Will the US and EU align Money Market Funds regulation?
There is growing consensus amongst regulators that money market funds (MMFs) are systemically risky and form part of the shadow banking industry but the crux is determining how, why and what should be done about them. In its efforts to delve more deeply into shadow banking, the Financial Stability Board (FSB) set up five working groups looking at various issues, with one dedicated to MMFs. A report is expected later this year. In parallel to provide input to the working group, the FSB asked the International Organisation of Securities Commissions (IOSCO) to investigate systemic risk in MMFs. IOSCO issued a consultation report at the end of April and is due to release policy recommendations in July.
Against this international backdrop, regulators have contributed further to the debate, including comments by the European Commission (EC) in its March green paper on shadow banking, the precursor to possible legislation next year. Last week, the European Systemic Risk Board (ESRB) published their first Occasional Paper, notably also addressing MMF concerns. Meanwhile, the US Senate Committee on Banking, Housing and Urban Affairs on 21 June heard evidence from Mary Schapiro, Chairman of the Securities and Exchange Commission.
In its green paper the EC expressed the belief that MMFs share significant characteristics with deposits – they can be susceptible to mass-redemptions, similar to ‘runs’ on banks – and therefore the EC believes that MMFs pose a threat to the financial system. Last week’s subsequent ESRB Occasional paper also highlighted that the potential maturity transformation by European-style longer-term MMFs can also mirror a key banking function.
The EC’s green paper stated that shadow banking activities are exposed to similar financial risks as banks, without being subject to comparable constraints imposed by banking regulation and supervision; activities could be financed by short-term funding, and that they are prone to risks of sudden and massive withdrawals of funds by clients. Massive redemptions, or runs, on MMFs, particularly in the US, during the financial crisis seriously exacerbated pressure on the system as a whole. In light of this, and in coordination with the FSB, the EC’s current work aims to “propose an appropriate approach to ensure comprehensive supervision of the shadow banking system, coupled with an adequate regulatory framework” to address concerns relating to financial stability.
Previous FSB work shows that the possibility of runs stems from the credit and liquidity risks, but also from the method of valuation employed by funds. MMFs which value their funds using a constant Net Asset Value (NAV) rather than a floating one are more susceptible to runs. It also noted that this can provide the first-mover advantage to investors who are the first to seek redemptions from funds in times of market stress, before the NAV is forced to drop, further exacerbating such runs. This concern is also shared in the US.
Both the US and the EU do have existing regulatory provisions – both generic and specific – which in part tackle MMF concerns. In Europe, most MMFs are constituted under the UCITS Directive; in the US MMFs are mutual funds regulated under the Investment Company Act of 1940. Both the US and the EU (via CESR) have made specific policy interventions since the beginning of the financial crisis, but we are now witnessing more considered policy responses to the financial crisis – which Schapiro’s evidence termed “important unfinished business from the financial crisis of 2008” in the shape of new, additional regulatory intervention.
The ESRB develops the analysis of possible policy approaches to addressing these regulatory concerns, which will be of particular interest to industry. With MMFs in the EU totalling some 1 trillion euros (the US value is estimated at 2.5 trillion dollars), the paper highlights the systemic importance of MMFs to the asset management industry. The ESRB also highlights the additional redemption pressure in time of stress that the informed nature of the institutional investor centric client base can cause.
The ESRB paper succinctly highlights the key policy implications predominantly under consideration – namely the move to a mandatory floating NAV, and/or the introduction of capital buffers for funds. One area of difference between the US and the EU is in the structure of the funds. The Committee of European Securities Regulators (CESR) - the predecessor to the European Securities and Markets Authority (ESMA) published guidance on MMFs in 2010, which came into effect on 1 July 2011. This laid bare a number of disclosure and credit risk requirements, and also created a distinction between short-term MMFs (STMMF), which can either have a floating or constant NAV, and longer-term MMFs which must have a floating NAV. The US requirements do not create such as distinction, and the scope of longer-term MMFs in the US is extremely limited, with US MMF appearing very similar to STMMF in Europe, including supporting a constant NAV.
In the US, the initial reforms, adopted and implemented in 2010, sought to reduce risk through reductions in maturities, improving credit standards and mandating liquidity requirements so that MMFs could better meet redemption demands.
However, Schapiro is now advocating a move to floating NAVs, or a requirement to maintain a capital buffer to support the funds’ stable values, possibly combined with limited restrictions or fees on redemptions. While the capital buffer would not necessarily be big enough to absorb losses from all credit events, it should absorb the relatively small mark-to-market losses that occur in a fund’s portfolio day to day, including when a fund is under stress. Schapiro believes this would increase MMFs’ ability to suffer losses without ‘breaking the buck’ and would permit, for example, MMFs to sell some securities at a loss to meet redemptions during a crisis.
