Asset Management and Investment Funds Legal and Regulatory Update March 2021
Welcome to the latest edition of our Asset Management and Investment Funds Legal and Regulatory Update.
In this issue we provide an overview of some developments in the area of liquidity risk management, including the Central Bank’s letter which issued to certain fund management companies and ESMA’s publication of the results of its 2020 Common Supervisory Action on UCITS liquidity risk management. We also take a look at the Central Bank’s consultation and draft guidance on outsourcing as well as the Central Bank’s launch of its new portal. Finally, we consider ESMA’s consultation on potential reforms of the EU Money Market Funds Regulation.
If you would like to discuss any of the topics covered, please feel free to contact a member of our team.
Liquidity Management: Central Bank Letter, Results of ESMA UCITS review and IOSCO Review
The Central Bank has issued a letter setting out its expectations for liquidity management frameworks and ESMA has published the results of its 2020 Common Supervisory Action on UCITS liquidity risk management
The Central Bank has issued a letter to certain fund management companies (“FMCs”) who were selected as part of its survey on liquidity risk management which was undertaken in 2020. This letter is a follow-on from the joint ESRB/ESMA liquidity risk project, pursuant to which the European Systemic Risk Board (“ESRB”) recommended that ESMA coordinate with national competent authorities (“NCAs”) to undertake a focused supervisory exercise with investment funds that have significant exposures to corporate debt and real estate assets. ESMA, the Central Bank and other EU NCAs coordinated this exercise and ESMA published its report on the findings in November 2020, which we reported on previously.
The Central Bank asks entities who received this letter to consider their liquidity frameworks and structures taking into account the significant market and redemption activity in 2020 and the findings in the ESMA report.
The letter asks FMCs to prepare for future liquidity shocks and sets out certain elements to consider when deciding what changes may be required to their liquidity frameworks, with an action plan to be implemented by the end of June 2021. While the letter was only issued to FMCs which were in scope for last year’s survey, the letter should inform how all funds and FMCs should consider liquidity risks and is helpful in terms of understanding the Central Bank’s expectations for liquidity management frameworks. In summary, the Central Bank’s letter indicates that the following elements are important when considering what actions may be required on foot of the letter:
- the alignment between the liquidity profile of funds’ assets, the risk profile of investors, redemption policies and settlement periods and the development of new policies to correct misalignments in a timely manner. This is of particular importance for funds investing in less liquid assets or assets that have demonstrated variable levels of liquidity in 2020;
- ensuring the full suite of liquidity management tools (“LMTs”) are in place and used appropriately. This should include consideration of the circumstances where LMTs are appropriate outside of stress scenarios, given their potential to enhance investor protection and dampen the effect of large increases in redemption requests on market conditions. FMCs should consider the extent to which the use of swing pricing or anti-dilution levies are required to ensure that transaction costs, including liquidity premia, associated with redemptions are borne by those exercising their redemption rights, limiting the effect of large redemption flows on remaining investors, particularly in times of stress and market volatility;
- the FMC’s policies and procedures around the use of LMTs should include appropriate disclosure in fund documentation and communication with investors to ensure clarity and transparency around the regular use of LMTs and conditions for their implementation;
- the assessment of all factors that could impact fund liquidity or trigger unplanned sale of assets (for example, the possibility of increased margin calls that may increase cash needs);
- a realistic and conservative estimate of which percentage of a fund’s assets can be liquidated over certain time periods and ensure redemption policies are aligned with this assessment. Any misalignment in this regard should be corrected in a timely manner;
- information on the profile of the investor base to better understand any potential risks associated with redemption patterns, particularly in stressed market conditions; and
- designing and testing funds’ liquidity risk management frameworks and planning for future market disruption events should not assume government or central bank intervention of the nature or scale seen in 2020.
