Regulation in a changing environment: some regulatory issues relevant to the Irish funds sector - Gerry Cross, Director of Policy and Risk

Address to Irish Fund Directors Association (IFDA)

Introductory Remarks

Good afternoon ladies and gentlemen.

Thank you for inviting me to be here today to talk about current regulatory issues as they relate to the funds sector. The asset management industry is of great and continuously growing importance to the economy and to the economic wellbeing of Irish and European citizens.

The fulfilment by the funds sector of its potential in supporting the economy and the economic wellbeing of citizens depends upon the confidence of the public in the quality and conduct of funds, their managers and delegates. And you as independent directors are at the heart of that.

The Central Bank very much welcomed the creation of your Association, roughly 18 months ago or so. We note and support your objectives to advocate industry best practice in corporate and fund governance as well as board oversight.  These very much align with the recent work completed by the Central Bank on fund management company effectiveness, which I will come to in a moment. But first let me say a few words about recent changes at the Central Bank of Ireland.

New structure in Central Bank of Ireland Financial Regulation

From 1 September, the financial regulation pillar of the Central Bank has been restructured into two separate pillars, prudential regulation and financial conduct. Ed Sibley has been appointed the Deputy Governor of the Prudential Regulation pillar, which includes the credit institutions, insurance and asset management directorates. Derville Rowland has been appointed the Director General of the Financial Conduct pillar and has responsibility for consumer protection, securities and markets supervision, and enforcement. Policy and Risk, which is my own area of responsibility, covers both prudential and conduct issues and has a dual reporting line to the Deputy Governor Prudential Regulation and the Director General Financial Conduct.

These changes reflect the increased scale and intensity of regulation and supervision over recent years, including the increased role of European level activity in our regulatory and supervisory activities. The establishment of the two regulatory pillars – prudential and financial conduct – reflects the strong commitment of the Central Bank to the fulfilment of our mandates in both these regards. These regulatory mandates are closely integrated into a “One Bank” approach which incorporates our other mandates of financial stability and price stability as part of the Eurosystem.

Fund Management Company effectiveness

The fund management company effectiveness package (which resulted from the so-called CP86 review), issued in December 2016. The new rules and guidance represented the culmination of three years’ focused work by the Central Bank to review and enhance the governance, oversight and delegation arrangements in place in Irish authorised fund management companies. Let me acknowledge again, as I have previously, the contribution that the funds’ directors community made to this work. This included the report that was developed at an early stage by the Committee on Collective Investment Governance and the significant amount of engagement by the funds directors’ community in the different consultation exercises that were undertaken.

The role of independent directors in the good governance of the funds sector cannot be overstated; in particular their indispensable responsibility for challenge and oversight, including oversight of the arrangements in place for the supervision of delegates. Our rules require that it be an independent director who must assume the organisational effectiveness role which is a key new role required as a result of the CP86 review.

The Organisational effectiveness role

The organisational effectiveness role evolves the responsibilities of the independent fund director who acts in this capacity into one which places the independent director clearly at the heart of a board’s activities.

It constructs a framework through which the effectiveness of the arrangements in place for the management of the fund are actively considered and reviewed on a continuing basis. The individual who carries out this role will be on the alert for organisational issues and will escalate them to the wider Board with proposals for change where necessary.

Having someone within the fund management company, who has the specific task of keeping the effectiveness of the organisational arrangements of the company under ongoing review is a key device for good governance. This role makes an important contribution to fund management companies’ meeting the Central Bank’s expectations in terms of governance standards, execution of directors’ duties, and the fulfilment of legal and regulatory obligations in a fluid environment.

As you know, all fund management companies must have the organisational effectiveness role in place by 01 July 2018 and fund management companies authorised after the 01 November 2015 have already begun complying with this requirement.

Regulatory and supervisory issues for 2018

Let me say a little bit now about some of the things that you can expect to see us focus on during 2018.

CP86 implementation. Clearly the implementation of the CP86 rules and guidance will remain central to our focus. Our enhanced requirements on the role of designated persons, on the oversight of delegates, on the organisational effectiveness role, and on directors’ time commitments to name a few will all remain within our supervisory focus. It is too early to say anything definitive about specific supervisory priorities for 2018 but we continue for example to focus on directors’ time commitments as part of our authorisation processes.

Brexit preparedness. We will continue to focus on Brexit preparedness across our regulated firms including the funds sector. While we should be hopeful that the negotiations between the UK and the EU-27 will lead to something different, a hard Brexit with the loss of passporting rights between the UK and the EU-27 is a material risk well within the planning horizon. Ensuring that regulated firms are planning effectively for this risk remains a key continuing focus for the Central Bank. We expect firms who have material UK-related business to have well-developed plans in place for dealing with the risks of a hard Brexit occurring in early 2019. This should include a clear focus on any implications for their customers and clients.