Given the similarities in issues in the EU and the US, and the cross-jurisdictional nature of many investors, the fund industry and investors may be hoping for a coordinated response; indeed the similarity of concerns and proposed policy response adds to this. However, both Paul Tucker, Bank of England’s Deputy Governor for Financial Stability and Chairman of the Financial Stability Board’s Resolution Steering Group, and Lord Turner, Chairman of the UK FSA, have voiced support for reforms, with Lord Turner supporting unilateral movement on MMFs. IOSCO’s policy recommendations later this month will certainly make for interesting – and potentially urgent reading.
MiFID II/MiFIR and MAD II/MAR progress continues as the Council Presidency passes from Denmark to Cyprus
As the Danish Presidency of the EU draws to a close, and the Cypriot Presidency takes over, a number of EU Council of Finance Ministers (Council) compromise texts and Presidency progress reports have been issued. This includes the latest compromise texts relating to MiFID II and MiFIR on 20 June, and on the Market Abuse Regulation (MAR) on 11 June, each accompanied by a ‘handover’ status report on progress so far.
The MiFID II/MiFIR current compromise texts have been split into three areas, with two areas already discussed prior to publication, with the final area debated on 26 June, after publication of the progress report.
The compromise text addresses some scope issues on MiFID II. Structured deposits have been included in the scope of MiFID II, but insurance-linked investment products have not, which will be a relief for many insurance entities (and would have overlapped with the scope of the Packaged Retail Investments Products (PRIPs) initiative and accompanying amendments to the Insurance Mediation Directive, which are expected to be published by the EC early in July). It also seeks to clarify and grant exemptions in relation to investment services and products aimed exclusively at hedging commercial risk with further ESMA clarification through a regulatory technical standard (RTS) on the exemption criteria.
The Organised Trading Facilities (OTF) requirements remain controversial - half of the Member States wish to see less strict rules for OTFs, whilst others wish to see the OTF definition removed and trading put on existing trading platforms; the progress report perhaps unsurprisingly indicates further debate as a consequence of this divide.
The compromise text, while maintaining the EC’s ban on proprietary trading on OTFs, permits matched principle trading (or back-to-back trading). ESMA is required, however, to produce a RTS to specify the ‘precise and narrow definition’ of matched trading which is permissible. However in principle this is a welcome concession for firms, albeit narrowly interpreted.
The application of general waivers from pre-trade transparency for non-equity instruments for request-for-quote and voice trading systems, and for professional participant traders divided Member States. The Danish Presidency notes that it has not found a solution in this area, and suggests that a more broad-based compromise with minimum size limits based on references prices may be a successful approach.
The area of investor protection has again faced scrutiny and amendment. The Council Working Group considers that a requirement to pass any inducements received from third parties onto a client does not preclude an independent definition. However, with some Member States already positioned in stricter interpretations (including the UK), the paper concedes that allowing some degree of controlled ‘reinforcement’ may be necessary (i.e. Member States should be given limited discretion to go beyond the rules). Although there was agreement within the working group that some UCITS products are too complicated for retail investors on an execution only basis, it prefers that this issue be covered by a review of the UCITS Directive, rather than in MiFID II.
The compromise text also amends the nature of guarantee schemes exposure. According to the EC’s proposals, individuals falling under exemptions from the directive would still have had to contribute to an Investor Compensation Scheme (ICS). However, the working group suggests that they may use insurance instead. Those firms providing now-in-scope structured deposit arrangements caught under the deposit guarantee scheme directive do not have to register under the ICS directive. While these measures may seek to remove duplication, from a consumer point of view the implications of having substitutable products with differing guarantee schemes, or even insurance backed support, may make products more difficult for consumers to understand and compare.
Finally, the draft text includes extensive changes on competent authorities and sanctions, which were discussed after publication of the progress report on 26 June 2012. The broadly supported aim has been to align provisions in MiFID II with sanctions provisions in MAR and the Transparency Directive, and whistleblower provisions with in CRD IV.
The MAR progress report appears to be more harmonized, with the Danish Presidency reporting general consensus. Six key outstanding issues remain, including a lack of common understanding between Member States of the kind of information that insiders are not allowed to trade, and on when information has to be disclosed. Member States have also agreed to wait for the outcome of an European Court of Justice ruling on the current MAD before finalising the regulation. In terms of insider dealing defences, most Member States agreed on the approach, but there was no agreement on the wording due to the creation of potential safe harbours or reverse burden of proof provisions under national laws.
The concept of accommodating local “accepted market practices” (where an action would fall under the market abuse regime but is currently permitted in Member States) was broadly agreed. However, Member States were keen to limit these exceptions to national markets, rather than allowing other Member States to introduce equivalent provisions.