Separately, ESMA has published the results of its 2020 Common Supervisory Action on UCITS liquidity risk management. The results found that most UCITS managers have implemented and apply sufficiently sound liquidity risk management processes. However, the exercise also identified shortcomings in the liquidity risk management (“LRM”) processes of certain UCITS managers. In this regard, the results highlighted that:
- with regard to LRM processes, arrangements and techniques, in certain instances there was no documentation available on or a lack of granularity was detected in various key areas such as pre-investment liquidity analyses and forecasts, escalation processes and verification of data reliability. In some cases, the LRM procedures examined did not cover all asset types or the use of LMTs;
- in certain cases, the LRM methodology and tools were not always appropriate, justified, forward-looking and back tested. ESMA highlighted concerns about failures to model investor behaviour or the impact of margin calls. The report noted that liquidity forecasts should be sufficiently robust and not unrealistic or unreasonably positive;
- UCITS funds are permitted to invest up to 10% of their assets in securities not listed or traded on a regulated market. However, ESMA found examples of where UCITS managers had failed to carry out a liquidity assessment on such securities, in contravention to EU rules;
- some UCITS managers had presumed that listed securities would always be liquid without adequately testing whether that assumption would hold true in stressed market conditions. In addition, without dedicated follow-ups on securities presumed liquid, some ongoing controls were insufficient as they were not based on reliable data on trading volumes;
- ESMA found instances of where portfolio management functions and liquidity risk management were the responsibility of the same team, creating a potential conflict of interests;
- in some cases, ESMA observed a lack of data quality checks and an over-reliance on a small number of data providers;
- ESMA reported some cases of missing, inaccurate, or unclear disclosures on liquidity risks and LMTs to investors in UCITS KIIDs and/or prospectuses;
- ESMA detected instances of infrequent, undetailed and unclear reporting to senior management on LRM and inadequate documented processes for the escalation of issues to senior management and boards;
- in certain cases, ESMA reported no regular second and third level controls of LRM policies and procedures; and
- external controls by the depositary and external auditors of the UCITS and UCITS managers were not performed in all cases.
ESMA’s findings are broadly consistent with the findings in the ESMA report which issued following the ESRB’s recommendations on fund liquidity risk on liquidity risks in corporate bond and real estate funds (as referenced above). While ESMA’s findings strictly only apply to UCITS, the broader nature of ESMA’s review suggests that all FMCs (especially those who manage open-ended AIFs) should consider ESMA’s conclusions.
Finally, IOSCO has launched a Thematic Review of the Recommendations for Liquidity Risk Management for Collective Investment Schemes issued in 2018 as well as an assessment on market participants’ responses to Covid-19 induced market stress. By way of reminder, the Recommendations are designed to: (a) ensure that liquidity risk is managed to safeguard and protect the interests of investors, including in stressed market conditions, and (b) address potential structural vulnerabilities in the asset management sector that could impact financial stability. The Review aims to assess the extent to which the Recommendations have been implemented through member regulatory frameworks and will also gather information on how the Recommendations are implemented by investment funds. The thematic report is expected to be published in Autumn 2022.
In the Review, IOSCO has also announced that, together with the Financial Stability Board, it is conducting an analysis on the availability, use and impact of LMTs for open-ended funds.
To inform both the Thematic Review and the joint analysis, IOSCO has issued a voluntary market participants’ survey. The survey closes to responses on 16 April 2021.
Outsourcing: Central Bank Consultation on Draft Guidance
The Central Bank has launched a Consultation on its draft Guidance on Outsourcing
Further to our Q & A on the Discussion Paper on Outsourcing which was issued by the Central Bank in November 2018, the Central Bank has published CP138 – Consultation on Cross-Industry Guidance on Outsourcing (CP138) together with its draft Cross-Industry Guidance on Outsourcing (the “Guidance”).
The Central Bank’s 2018 Discussion Paper, which summarised the results of its 2017 cross-sectoral survey on outsourcing activity, highlighted weaknesses in board awareness, governance and risk management. In CP138, the Central Bank notes that this position has not materially improved. As such, outsourcing remains extremely high on the Central Bank’s supervisory agenda and the draft Guidance is designed to:
- set out the Central Bank’s expectations regarding the governance and management of outsourcing risk by regulated firms;
- remind boards and senior management of regulated firms of their responsibilities; and
- promote standards and practices that underpin robust outsourcing frameworks.
