Asset Management & Investment Funds: EU & International Developments – September 2023
Asset Management & Investment Funds: EU & International Developments – September 2023
European Commission consults on SFDR implementation and options to improve the SFDR framework
On 14 September 2023 the European Commission (the Commission) launched a targeted consultation (the Consultation) seeking feedback from financial market participants (FMPs) and other relevant stakeholders (including national competent authorities and investors) on the implementation of the Sustainable Finance Disclosures Regulation (SFDR) with potentially far-reaching consequences for the existing regime.
Feedback is requested by the Commission on the following (which correspond to Sections 1 – 4 of the Consultation):
the current requirements of SFDR
the interaction of SFDR with other sustainable finance legislation
potential changes to existing disclosure requirements for FMPs, and
the potential establishment of a categorisation system for financial products.
Sections 1 and 2 of the Consultation (also included in a public consultation simultaneously published by the Commission) cover questions relating to how well SFDR works in practice and the potential issues stakeholders might be facing in implementing it. In Sections 3 and 4 of the Consultation, the Commission looks to the future, assessing options to address potential shortcomings of the regime. A summary of each section of the Consultation is set out below.
1. Current requirements of the SFDR
The questions posed in this section of the Consultation are designed to assess issues encountered with the implementation of the SFDR and views on whether the SFDR is effectively and efficiently meeting its objectives of providing transparency to investors about: (i) sustainability risks that can affect the value of and return on their investments; and (ii) the adverse impacts that such investments have on the environment and society. The questions are designed to assess:
the effectiveness of SFDR in achieving its objectives
the effectiveness of entity and product level disclosures around principal adverse impacts (PAIs), including the use of PAI indicators for the purposes of the do no significant harm (DNSH) test which must be satisfied by all ‘sustainable investments’ as defined under Article 2(17) SFDR
the cost of disclosures under SFDR and
data challenges and the use of estimates.
2. Interaction of SFDR with other sustainable finance legislation
The Commission seeks views on the interactions of SFDR with other legislation, namely the Taxonomy Regulation, the Corporate Sustainability Reporting Directive (CSRD), the Markets in Financial Instruments Directive (MiFID II), the Regulation on Packaged Retail Investment and Insurance Products (PRIIPs) and the Benchmarks Regulation, and any potential inconsistencies or misalignments that may exist.
3.Potential changes to existing disclosure requirements
The Commission seeks feedback on existing entity and product level disclosure requirements.
Entity level: the Commission queries the appropriateness of including entity level disclosure requirements in SFDR, the potential for streamlining these disclosures, to the extent they arise under various pieces of legislation and the usefulness of:
FMP entity-level website disclosure requirements (as contained in Articles 3 – 5 SFDR, these cover the integration of sustainability risks, including in remuneration policies of the FMP and PAI-related disclosures), and
the PAI indicators set out in Annex I of the SFDR Delegated Regulation.
Product level: the Commission seeks feedback on a variety of questions relating to product level sustainability-related disclosures. Of particular note is the Commission’s request for views on the appropriateness of introducing uniform or standardised disclosure requirements for all products regardless of their sustainability claims. This would represent a significant departure from the existing regime, pursuant to which enhanced disclosure requirements apply only to products that make sustainability claims (i.e. financial products in scope of Article 8 and Article 9 SFDR). This question is, of course linked to the potential establishment of a categorisation system for financial products, dealt with in Section 4 of the Consultation.
4. Potential establishment of a categorisation system for financial products
Acknowledging that Articles 8 and 9 of the SFDR are being used as de facto product labels (giving rise to potential greenwashing risk) and that this is suggestive of market demand for sustainable product categories, the Commission seeks views on the merits of creating a new product categorisation system, proposing two broad alternative approaches as a starting point:
converting Articles 8 and 9 into formal product categories and clarifying and adding additional criteria to underpin the existing concepts of environmental/social characteristics, sustainable investment, DNSH, etc., and
a system focused on the type of investment strategy in question (e.g. promise of positive contribution to certain sustainability objectives, transition focus, etc.) based on criteria that do not necessarily relate to existing Article 8 and 9 SFDR disclosure concepts.
Replies to the online questionnaire must be received by the Commission by 15 December 2023.
