“An evolving supervisory approach in the funds sector” - Remarks by Patricia Dunne, Director of Securities and Markets Supervision at the Irish Funds Asset Manager Forum

Good afternoon everyone and thank you to Irish funds for inviting me to speak to you today. 

Firstly, I will talk a bit about how our supervisory approach to the funds sector is evolving and the recent changes we have introduced. I will also discuss some of our key supervisory and regulatory priorities and three areas in particular: (i) sustainable finance (ii) delegation and (iii) ELTIFs.

New Supervisory Model

As the funds sector continues to grow, we are focused on creating a regulatory environment, which is effective, adaptable and targeted at the right areas and relevant risks.  This has influenced the changes we have introduced to our supervisory approach.

This evolution includes:

1. an increased emphasis through our engagement with management companies on the risks that are generated by funds which they are responsible for,
2. Greater focus and use of thematics and sector analysis,
3. An increased focus on potential systemic risks from funds
4. We also continue to develop our data and risk analytic capabilities

These changes reflect our recent experience of supervising exceptional market events such as the COVID-19 market shock, the disruption caused by the Russian invasion of Ukraine and the market volatility in the UK gilt market in Q4 2022. 

I’ll explain in a bit more detail about two elements of this evolution

An increased emphasis on product risks allows the Central Bank to follow the risk; both from the management company perspective, and across the sector as a whole and help Sustainable Finance Disclosures Regulation Sustainable Finance Disclosures Regulation to ensure engagements with firms are as effective as possible.  While direct fund supervision continues to be an important part of our engagement, our intention is to also direct greater attention towards management companies and their underlying funds.  Firms should feel this change in approach in your engagement with the Bank, with a greater focus on product and product risk based discussion, as well as traditional prudential topics.

A greater focus and use of thematics or sector analysis facilitates the identification and assessment of sectoral risks, while also engaging with industry to promote higher standards. This programme of work includes European initiatives coordinated by ESMA – via CSAs. It also includes local initiatives, which we have decided to focus on. We are currently conducting an ESMA coordinated CSA on Sustainability and Disclosure Risk.  This will take place over two phases. The first phase is due to conclude by January 2024 and is focusing on greenwashing risks. The second phase will conclude by September 2024 and is focused on sustainability and disclosure issues generally. All firms have now responded to our questionnaire and supervisors are currently in the process of reviewing the responses.

In terms of local supervisory initiatives, there are a number that I would like to highlight. The first relates to a thematic review which commenced earlier this year and focused on Exchange Traded Funds specifically to gain a better understanding of the roles played by Authorised Participants and Market Makers in the ETF ecosystem, in order to assess the functioning of the Irish ETF sector. 

There are also a number of areas where we are carrying out mini thematic reviews. Those areas include (i) looking at the role of non-discretionary investment advisors, (ii) examining conflicts of interest for management companies and (iii) investigating the use of the Fixed Operating Expense Model in some investment funds. There is clearly a wide range of issues under consideration. The use of such mini-thematic reviews will likely be a feature of the regulatory toolkit going forward; as a result, industry can expect to see more frequent targeted questionnaires focused on specific areas of risk. Clearly not every piece of thematic work warrants an industry letter, this depends on the nature and purpose of individual reviews. However, we are currently considering how best to communicate the outcome from those reviews, perhaps in the form of an annual bulletin.

Sustainable Finance/ESG

I’ll now turn my attention to Sustainable Finance.  In a recent speech I gave on this topic I highlighted some supervisory observations post the implementation of SFDR (Sustainable Finance Disclosures Regulation) and Taxonomy Regulation. As I mentioned we will be hosting a workshop with key stakeholders in the funds industry to discuss these findings later this month.

For the purpose of this discussion, it may be useful to remind ourselves of what SFDR is trying to achieve, how far we have come and areas of focus for the Bank, including on the topic of data.

While I think we can all agree that the introduction of the SFDR has been challenging for both regulators and market participants alike, it has been extremely important to introduce a harmonised approach to sustainable finance across the EU.

For the first time, this has helped integrate sustainability factors into the investment mandates of funds with the aim of improving transparency, protecting investors and addressing potential greenwashing.  We do acknowledge and agree, however, that enhancements and further harmonisation of the framework is needed.

But currently there is a risk that the demand for these products, creates an incentive for them to be marketed as ‘greener’ than they may be in practice, which gives rise to the potential for misleading disclosures. 

So to support and protect investors, it is critical to create a common language and classification system which defines what is considered green and sustainable.  There is clearly more work that needs to be done in this area, including ensuring investors have a clear understanding of the choices they are making when investing in green products. The regulatory framework should allow industry to assess and assign appropriate classifications to their holdings using reliable and consistent data and criteria.  The European Commission has already begun discussions on what SFDR 2 might look like in this regard.  The European Securities and Markets Authority (ESMA) also continue to promote convergence and harmonisation around ESG products including their recent proposal on naming conventions for funds.

Whilst SFDR is primarily focussed on disclosure, the Central Bank recognises that disclosure alone may not be sufficient to prevent potential risks and must be supported by effective investment processes and appropriate risk management.  I want to mention some areas of supervisory focus.   These are:

(i) the Adaptation of Risk Management Frameworks – as you know both AIFMs and UCITS Management Companies are required to consider sustainability risk factors when undertaking their due diligence on investments and must take sustainability risks into account in their organisational procedures and risk management policies. 

