adjustments are still necessary to address the remaining vulnerabilities of the investment management sector. ESMA clearly believes that the ongoing EU regulatory reforms are going in the right direction, and that money market funds’ resilience could be strengthened via improvements to the EU MMF regulation. It is clear that ESMA expects asset managers to assume their responsibility for managing their funds prudently in these challenging macroeconomic times. OEFs need particular attention with regard to liquidity and leverage risk. Two aspects appear essential here: on one side asset managers need to prepare for further and prolonged adverse events, and on the other side according to Verena Ross, supervisors will be stepping up their efforts in assessing risks and taking adequate actions in response to the risks identified.