MiFID preparedness is of course a key concern for us; and my colleague Michael Hodson has addressed this particular issue in recent presentations.  Within my own Directorate, we have consulted on a second edition of our Investment Firms Regulations to take account of MiFID II matters and also to continue to develop our single rulebook approach for each sector.  Your response to that consultation was very welcome.  We are on track to deliver feedback and have the revised requirements in place by the MiFID II implementation date.  Thereafter we will focus on the emerging policy issues including those which are or which will be under discussion at ESMA.

IT and Cyber risk. The Central Bank will continue its focus on IT and Cyber risk across financial firms. IT is at the heart of financial services business, whatever the precise form of that business. IT and IT risk cannot and must not be thought of as ancillary to the core business of the firm. IT and Cyber risk management have in very many cases not been done well by financial firms and have not been given sufficient effective attention by senior management. Very often, much too often, it has been seen as a problem “to be sorted out by IT”. That simply will not do. Moreover, the context is one of rapid change. Something which adds materially to the challenges and the risks, even while representing opportunities for firms and their customers.

A year ago, the Central Bank published Cross Industry Guidance on IT and Cybersecurity Risks. This set out in relatively straightforward terms what we expect of firms, of all types, and in particular of their boards and senior management when it comes to addressing IT and cyber risk. This guidance sets out what supervisors’ expectations are in this regard. It will continue to be the focus of our supervisory attention in the coming period. Though I would note that the guidance is written with a general application perspective which will be enhanced and elaborated in the supervision of different firms, in particular large and complex ones.

Outsourcing. An issue that is the focus of attention generally across sectors at the moment is outsourcing. You will have seen for example the output of the thematic review of outsourcing in the funds administration sector that was carried out last year. This noted amongst other things the significant level of outsourcing in that sector and was followed up with a series of observations and recommendations many of which were subsequently incorporated into guidance we provided to accompany the Central Bank Investment Firms Regulations.

This reflects the wider fact that outsourcing continues to grow in importance across industry generally including the financial industry, that outsourcing practices continue to develop and the complexity of arrangements to grow, and that this gives rise to enhanced challenges, including for supervision.

Against this backdrop, the Central Bank is currently undertaking a cross-sectoral analysis of outsourcing practices. We will very shortly issue a survey to firms across the range of sectors concerning outsourcing arrangements that they use. The aim of the Survey is to gain further insight into the current and future pattern of outsourcing arrangements from a cross-sectoral perspective. This includes both third party and intra-group arrangements. We will be asking for information in respect of the types of services and operations outsourced, materiality and concentration of outsourced arrangements, contractual arrangements in place, contingency planning and the extent of oversight and assurance reviews conducted.  The Survey cohort will include all PRISM High, Medium-High and Medium-Low Impact Regulated firms.

At this stage our focus is very much a fact finding one. We want to enrichen the understanding of the current state of outsourcing practices and to gain an integrated view of these. The next stage will be to consider what might be the risk governance and/or supervisory implications of this rapidly developing area of industry practice.

Money Market Fund Regulation. In July, after much discussion since it was first proposed in 2013, the Money Market Funds Regulation entered into force. The EU MMF reform agenda was driven by financial stability concerns and the final Regulation will strengthen rules in relation to MMFs generally and CNAV MMFs in particular. There is much to be done in the coming months to ensure industry are well prepared for the changes coming down the track.

In this context, over the coming months, further engagement with industry will take place through my colleagues in Securities Market Supervision. While the Central Bank will be working closely with industry to foster preparedness, fund management companies have a responsibility to ensure they have taken the appropriate steps in terms of corporate calendar planning, fund documentation updates and any other steps that may be required to ensure compliance in a timely manner.

Messaging from the Central Bank around updates to authorisation and supervisory processes on foot of the MMF Regulation will be laid out in forthcoming industry engagements.

Most of you will be aware that in May this year, ESMA consulted on the Level 2 measures under the MMF Regulation and on ESMA guidelines in relation to stress testing. The Central Bank of Ireland is actively contributing to policy development within the investment management standing committee at ESMA to deliver these supplementary measures.  The work is nearing conclusion.  The outcome will be advice to the European Commission related to reverse repurchase agreements, the internal credit assessment methodologies of the fund manager and a template for the reporting of the required information to competent authorities.  ESMA will also finalise the guidelines on stress testing before end year – it is worth noting that these guidelines will be updated annually taking market developments into account.  This is required under the Regulation.

