Asset Management & Investment Funds: EU & International Developments - February 2018

EU Commission notices on the consequences of Brexit on Asset Management and other banking and finance sectors

On 8 February 2018, the EU Commission published a new webpage containing a number of notices setting out the consequences that the UK withdrawal from the EU will have on banking and finance rules.

The webpage links to notices on:

• Markets in financial instruments
• Banking and payment services
• Post-trade financial services
• Asset management
• Credit rating agencies
• Insurance and reinsurance
• Statutory audit

The Commission explains in each notice that, unless a ratified withdrawal agreement establishes another date, all EU primary and secondary law will cease to apply to the UK from 30 March 2019. The UK will then become a third country. Each note sets out the consequences of EU rules in the above areas no longer applying to the UK.

MMF Regulation - EU Commission letter to ESMA on share cancellation.

On 2 February 2018, ESMA published a letter from Olivier Guersent, EU Commission Director-General, DG FISMA, to Steven Maijoor, ESMA Chair, on the implementation of the Regulation on money market funds (MMF Regulation).

The letter concerns the practice of share cancellation (also referred to as the reverse distribution mechanism or share destruction). In its May 2017 consultation paper on its technical advice, implementing technical standards and guidelines under the MMF Regulation, ESMA gave its view that share cancellation was not allowed under the MMF Regulation. ESMA then sought the view of the Commission's legal services on this issue when it submitted its final report to the Commission in November 2017.

The Commission agrees with ESMA's analysis that the practice of share cancellation is not compatible with the MMF Regulation. ESMA's website states that it is considering possible next steps with a view to promoting convergent application of the Benchmark Regulation across the EU.

Benchmarks Regulation – Updated ESMA Q&As

ESMA published an updated version of its Q&As on Benchmarks Regulation with two new Q&As, relating to:

• Commodity benchmarks: how the threshold in the exemption under Article 2(2)(g) of the Benchmarks Regulation should be calculated (Q&A 4.4).
• Definition of a benchmark and investment funds and specifically what types of investment funds are considered to be using an index. ESMA considers that:
  • investment funds using indices to measure their performance with the purpose of tracking the return of such indices include:
    - investment funds the strategy of which is to replicate or track the performances of an index or indices e.g. through synthetic or physical replication; and
    - structured investment funds that provide investors with algorithm-based payoffs that are linked to the performance, or to the realisation of price changes or other conditions, of indices.
  • Investment funds, including actively managed funds, fall within the scope of the Benchmarks Regulation as users of benchmarks if the composition of a fund's portfolio is constrained by reference to an index.
  • the Benchmarks Regulation does not apply to funds that reference indices in their documentation solely to compare the fund's performance to the performance of an index (for example, in a prospectus or promotional literature).

CIS liquidity risk management - IOSCO recommendations and good practices

The International Organization of Securities Commissions (IOSCO) published:

• A final report on recommendations for liquidity risk management for collective investment schemes (CIS). The report sets out IOSCO's recommendations to entities responsible for managing the liquidity of CIS (responsible entities) to ensure that liquidity is managed to safeguard and protect the interests of investors, including in stressed market conditions. The 17 recommendations are set out in section 2 of the report. As well as its recommendations to responsible entities, the report includes IOSCO's additional guidance to securities regulators to promote good liquidity management practices for CIS.

The report constitutes the final step in IOSCO's response to address potential structural vulnerabilities in the asset management sector that could impact financial stability, which were published by the Financial Stability Board in January 2017. IOSCO will assess implementation across relevant jurisdictions in two to three years' time.

• A final report on good practices and issues for consideration for open-ended fund liquidity and risk management. The report is structured in three sections:
  • consistency between the liquidity of a fund's assets and its liabilities
  • liquidity risk management tools and
  • fund-level stress testing.

The report is a reference guide for regulators as to how various jurisdictions regulate liquidity risk practices. The report also provides examples of where, when and how certain tools have been used in the past and how they can be used in the future. It also describes good practices for liquidity risk management throughout the life cycle of a fund. For investors, the report outlines scenarios in which an asset manager may use liquidity management tools to manage liquidity issues in certain funds.

The two reports should be read together.

ESRB recommends that ESMA and the EU Commission develop legislation and guidance on leverage and liquidity in investment funds

The European Systemic Risk Board (ESRB) recommended that ESMA and the EU Commission develop legislation and guidance on leverage and liquidity in investment funds.

