Address by Director of Markets Gareth Murphy at an industry briefing hosted by the Irish Funds Industry Association

Irish funds regulation after the implementation of AIFMD

Good evening, ladies and gentlemen. I am grateful for the opportunity to speak to you today about the Central Bank’s consultation in relation to the regulation of Alternative Investment Funds ¹.

In the next 15-20 minutes, I will:

• Set out the Central Bank’s objectives in relation to funds regulation;
• Explain the Central Bank’s thinking when we embarked upon a review of our non-UCITS rule book;
• Talk through some of the key areas which challenged our thinking, and
• Give some pointers to our areas of supervisory focus in 2013.

Hopefully by now you will have read the Central Bank’s consultation document setting out our proposed policies in relation to the regulation of Alternative Investment Funds (AIFs) and you will not be put off if I refer to AIFs, QIFs, QIAIFs and RIAIFs without further elaboration.

Before I start, I think that it is worth pointing out a few things:

• The Irish funds industry is very significant globally with over EUR 2trn of assets under administration and over EUR 1trn of funds authorised here;
• We appreciate that there are a number of natural advantages which encourage the growth of the funds industry in Ireland such as language, time-zone, taxes, legal system, workforce etc.

That said, we are also mindful of the substantial responsibility that goes with being a regulator in one of the world’s largest fund jurisdictions. This puts the work of the Central Bank in the spotlight. We believe that it is important to step up to the plate in taking a leading role in international policy debates and decision-making processes. We also believe that we are at the forefront in crafting a practical supervisory approach in a resource-constrained environment where the primary purpose of our supervision is a well-functioning market which matches end-investors with end-issuers.

(a) Purpose of regulation

I often start with the question “why regulate?” It is not a trivial question and I find that in a time of substantial regulatory change where reams of documents are being produced suggesting various financial reforms, it is important to keep this at the forefront of our minds. To answer this, it is helpful to ask three other questions:

• what is the economic purpose of the funds industry?
• what does it mean for this industry to work well? and
• how can regulation help?

At its simplest, the funds industry exists because there are those with excess capital who can be matched with those in need of capital. Funds allow investors (a) to access a broad range of investment opportunities, (b) to improve the risk/return profile of their investments and (c) to delegate oversight over their investments. In particular, investors seek to benefit from economies of scale which deliver lower set-up and servicing costs.

Fund promoters, managers, administrators, custodians, accountants, tax experts and lawyers have a valuable role to play in ensuring that the core relationship between the end-investor and the end-issuer works effectively.

But we know that things can go wrong. The fact that the outcomes for end-issuers or end-investors may not be satisfactory is often due to:

• the misalignment of incentives between parties involved in the creation and servicing of a fund;
• the information asymmetries which hamper investors’ understanding of a fund;
• the challenges which investors (and other parties) face when making decisions where the quality, quantity, relevance and frequency of information is uncertain.

So it is worth reminding ourselves of the key high-level objectives ² which regulators are tasked with, namely:

• protecting investors;
• maintaining market integrity; and
• mitigating systemic risk.

When we have encountered thorny policy issues over the last few months, we invariably came back to testing our ideas against the delivery of one or more of these high-level objectives.

(b) Approach to revising the non-UCITS rule book

Let me take a few moments to outline our approach to the revision of our non-UCITS rule book. Our first task was to consider how AIFMD could be implemented in Ireland and in good time before 22 July this year.

Possible overlap between AIFMD and existing NU Notices

While AIFMD sets out to regulate the AIFM, it crosses over into many areas which relate to investment funds regulation, i.e. regulation of the AIF. These areas include valuation, risk management, safe-keeping of investment fund assets and disclosure requirements. These are all areas where we currently have national requirements in Ireland. Moreover, there are other areas where the AIFMD rules, indirectly, touch on areas where we have traditionally imposed specific requirements on funds, for example, in relation to share classes. In making the alternative investment fund manager – the AIFM – the focus of regulatory engagement ³, it was clear to us that by simply adopting AIFMD without changing our existing regime, we risked creating a situation where we had two rule books overlapping on a number of issues. Not only would this create additional tasks for the Central Bank and for industry, the additional confusion and cost was also likely to adversely impact investors.

So one of our first objectives was to look at areas of overlap and to trim back our non-UCITS fund regime so that our new regulatory regime for alternative investment funds and our implementation of AIFMD would sit side-by-side and complement each other.