ESA report on voluntary disclosure of PAIs under SFDR
The Joint Committee of the three European Supervisory Authorities (the ESAs) published their second annual Report on the extent of voluntary disclosure of principal adverse impacts of investment decisions on sustainability factors (PAIs) under Article 18 SFDR. The first report, which issued in 2022, prior to the applicability of SFDR Level 2 disclosures, was discussed here. The results of both reports are based on survey feedback from NCAs.
2023 key findings
the results show an overall improvement in the application of voluntary disclosures compared to the previous year, although there is still significant variation in the extent of compliance with the requirements and in the quality of the disclosures both across FMPs and jurisdictions
disclosures, compared to last year, appear easier and more straightforward to find on websites
explanations of non-consideration of PAIs by FMPs are still not fully complete or satisfactory
where PAIs are considered, the disclosures on the degree of alignment with the Paris Agreement are still vaguely formulated
the level of understanding of voluntary disclosure of PAIs by financial products is limited and deserves further analysis in the ESA’s future reports.
The report also includes good and bad practices and preliminary recommendations. The ESAs note however that the examples of entity-level and product-level “do’s” and “don’ts” provided should not be understood to affect disclosures made under the mandatory SFDR templates.
In the context of the comprehensive assessment of the SFDR, the ESAs invite the European Commission to consider:
a way to introduce proportionality for FMPs other than the 500 employee threshold
whether product level disclosures under Article 7 SFDR should also follow a comply or explain basis, regardless of whether the FMP applies Article 4(1)(a) SFDR
reducing the frequency of the Article 18 SFDR report to allow for more meaningful analysis of long term trends.
The ESAs again include recommendations to NCAs to assist them in their ongoing supervisory actions. These include:
follow up with non-compliance and consideration of enforcement tools
support to FMPs to facilitate an understanding about compliance with Article 4(1)(a) SFDR disclosures
the use of tools that could assist NCAs to identify information on voluntary disclosures on PAI considerations of products disclosing under Article 8 and Article 9 SFDR
a need for a build-up of expertise to enable compliance checks. The ESAs clarify certain concepts such as ‘consider’ and ‘take into account’ and use of terms such as ‘ESG criteria’, ‘ESG risk’ and ‘sustainable investment goals’.
The European Commission may take the ESAs main findings into account in the context of their comprehensive assessment of the functioning of the SFDR. Future iterations of the report will include an assessment of the PAI disclosure template (Table 1-3 of Annex 1 of the SFDR) which started being used on 30 June 2023 and on the disclosure of engagement policies. However, the main purpose of future reports will remain an assessment of how widespread those disclosures have become and to indicate best practices.
follow up work under the recently concluded reviews of the AIFMD and UCITS Directives and the Central Securities Depositories Regulation (CSDR). The ongoing reviews of the European Market Infrastructure Regulation (EMIR) as well as the new Listing Act may also lead to new mandates for ESMA in 2024.
engaging with retail investors through coordinated communication with National Competent Authorities (NCAs), to enhance investor understanding
assisting in the finalisation (and possibly start of implementation) of the new Retail Investment Strategy
assessing whether the NCAs have sufficiently improved their supervision of investment firms' cross-border activities
delivering its final report on greenwashing, proposing actions to combat this practice
developing rules for sustainable finance as part of the new European Green Bond Regulation
completing work on technical standards and guidelines in relation to the Markets in Crypto-Assets Regulation (MiCA)
completing work on technical standards and guidelines in relation to the Digital Operational Resilience Act (DORA) and continuing to adapt its supervisory efforts to be ready for the entry into application of DORA in 2025
beginning the process of selecting and authorising Consolidated Tape Providers (CTPs) in the EU. The authorisation of the first CTPs will increase transparency and foster a single data source across the EU's financial markets
finalising technical standards for the European Single Access Point (ESAP) and continuing preparatory work on the necessary IT infrastructure that will support it
further improving data quality outputs for all supervisory data and enhancing the ability to share and analyse this data, in close cooperation with NCAs and other EU authorities.
Political context: “2024 will be an important year for the European Union as a whole, with a new Parliament and Commission following the elections next June. ESMA will engage with and support them in determining the priorities for the next legislative period, providing technical advice and input on the different legislative initiatives across our remit.".
Economic context: marked by high inflation, heightened geopolitical tensions and rapid technological changes.