From a domestic perspective, we will be making updates to our regulatory rulebooks – the Central Bank UCITS Regulations and AIF Rulebook - to accommodate the relevant changes stemming from the MMF Regulation.

Investment funds fees: One issue that it is important to mention is that related to investment fund fees.  This topic has received a lot of attention in recent times.  I think it is right that this is the case – for example, investment funds provide a means for increased pension provision, now so important as we move from defined benefit arrangements.  It is important that investors, particularly retail investors, have trust in the industry and can understand the proposal presented to them in order to make an informed decision.  Many reports have highlighted concerns however.  These include the lack of transparency and the possibility that not all funds are in compliance with the disclosure requirements which currently apply. The negative impact of fees and commissions on returns are also highlighted.   I do not intend to address the matter in detail today other than to signal that you can expect further scrutiny by regulators into this area, including at the European level.

Exchange Traded Funds

In May, we published a Discussion Paper on Exchange Traded Funds.

It was prompted by three thoughts:

1. The ETFs market is very large and has grown at a rapid pace over recent years;
2. Ireland is home to the largest number of European ETFs;
3. It is important that all understand, as well as possible, and in as detailed a way as possible, the way in which ETFs function, the dynamics inherent in their operation, any risks that are associated with them, and how and to what extent those risks are mitigated.

The Discussion Paper was published in a genuine spirit of openness and seeking to deepen our understanding of the product. I think there is a similar spirit of enquiry to be found in the work of other regulators – for example, the recent study of the French Autorité des Marchés Financiers (AMF) in their recent paper, the work that IOSCO is commencing.

If you look at our Discussion paper you will see that our questions fall into a small number of key themes.

First of all we discuss a number of questions under the broad heading of investor expectations. In the work that the Central Bank of Ireland has done in relation to both investor protection and systemic risk in the funds sector generally, one of the issues that has continually asserted itself as central is that of investor expectations. And in particular the question of the alignment of investor expectation and the actual functioning of the fund, particularly in times of stress. It is at such moments, and depending upon the alignment of expectations and the reality of the functioning of the fund, that much depends.

Under this heading, for example, the role of Approved Participants is closely examined. And in particular of course the fact that they are a key source of liquidity, but with no contractual obligation. The price arbitrage mechanism that is at the heart of alignment of the ETF share price and the NAV is considered. And inputs sought as to whether there are potential weaknesses in this structure. Is it the case that the arbitrage mechanism can be relied on to keep prices closely enough aligned? Or is there a risk that in times of stress the secondary market price will diverge materially from the underlying in a way that investors would not have expected.

In the Discussion Paper we go on to consider ESMA guidance that in certain circumstances the primary dealing facility should be opened up to ETF shareholders where the shares were procured on the secondary market. And the Paper asks for insights as to how such an approach might work in practice.

We also note research which suggests that even in normal times the ETF share price can trade at a material discount to NAV. And we ask whether this is something that regulators should be concerned about.

Currently, while not having a strict rule, the Central Bank has indicated an expectation that ETFs disclose their portfolios publicly on a daily basis. The Discussion Paper asks whether such disclosure should indeed be expected / compulsory.

The Discussion Paper also sets out our understanding of the functioning of specific aspects of ETFs and asks whether these give rise to risks and if so, whether and how these risks are mitigated.

For example the question of interconnection and concentration risk is considered. This includes the risk of counterparty risk (through hedging, SFT exposures, etc) and AP dependence all linking together through connected parties. With such risk being potentially further increased in the case of synthetic ETFs.

Of course any such risks are significantly mitigated by the collateral arrangements that are put in place. The Discussion paper also raises the question of collateral risk. The risk that there is an undue mismatch between the realisable value of the collateral and the value at risk in a stressed situation. The DP asks for views as to whether there would be a case for collateral received to be correlated with the underlying index? And whether this would be practical?

Our Discussion Paper also explores the broader market functioning aspects of ETFs and their burgeoning popularity. What if anything might be their impact on the overall orderliness and resilience of relevant markets. And if there is an impact is it beneficial, as some research and commentators suggest, or detrimental as others suggest?

Take inclusion in an index. On the one hand this can give rise to increased demand and therefore increased liquidity. However, due to finite availability it can also give rise to increased illiquidity.

The informational efficiency of the underlying securities may be increased, or decreased, depending upon which analysis or view you follow. ETFs because of their secondary market pricing can contribute to price discovery. At least at the aggregate basket level. Others have argued that over time lower availability of the underlying stock and of informed traders willing to trade in them leads to less informational efficiency of that stock.