Rationalising our Non-UCITS notices

The Central Bank currently has 25 Non-UCITS notices and 13 Non-UCITS Guidance notes in issue. In looking at the overlap, we started to make amendments to each of these documents. This was a valuable exercise as it highlighted the extent of the changes that were to follow. However, we realised at a certain stage that wholesale tinkering with the fabric of the building - to use a construction analogy - would lead to a less stable structure. Therefore it made more sense to pull the building down and start again from the ground up. This is one of the reasons why we have consulted on a revised handbook which is structured over six sections. It is also important to emphasise that we see this new handbook as an organic document which will evolve and develop over time.

Timing issues

Implementing AIFMD is a multi-facetted task which goes beyond writing a new rule book. There are also other issues in terms of updating existing legislation ⁴, devising new authorisation processes, being prepared to implement the reporting requirements under AIFMD and adapting our supervisory approach for the future. Conscious of the time that this would take and also the increased workload on staff at the Central Bank, Department of Finance and the Office of the Attorney General arising from Ireland’s role as President of the EU Council, we saw the urgency to do much of the preparatory work last year. We were mindful of industry representations to the effect that AIFMD ushered a period of uncertainty which could be best resolved by consulting as early as possible with the possible policy positions which would be incorporated into our new rule book. On this point, both the Central Bank and industry were aligned.

That said, given the points I have made earlier about how AIFMD and our new AIF rule book complementing each other and the fact that AIFMD is effective from 22 July, the new AIF rulebook will not be effective before then.

Further regulatory change

Regulatory change affecting the funds industry does not stop with AIFMD. Further changes are expected to the UCITS regime in relation to depository requirements and remuneration. Also, the lively debate on shadow banking reform will lead to recommendations from the European Commission in relation to money market funds.

One of the issues which continues to challenge financial regulators when it comes to the authorisation of UCITS funds is the diversity of the types of fund which are being authorised. Looking across the population of UCITS funds, I see great diversity in terms of the use of leverage, the types of assets being invested in, the derivatives strategies being employed, the types of indices being referenced and variations in the use yield enhancement techniques. And the trend is mostly one way towards greater complexity which poses challenges for all investors.

More and more, I can see that less sophisticated investors (whether retail or otherwise) will struggle to unravel the risks, complexities and cost structures of some UCITS products. Mindful of this, and the potential for regulatory reform to address these concerns, we saw the revisions to our non-UCITS rule book as a genuine opportunity to create a regulated non-UCITS product which might be more appropriate for more complex funds that are currently being authorised under the UCITS framework.

Catering for investor diversity

In time, we believe that the AIF handbook may be seen as a crucial step in creating a range of funds products which span the spectrum of investors measured in terms of risk appetite and risk management capability.

You will be aware that ‘disclosure-based regulation’ has come under the spotlight in recent years. Indeed it has been said that 'caveat emptor is dead'. In the past, strong arguments were made that comprehensive disclosure would discharge issuers of their obligations to protect investors. It is clear that investors are not always protected if they cannot assimilate the messages hidden in large prospectuses, information memoranda and offering circulars.⁵   That said, the extreme alternative to disclosure-based regulation is merit-based regulation where the financial authority acts a filter for what is to be issued. One sensible and practical approach to addressing the weaknesses in disclosure-based regulation is to attempt to align investor capability with certain types of regulated fund which are differentiated by complexity. The recent consultation is a response to this as it offers the possibility of having three pre-dominant types of Irish authorised funds – UCITS, RIAIF and QIAIF – catering for distinct segments of the investor population.

(c) Challenges encountered along the way

Allow me to talk about some of the key issues which have arisen in our discussions about our draft AIF rule book:

Promoter requirement

It is currently not possible to establish an Irish AIF unless the promoter has been accepted by the Central Bank and acceptance is based, amongst other things, on matters such as regulatory status and amount of capital. In the past, we have relied on this promoter requirement to ensure that there is a party who can step in and work with the Central Bank when a fund gets into difficulties. In the light of the future regulation of the AIFM we believe that this requirement can be removed. We believe that the forthcoming AIF handbook will play an important role in clarifying the obligations of directors under the Fitness and Probity Standards when funds get into difficulties.

Circumventing the AIFMD regime

When we introduced the QIF regime in Ireland some years ago, we realised that it would be necessary to impose certain eligible asset restrictions around QIFs investing in other funds. There was, and is, little point in devising a regulatory regime which can be easily circumvented where investment is channelled through other less regulated vehicles, especially if this dilutes investor protection. AIFMD does not address this point, as such. This is less an issue about the marketing of feeder funds as defined under article 4 of the AIFMD and more an issue of ensuring that investors are not exposed to undue risks because the master fund falls outside the regulatory framework. Following responses to the consultation (CP60), we are looking at approaches to this issue which ensure that investors have levels of protection which are commensurate with their capabilities, sophistication and risk appetite.