ESRB paper on the EU regulatory framework for investment funds and systemic risks
The European Systemic Risk Board (ESRB) published an issues note describing how the EU regulatory framework for investment funds could enhance the prevention and mitigation of systemic risks. While the note focuses on investment funds with large exposures to corporate debt and real estate, the policy options might also apply to other fund types with vulnerabilities similar to those present in corporate debt funds and real estate funds. This issues note will inform the Financial Stability Board's (FSB) recent consultation on policies to address vulnerabilities from liquidity mismatch in open-ended funds (discussed in our July bulletin). This forms part of the current narrative on the adoption of a macroprudential framework. In its recent discussion paper, the CBI highlighted the absence of high-quality data which would allow for meaningful analysis of the resilience of the funds sector to market shocks.
The ESRB's conclusions include the following:
The structural vulnerabilities of investment funds arise mainly from liquidity mismatch and the use of leverage and may become systemic when they trigger, transmit and/or amplify shocks to the wider financial system or real economy through their interconnections.
The ESRB welcomes the provisional agreement in July 2023 (discussed here) on revisions to AIFMD and the UCITS Directive, particularly the increased availability and consistent use of LMTs for fund managers. We await publication of final text of the revisions.
Investment fund resilience could be improved by adapting certain existing policy tools. These include longer notice periods, lower redemption frequency, setting up certain funds as closed-end funds, anti-dilution liquidity management tools (LMTs), such as swing pricing, dual pricing, anti-dilution levies or redemption fees and leveraged funds could hold appropriate calibrated liquidity buffers.
In addition to adapting existing policy tools, there is merit in analysing and exploring further avenues to enhance the policy toolkit for investment funds from a financial stability perspective. These might include enhancing the liquidity bucketing approach and structural changes, such as developing an ex ante policy instrument and regulatory interventions.
ESMA’s second Trends, Risks and Vulnerabilities Report of 2023
ESMA published its second Trends, Risks and Vulnerabilities (TRV) Report of 2023. Markets are set to remain very sensitive to potential deteriorations in economic fundamentals or risks in the financial sector. The main findings included:
Securities markets: Equity markets rose in 1H23, even though the market stress related to US banks led to increased volatility and bid-ask spreads in March and April. Credit risk indicators showed mixed signals, with early signs of deterioration such as increasing corporate high-yield defaults and sovereign downgrades but limited movements on sovereign credit spreads.
Asset management: The EU fund sector partly recovered after the historical decline experienced in 2022, primarily due to valuation effects. Bond funds received inflows, which contrasts with the outflows in 2022. Fixed income funds which reduced their maturity and interest rate sensitivity during the monetary tightening are now positioned to benefit from higher yields. Fund risks remain high due to prevailing credit, valuation, liquidity and interest rate risks, especially for funds combining several vulnerabilities, such as in the real estate fund sector.
Sustainable finance: The EU market for ESG products and sustainable investments has continued to grow at a robust pace. The demand for funds with a sustainable investment objective remained strong.
ESA’s Autumn 2023 report on risks and vulnerabilities in the EU financial system
The economic outlook remains fragile, not least amid persistently elevated geopolitical risks, high inflation, and an uncertain macro-financial outlook.
Against the backdrop of these risks and vulnerabilities, the ESAs advise national competent authorities, financial institutions and market participants to take various policy actions, including placing high importance on effective risk management and governance arrangements, in particular in relation to liquidity risk and interest rate risk. Financial institutions need to remain resilient to the impact of future substantial interest rate changes.
EU list of high-risk third countries. Commission Delegated Regulation (EU) 2023/1675 amending Delegated Regulation (EU) 2016/1675 to add Cameroon and Vietnam to the list of high-risk third countries was published on 28 September in the Official Journal of the EU. This Regulation will enter into force on the twentieth day following that of its publication in the Official Journal - 18 October 2023.
FATF MER on Luxembourg. The Financial Action Task Force (FATF) issued its mutual evaluation report on Luxembourg. The report summarises the anti-money laundering and counter-terrorist financing (AML/CFT) measures in place in Luxembourg in November 2022. It also provides recommendations on how the system could be strengthened. The report is of particular interest because of Luxembourg’s status as a large international financial hub, with significant cross-border financial flows and international clientele and because of the many financial service providers who operate in both Ireland and Luxembourg.