(ii) Securities Lending – We plan to examine whether funds which engage in securities lending are in a position to meet their environmental or social characteristics if they have lent shares and those loaned shares lead to positions which would not qualify as sustainable investments.   

(iii)  Machine learning – Our intention is to expand our ESG analysis to incorporate machine learning practices, in particular natural language processing, in order to extract information from fund and industry documentation. We are examining ways to convert fund documentation and text data into database formats.  In time, this will allow us to assess new types of data ranging from social indicators to hazardous waste, water, land usage and recycling practices.  Our goal is to implement a broad data approach, incorporating data which can be used to assess the veracity of individual claims made within fund documentation

The Central Bank is committed to supporting the growth of this segment in Ireland and enabling the significant investment in sustainable projects needed to support the transition to carbon neutrality.  Whilst the onus is on the responsible persons to ensure that they meet the obligations set out under SFDR, it is also crucial to have dialogue between supervisors and industry to share developments at a European level, as well as our experiences in this area generally. 

In this regard, we intend to continue to openly and regularly engage with the funds industry and will also use publications on the Central Bank website to ensure that regulatory developments are outlined and that our expectations are clear.

Delegation

Delegation has an important role to play in the funds sector, which can bring benefits as well as risks.  Delegation does not, however, reduce the fund management company’s ultimate responsibility and, therefore, we must be satisfied that management companies are both resourced and capable of effective due diligence, oversight and monitoring obligations where specific roles and activities have been delegated. 

This continues to be a focus for NCAs and the ESAs with Brexit causing an even greater level of scrutiny in this area.  Part of the Central Bank’s response to this was the publication of the Cross-Industry Guidance on Outsourcing in December 2021, which supplements the existing EU guidance relevant to the management of outsourcing risk. 

ESMA have also given significant consideration to the elements of substance and delegation, particularly by applying more focus to structures involving third country service providers.  As part of the objective of supervisory convergence, ESMA will conduct a peer review on depositaries and another on outsourcing in 2024/2025.  As a significant fund jurisdiction, we expect to be part of this review. 

It is important to note that Ireland already has robust requirements in place to prevent the establishment and operation of “letterbox” entities and to ensure firms are structured appropriately to effectively oversee their delegates.  However, we continue to refine and enhance our domestic rules to ensure they align to EU level requirements, and accurately reflect our expectations in terms of their substantive structures, activities and risk profile.

In this regard, it is important to be aware that the AIFMD review is likely to bring targeted changes to the current regime to enhance the reporting of delegation activity, particularly to third countries. The proposals contained in the AIFMD Review mark the start of a longer-term process that will take a more comprehensive look into delegation in Europe. 

I would encourage all participants within the funds industry to proactively engage at both national and European level on this work.  Your views and insights are vital in forming a targeted and effective regulatory approach to this topic.

ELTIFs

Finally, just to briefly mention one of our current regulatory priorities.  As you know, the European Long Term Investment Funds (ELTIF) regime was developed for alternative investment funds which channel capital into European long-term investments in the real economy. 

Due to the relatively low number of ELTIFs launched in the EU, the European Commission consulted on revisions to the framework to address perceived roadblocks.

The amending ELTIF Regulation will apply from 10 January 2024.  There is simultaneous work ongoing to develop the draft regulatory technical standards under the revised ETLIF Regulation and the full package of measures are expected in Q1 2024. 

Under the current Irish framework ELTIFs require dual authorisation, firstly as an ELTIF under the ELTIF Regulation and also as a RIAIF or QIAIF under the Central Bank’s AIF Rulebook.. To address this the Central Bank is proposing to introduce a dedicated chapter in the AIF Rulebook to provide for a single dedicated ELTIF product authorisation.  In this regard, we issued a Consultation Paper on 1 November, which includes the new ELTIF chapter.  This will set out the rules applicable to ELTIFs and will supplement the requirements of the ELTIF Regulation.  The proposed ELTIF chapter contains only those rules deemed essential in ensuring investor protection and transparency and are aligned with the provisions that are also applicable to QIAIFs and RIAIFs.

The consultation process will remain open until 13 December 2023 so once again I would encourage you to provide your views to ensure all of your concerns/suggestions are considered in the development of our approach.

Conclusion

Let me conclude there.

The continued evolution of our approach to the supervision of the funds sector is crucial given its growth in size and complexity. I have discussed some of the key regulatory and supervisory priorities for the Central Bank including delegation; ELTIF and of course SFDR but there are many more.

As we move towards the end of 2023, I am sure a lot of you are in the throes of 2024 planning and we are having the same discussions.  I have no doubt 2024 will be as busy and, at times, as challenging as the last few years, but we will continue to focus on transparency and fair treatment of investors as well as broader financial stability risks.    We also recognise the important role of the sector in providing an alternative source of financing to both the Irish and European real economies, supporting economic growth, innovation and of course the transition to a sustainable economy.

We don’t just welcome your continued engagement – we see it as essential to our mission of serving the public interest while ensuring that the financial system and the funds sector operates in the best interests of consumers, investors and the wider economy.

I will now open the floor to any questions that you may have.