Liquidity - fairness to all investors

I mentioned at the outset that there are elements of the AIFMD which will impact on areas of fund regulation which are currently subject to prescriptive rules by the Central Bank. The way in which we have regulated share classes is a case in point. To date we have required that all share classes within an investment fund (or within a sub-fund in the case of an umbrella fund) should be subject to the same dealing arrangements. In the light of the requirements of AIFMD in relation to fair treatment of investors and conflicts of interest, we accept that investors in QIAIFs (as distinct from RIAIFs) should be able to grasp the impact of investing in a share class which has different dealing frequencies to other share classes.

Use of side-pockets

The financial crisis showed that the use of side-pockets can be a useful tool for fund managers in the case of distressed assets. I would draw your attention to the FSB report on Shadow Banking from November last which also raises the possibility of using side-pockets to mitigate runs. We currently prohibit all funds, including QIAIFs from allocating newly acquired assets to side-pockets. There are calls for a relaxation of this prohibition. The consultation paper sets out the questions we had in this regard. As part of that work, we also need to consider the fact that the distinction between open- and closed-ended funds may be blurred.

AIFs with AIFMs below the threshold

In drafting the AIF Handbook, one of our key decisions has been to place reliance on various requirements originating from the AIFMD and this has led to the removal of a number of overlapping requirements which have previously applied as part of our domestic regime. But that leaves open the question as to how those RIAIFs and QIAIFs with AIFMs which fall below the AIFMD thresholds should be treated. We have received substantial feedback through the consultation advising against the more parsimonious proposals of the draft AIF handbook. As a result, for QIAIFs with an AIFM below the threshold, we are contemplating an approach where the full scope of the AIFMD would not always apply.

Authorisation process

The Central Bank is working towards having authorisation processes and procedures for AIFMs and AIFs in place well in advance of 22 July 2013 so that new applications for authorisation under the AIFMD can be received and processed prior to that date (of course, authorisation under the AIFMD cannot be effective until 22 July 2013 at the earliest). It is, however, expected that these processes and procedures will be in place towards the end of Quarter 1 of 2013. These processes and procedures will be based on the provisions of the AIF Handbook which is also expected to be finalised by end-Quarter 1 of 2013.

You will be aware that there is some uncertainty regarding the date from which AIFMs must comply with the AIFMD. It is for the European Commission (EC) to set out a basis for a common approach to when AIFMs are expected to be compliant with the Directive. We recognise the importance of this issue but I do not wish to give any premature guidance in one direction or the other - it is important that a uniform EU approach emerges. Notwithstanding the pressure of time on firms and national authorities, that still seems to us the correct approach to ensure orderly implementation.

(d) Future supervision of funds and funds service providers

I would like to take a few moments to talk about the supervision of funds and fund service providers.

Last June, I set out the Central Bank’s new approach to the supervision of funds and funds service providers. I explained how the Central Bank's new risk-based supervisory approach - called PRISM - prioritises our supervisory resources.⁶  Essentially, this framework divides all of the different types of regulated entity into four impact categories. Impact is measure of the damage or harm which would result from a failure of a firm (or regulated entity). The minimum level of supervisory engagement of the Central Bank depends on the impact categorization of a firm. In general, higher impact firms get more supervisory attention, lower impact firms receive less supervisory attention.

For the most part, the funds industry comprises of lower impact entities. However, the Central Bank recognises the funds industry as a ‘high impact industry’. This means that while we are concerned about the damaging effects of a regulatory failure at an individual firm (or regulated entity), we are also concerned about the damaging effects which such a regulatory failure could have on such a high-profile industry. So our supervisory approach has a firm-specific focus (aligned with PRISM) and a sectoral focus based on the scale of the funds industry, its ever-evolving nature and the need to be current with the attention it receives from international policymakers.

For funds and fund service providers, PRISM went live last May. Seven months in, many of you may not yet have had the experience of this new approach. For the coming year, supervisors will be especially attentive to (amongst other things) (i) the quality of systems and controls and (ii) the quality of regulatory returns. This will be picked up through full supervisory risk assessments of our medium-high and medium-low impact fund service providers as well as thematic inspections of firms selected from the population of administrators, custodians and fund managers.