Then there is the further question as to whether ETFs and the manner in which they function give rise to the fragile liquidity. This is the phenomenon by which investors may be attracted to invest in an asset where they would not otherwise because of liquidity concerns. If correct, it is argued, this could give rise to the potential for sudden flights and an accelerated drop in value in the underlying due to the disappearance of this fragile liquidity.

The Discussion Paper also considers particular types of ETFs such as active ETFs and leveraged ETFs and considers whether these give rise to a different set of risks and if so how they might be managed.

The responses received to the Discussion Paper provide a range of views on the issues raised. With a view to exploring these further, the Central Bank will be hosting a conference in the Convention Centre on 29 November examining ETFs in the context of stability and growth.  We’ll be dealing with liquidity, product strategies, underlying markets and the future of ETFs amongst others. I’m delighted to say that speakers with include the Central Bank’s Director General for Financial Conduct Derville Rowland, Paul Andrews, Secretary General of IOSCO, and the SEC’S Deputy Chief Economist Scott Bauguess.

Brexit

In terms of the relocation of the EU activities of UK-based firms, a great deal has been said and done in this area over recent months. Work related to this aspect has been and continues to be an important focus of the Central Bank and its staff during this period. As has been said many times, our approach is based on a high quality combination of transparency, rigour and pragmatism and is strongly embedded in the work of European authorities – about which I will say more shortly. It has been said a number of times, and it remains the case, that Ireland can expect to achieve a meaningful share of such relocating business.

The ECB / Single Supervisory Mechanism, the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) have all issued important guidance or opinions in relation to Brexit. The European Banking Authority (EBA) can be expected to follow suit shortly. These set out principles aimed at fostering consistency in the authorisation and supervision of entities, activities and functions proposing to relocate from the United Kingdom. Because of the importance of achieving convergence in this area, the Central Bank has been proactively engaged in, and is strongly supportive of, this work of the European authorities.

It is very important that in dealing with the many challenging questions that arise in the context of relocating firms, divergent approaches do not emerge amongst different supervisory authorities across Europe. If they do, then there is a risk that these differences will begin to drive firms’ behaviours and decisions. As Governor Lane said as early as early as a year ago, banks’ decisions in the context of Brexit should not be driven by regulatory differences but by important matters such as business model, employee and work force concerns, cultural fit, communications, etc.

The Central Bank is conducting a review of ESMA’s three sector specific opinions. While this review is not complete we are finding that our approach is in general terms very consistent with what is in those opinions. This is not surprising as some of the key issues are ones to which we have given a significant amount of close consideration over the recent period, even before Brexit emerged.

For example, Ireland is a global centre for the funds industry. We have given a great deal of detailed thought to the appropriate approach to be adopted to location, outsourcing, delegation and effective supervision in the funds industry. We have developed very detailed guidance and some additional rules to ensure that the funds industry in Ireland can develop orderly relations with service providers across the globe which serve their investors well. In view of the quality and intensity of the work we have done on these issues, it is not surprising to us to find that our conclusions turn out to be in line with best practices as seen by ESMA.

In a number of specific cases, small amendments may be required to Central Bank authorisation processes arising from the Brexit opinions of ESMA. If any material process changes were to be needed this would be done in a transparent manner with the Central Bank seeking feedback on any proposed changes.

To support its Opinion, ESMA has established a ‘Supervisory Coordination Network’. This is a new development. In this forum national competent authorities are called on to present the key features and aspects of relocation related applications and how they propose to deal with those. This provides strong support to the consistent implementation of the Opinions across different EU jurisdictions. The Central Bank has welcomed this development. We are active participants in the forum and have found that it provides for an effective exchange between supervisors and ESMA. We are confident that it will contribute to the achievement of consistent outcomes.

One question that has arisen in the context of relocation, is whether the ECB/SSM should have supervisory jurisdiction in relation to large investment banks - sometimes referred to as broker-dealers - which although investment firms in legal nature, can have bank-like significance for the financial system. At the Central Bank we take the view that given the similarities between such entities and banks, and given the potential systemic effects of their failure, there is considerable merit in the idea that the ECB/SSM should be given responsibility for their supervision. There would of course be a number of legal, technical and conceptual challenges to be overcome if this were to be the outcome sought.

Of course all of this takes place in a very dynamic context. We have seen only very recently the European Commission’s new proposals for revising the governance and responsibilities of the European Supervisory Authorities (ESAs). The Central Bank remains closely engaged in and responsive to such continuing changes, or proposed changes, in the landscape. As you would expect we are currently closely examining the Commission’s proposals to see what they would mean for the functioning of financial markets and services.

Conclusion

Let me conclude there.

I am grateful for your time and attention, and look forward to any questions you might have.

*My thanks to Cameron Carr for his input to this speech.