Despite being a Regulation, and therefore directly applicable, the Danish Presidency report describes it as ‘Directive like’ and therefore in need of Member State implementation due to potential conflicts with and limitations on existing domestic regimes. The report indicates that competent authorities would not want to have their powers limited – which is not the intention but depending on the reading of the text is a possible outcome. This is similar to the area of sanctions where the Presidency’s compromise aims to provide sufficient flexibility for Member States. This flexibility also extends to publication of sanctions, which can be anonymised, and/or published for information purposes (rather than as a sanction itself).
The latest compromise text offers little by way of additional content from that highlighted in the progress report. Greater harmonisation with MiFID and MiFIR, incorporating new definitions of an OTF and emissions allowances are included, as are direct references to MiFID for reporting obligations. The compromise text does potentially amend the scope, taking on an extra-territorial impact, with the additional requirement that the prohibitions of the Regulation also apply to “actions carried out outside the Union where such actions have an effect on the markets of the Union” - the text does not elaborate on how that would be effectively policed.
The progress reports suggest that substantial negotiations will still need to take place under the Cypriot Presidency before the Council will be in a position to start negotiations with the European Parliament and the EC in trilogue on MiFID II/MiFIR. The working group is said to be aiming at an agreed mandate for the trilogue discussions by October. Work in the Economic and Monetary Affairs Committee (ECON) of the European Parliament is moving quickly with a vote on the ECON draft report scheduled for 10 July which will mean that the Parliament will be well-placed to commence trilogue negotiations as soon as the Council has agreed its position.
MAD II/MAR negotiations will be aligned with those on MiFID II/MiFIR both in content and timing as both regimes are intended to come into play at the same time.
ESMA and EBA publish EMIR RTS
With the ‘go live’ date for the Regulation on OTC derivatives, central counterparties and trade repositories (dubbed ‘EMIR’) in just over six months, work is progressing quickly on related regulatory and implementing technical standards (ITS), even before the Regulation text is in force. ESMA and the European Banking Authority (EBA) have published draft implementing measures for EMIR. Following discussion papers issued in February and March, on 25 June ESMA published its proposals for RTS and ITS for which it has sole responsibility. The EBA had previously released its proposals for an RTS on capital requirements for central counterparties on 15 June. This constitutes the bulk of the Level 2 rules with one major gap: the consultation paper due from the European Supervisory Authorities jointly on risk mitigation techniques for non-cleared OTC derivatives (essentially on collateral requirements). This is likely to be released later in the summer.
ESMA’s consultation paper on the draft RTS covers the regulation of OTC derivatives, central counterparties (CCP) and trade repositories (TR). ESMA makes proposals for TR reporting obligations and provides detail on the information requirements for TR’s seeking ESMA registration, and information to be made available to relevant authorities.
On OTC derivatives, ESMA considers OTC derivative clearing obligations and the risk mitigation techniques for contracts not cleared by a CCP for which ESMA remains solely responsible. ESMA has responded to industry concerns by confirming exemptions for certain commercial hedging arrangements, a concern some companies cited due to potential increased cost.
ESMA is proposing the introduction of separate thresholds for five classes of derivatives – credit, equity, interest rate, foreign exchange, and commodity derivatives, below which the requirements for central clearing will not apply. For credit and equity derivatives the proposed threshold is 1 billion euros; for interest-rate, FX and commodity it is 3 billion euros. Crossing the threshold for any of these classes would bring the trading of all classes of derivatives into the scope of the EMIR clearing obligations.
ESMA considers specific CCP requirements, setting out the prudential and conduct of business elements applicable to CCPs, and organisational requirements. This supplements EBA’s consultation on specific additional capital requirements to be imposed on CCPs. EMIR specifies CCP capital requirements in relation to the clearing activities. EBA, however, was tasked to develop supplemental requirements covering credit, counterparty and market risks arising from other activities of the CCP, and overall operational risks (including operational expenses incurred ‘an appropriate timespan’ for winding-down or restructuring activities).
In terms of the ‘appropriate timespan’, EBA determines that this must be at least one year (CCPs will have to justify the timespan – of one year or over – which they choose for this calculation). In terms of capital requirements with regards to the various risks, EBA uses the Capital Requirement Regulation (CRR) regime as a benchmark. National supervisors will be able to require additional capital, over and above these requirements, to take account of specific business and legal risks run by individual CCPs. One key issue to note, however, is that in order for national supervisors to ensure CCPs comply with their capital requirements at all times, as required in the Level 1 text, EBA is suggesting a notification threshold of 25% over the required capital amount.
Both the EBA and ESMA plan to hold public hearings for interested parties. The consultation on the EBA paper runs to 31 July: EBA will hold a public hearing on 4 July. ESMA will be holding a public hearing in Paris on July 12 and is accepting responses to its consultation paper until 5 August.
Getting these consultations underway is progress, but the timetable for this work remains very challenging for the EU to meet G20 commitments for the end of 2012. Firms need more certainty on EMIR quickly, in order to prepare for implementation in an orderly fashion.