The draft Guidance sets out detailed requirements in relation to the following: contractual arrangements with outsourcing service providers; governance and ongoing monitoring of outsourcing arrangements; risk assessment and due diligence on outsourcing service providers; and the need to implement an outsourcing policy and register.
Notably, the draft Guidance is relevant to all regulated entities that outsource services and/or functions and will have a significant bearing on all boards of directors of UCITS and AIF corporate funds and FMCs which includes self-managed investment companies. Many of the existing outsourcing frameworks, such as the EBA Guidelines on Outsourcing Arrangements (February 2019) (the “EBA Guidelines”), apply only to sub-sets of regulated firms (such as, in the case of the EBA Guidelines, banks, CRD investment firms, payment institutions and e-money institutions).
The Central Bank is particularly focused on the outsourcing of “critical or important” functions (in line with the EBA Guidelines) but not exclusively so. The Central Bank envisages entities “predominantly” (but not exclusively) applying the draft Guidance in respect of any outsourcing of their “critical or important” functions. However, the draft Guidance contemplates proportionate application, whereby an entity may apply the draft Guidance differently by reference to the nature, scale and complexity of its business and the extent to which it engages in outsourcing of “critical or important” functions.
For further information, please see our briefing on the draft Guidance.
Central Bank Portal Open
The Central Bank has launched an online portal to facilitate certain filings
The Central Bank has launched an online portal to facilitate the submission of amendments to previously filed fund documentation (the “Portal”). Prior to the Portal launch, amendments to fund documentation were required to be filed through an email based submission to the Central Bank. The Portal allows authorised users to view information relating to the fund, to notify the Central Bank of required changes to that information and to communicate with the Central Bank regarding these changes via Portal messages.
To get set-up on the Portal, the Central Bank has asked each regulated entity to nominate a “Portal Administrator”. The Portal Administrator is responsible for the entity’s use of the Portal, including management of the Portal users’ access and permissions. The Portal Administrator is a separate role from the ONR Administrator, but may be fulfilled by the same person.
Typically, an entity’s legal advisor will log into the Portal and make any amendment filings on the entity’s behalf. To enable the legal advisor to make the relevant amendment filings, the Portal Administrator will need to grant the legal advisor the appropriate permissions.
The Central Bank has indicated that, over time, the Portal’s offering will expand to include additional regulatory and statistical services, including industry levy management, online returns and fitness and probity applications among other services.
For further information on the Portal and how it operates, please refer to the “Key Concepts” section of the relevant Central Bank webpage.
ESMA consultation on reform of EU Money Market Funds Regulation
ESMA has launched a consultation on potential reforms of the EU Money Market Funds Regulation
ESMA has launched a consultation on potential reforms of the EU Money Market Funds Regulation (“MMFR”). Through this consultation, ESMA aims to review the stress experienced by money market funds (“MMFs”) during the March 2020 market volatility and assess the roles played by markets, investors and regulation. ESMA’s paper sets out four potential reforms for MMFs, as follows:
- the first proposal focuses on the liability side of these strategies, such as decoupling regulatory thresholds from suspensions and gates to limit liquidity stress. Under this potential reform, managers of MMFs would be required to use liquidity management tools such as swing pricing whereby the dealing price is adjusted to take into account of trading costs;
- the second reform targets the asset side of MMFs and focuses on requirements around liquidity buffers and their use;
- the third proposal targets both the liability and asset side and reviews the status of certain types of MMFs such as stable net asset value funds and low-volatility net asset value; and
- the final proposal relates to reforms that are external to the strategies themselves by assessing whether the role of sponsor support should be altered. In addition, ESMA wishes to gather feedback from stakeholders on other potential changes, particularly linked to ratings, disclosures and stress testing.
The consultation closes on 30 June 2021. ESMA will consider the feedback it received to this consultation in Q2 2021 and expects to publish its opinion on the review of the MMFR in the second half of 2021. Once the findings of ESMA’s consultation are available, the European Commission expects to review the adequacy of the MMFR from a prudential and economic point of view by 21 July 2022.