The Central Bank is prepared to take decisive action when there are regulatory breaches so as to protect the interests of market participants and/or preserve the integrity of the regulatory system. A risk-based supervisory approach necessarily devotes fewer resources to lower impact regulated entities. The quid pro quo for this supervisory approach is a willingness to take enforcement action and impose sanctions where there are failures to follow the rule-book.

More specifically, we have put a lot of effort into building our capability to receive regulatory returns from funds and funds service providers electronically.⁷  Accurate and comprehensive data is an efficient way for the Central Bank to monitor the activities of firms whilst focussing our resources where it matters. It is worth mentioning the reporting obligations of the AIFM here. These regulatory returns fulfil three roles: (i) prudential assessment of firm’s financials and operations, (ii) informing the Central Bank on key trends and (iii) assisting the European Systemic Risk Board in filling out the larger picture of systemic risk across Europe.

As the expression goes: ‘garbage in – garbage out’. We cannot allow poor regulatory returns to undermine the supervisory effort and to ultimately damage the interests of investors and issuers. Where we establish evidence of sloppy approaches to regulatory returns – as with other regulatory breaches – regulatory sanctions are likely to follow.

You will be aware that many funds are currently complying with IFIA’s Code for the Corporate Governance of funds. The Central Bank will undertake a number of themed inspections of funds during the second quarter of this year and assess the degree of compliance across the industry and also will commence a review of the effect of the code later this year to determine whether the code has had the desired effect of improving fund governance.

Conclusion

To conclude, a long road has been travelled so that we could issue the consultation at the end of October. But the journey continues. There is still a lot of work to do in the coming months and the consultation process offered you all an opportunity to provide constructive input on a new regulatory framework which may endure for a number of years to come. In settling the key policy questions at this stage, we believe that we have provided a clear path to implementing the AIFMD which removes as much uncertainty as possible. I believe that this is good news for all involved in the Irish funds industry.

I would like to thank those of you who responded to the Central Bank’s consultation on the implementation of AIFMD. To remind you of the steps to follow, the Central Bank will issue a response to the consultation along with a revised draft AIF Handbook reflecting our considered view on the adjustments which need to be made in light of the responses by end of this month. There will then follow a detailed technical review of this handbook, focusing on the requirements that the Central Bank is itself imposing which are additional to those imposed in legislation, to ensure that the policies which have been adopted can be implemented within our supervisory framework and are enforceable. A final version of the AIF handbook - which may look somewhat different but which will, in substance, be very similar - will issue after that review has been completed.

I would like to thank IFIA for their positive engagement at crucial junctures during this process. As I have explained, the Central Bank has had to consider a large number of issues over the last few months and I am grateful for the constructive approach which was taken in supporting the Central Bank’s work.

Finally, I would remind you that AIFMD is not the last word on regulatory reform in the funds industry. Further changes in relation to MMFs and UCITS will follow in the coming months. But I am confident that the current consultation process charts a path ahead which will complement further changes.

References

Calvino, N., (2006), “Public Enforcement in the EU: Deterrent Effect and Proportionality of Fines”, European University Institute

Central Bank (2011), “PRISM Explained”

Central Bank (2012), “Proposed changes to the regulatory reporting requirements of Irish authorised collective investment schemes”, Consultation Paper CP59

Central Bank (2012), “Consultation on the implementation of the Alternative Investment Fund Managers Directive”, Consultation Paper CP60

IOSCO (2010), “Objectives and Principles of Securities Regulation”

Jackson, H., (2008)

Murphy, G., (2012), Address at 3rd Prospectus Directive Conference hosted by Euromoney, London

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¹  See the Central Bank consultation paper CP60 Consultation on implementation of Alternative Investment Fund Manager Directive

² See IOSCO (2010), “Objectives and Principles of Securities Regulation”

³ AIFMD, Recital 10

⁴ Each of the legislative acts requiring non-UCITS investment funds to hold an authorisation in Ireland will need to be updated as a result of AIFMD. These are (a) Unit Trusts Act 1990, (b) Companies Act 1990 Part XIII, (c) Investment Limited Partnerships Act 1994 and (d) Investment Funds, Companies and Miscellaneous Provisions Act 2005.

⁵ Murphy, G., (2012), Address at 3rd Prospectus Directive Conference hosted by Euromoney, London

⁶ See Central Bank (2011), “PRISM Explained”

7 See Central Bank Consultation Document CP 59 on Reporting Requirements for Collective Investment Schemes