The ESRB is concerned that increased financial intermediation by investment funds may result in the amplification of any future financial crisis. This is because mismatches between the liquidity of funds' assets and their redemption profiles may result in "fire sales" in order to meet redemption requests in times of market stress. Such sales could adversely affect other financial market participants that own the same or correlated assets. More specifically, the ESRB recommends that:

• The EU Commission develop legislation that sets out a legal framework governing liquidity management tools in the design of investment funds.
• The EU Commission develop legislation that includes measures to limit the extent to which the use of liquidity transformation in open-ended AIFs can contribute to the build-up of systemic risks or the risk of disorderly markets.
• ESMA develop guidance for managers of AIFs and UCITS for the stress testing of liquidity risk for individual funds.
• The EU Commission develop legislation that requires reporting of UCITS liquidity risk and leverage data to national competent authorities.
• ESMA provide guidance on Article 25 of the AIFMD, including guidance on the framework to assess the extent to which use of leverage within the AIF sector contributes to systemic risk, and on macro prudential leverage limits.
• Section 2.3 of the recommendation contains a timeline, with suggested dates in 2019 and 2020.

EBA recommendations on outsourcing to cloud service providers

The European Banking Authority (EBA) published its final recommendations on outsourcing to cloud service providers. The recommendations are addressed to credit institutions, investment firms and competent authorities. They specify the supervisory requirements and processes that apply when financial institutions outsource to cloud service providers. The recommendations will apply from 1 July 2018.

ESMA Risk Assessment Work Programme 2018

ESMA published its Risk Assessment Work Programme, setting out its priorities in assessing risks for securities markets for 2018:

• As market data collected under the AIFMD, MiFID and EMIR mandates and others are becoming available, ESMA is, with the National Competent Authorities, completing the necessary technical infrastructure for their processing, programming routines for their management, and making them available for the relevant analytical evaluation.
• ESMA is planning to complement its ongoing market monitoring through its semi-annual Report on Trends, Risks and Vulnerabilities and its quarterly Risk Dashboards by launching an annual report series on EU derivatives markets, based on EMIR data, as well as an annual report series on EU AIFs, drawing on AIFMD data.
• ESMA will also continue to pursue in-depth analyses around key topics, including market and fund liquidity, fund leverage, and the impact of innovation especially in the areas of market infrastructures and investment advice.

ESMA Supervisory Convergence Work Programme 2018

ESMA published its 2018 Supervisory Convergence Work Programme. MiFID II implementation, improved data quality, financial innovation and the UK's withdrawal from the EU are key convergence priorities for 2018

ESMA interactive single rulebook

ESMA launched a new interactive single rulebook to help facilitate the consistent application of the EU single rulebook in the securities markets area.

The new tool aims to provide a comprehensive overview of and easy access to all level 2 and level 3 measures adopted in relation to a level 1 text. This includes all relevant delegated and implementing acts adopted by the EU Commission including regulatory technical standards and implementing technical standards developed by ESMA and endorsed by the Commission, as well as guidelines, opinions and Q&As issued by ESMA. Users are advised to refer to the Official Journal of the EU for the authentic version of EU legislation.

ESMA launched the first rulebook with the level 1 text of the UCITS IV Directive. It appears to be of very limited value at present.

ESMA plans to provide an interactive version for each key level 1 text under its remit over time, with the next texts being the Credit Rating Agencies Regulation, the MiFID II Directive and MiFIR.

EU Commission survey on the functioning of the AIFMD

As detailed above, the EU Commission has contracted KPMG to carry out research on how the AIFMD has worked in practice and to what extent its objectives have been met. This survey is an important part of the KPMG research. Its aim is to gather the views of stakeholders on

• the AIFMD's requirements
• their experience in applying them
• the market impacts of the directive

ESMA Stakeholder Survey

ESMA launched a short survey, and seeks input from all market participants and other stakeholders regarding the way they interact with ESMA. The survey is open for comments until 30 March 2018. ESMA set out an overview of the ways it interacts with stakeholders which can be found on its website.

Anti-Money Laundering/ Combating the Financing of Terror/ Corruption

Tunisia, Sri Lanka and Trinidad and Tobago added to EU AML blacklist.

The EU Commission is obliged to prepare a list of high-risk third countries for the purposes of 4AMLD. The EU Parliament has veto power over the blacklist. In the past, the EU Parliament and Commission have disagreed over this list. Despite intense efforts, by some MEPs, they failed to achieve the 376-vote absolute majority needed to reject the inclusion of Tunisia, Sri Lanka, and Trinidad and Tobago in the EU Commission’s list. The list will take effect 20 days after it is published in the OJ. Ireland has not yet transposed 4AMLD but firms will likely factor in the list.

For more information please contact a member of the Asset Management and Investment Funds Team.

Date Published: 28 February 2018