Including updates on remuneration guidelines for AIFMs, IT systems at banks and high frequency trading


ESMA issue remuneration guidelines for AIFMs

The European Securities and Markets Authority (ESMA) published a consultation paper, with 50 questions on guidelines on sound remuneration policies last week in respect of the Alternative Investment Fund Managers (AIFM) Directive. It covers a wide gamut of areas related to remuneration including governance arrangements, disclosure requirements and the treatment of AIFMs that are part of a wider group.

The consultation arises from Annex II of the AIFM Directive (2011/61/EU) which requires AIFMs to have sound remuneration policies in place for certain categories of staff, including senior management, risk-takers and those in control functions. Similar to post-crisis guidelines for banks, regulators want AIFMs to have robust governance arrangements, which include a clear organisational structure with “well defined, transparent and consistent lines of responsibility”.

The guidelines will apply to all AIFMs within the scope of the AIFM Directive (the proportionality principle will apply) and will enter into force on 22 July 2013 when the Directive is implemented.

The guidelines will apply to the following categories of staff:
  • members of the governing body of an AIFM
  • senior management
  • staff involved in control functions such as risk management, compliance, internal audit and similar functions within an AIFM
  • staff responsible for heading the portfolio management, administration, marketing and human resources.
However, any member of staff whose professional activities who – either individually or collectively as members of a group–can exert material influence on the AIFM’s risk profile or on an AIF it manages will be captured by these guidelines, regardless of whether they fit into the categories above.

Under the guidelines, remuneration consists of all forms of payment or benefit paid by the AIFM, of any amount paid by the AIF itself, including carried interest, and of any transfer of units or shares of the AIF, in exchange for professional services rendered by the AIFM staff. The principles will not apply to fees and commissions received by intermediaries and external service providers in case of outsourced activities.

Remuneration policy and practices will be reviewed on an annual basis at a minimum. The review should assess:
  • the overall remuneration system
  • the appropriateness of payouts, ensuring that the risk profile, long-term objectives and goals of the AIFM are adequately reflected
  • the consistency of remuneration procedures with national and international regulations, principles and standards.
Part or all of this review may be externally commissioned (when appropriate according to the proportionality principle). Larger and more complex AIFMs are expected to have sufficient resources to conduct the review internally, although external consultants may complement and support the AIFM in carrying out such tasks. The relevant internal control functions (i.e. internal audit, risk management, compliance functions, etc.) as well as other key supervisory function committees (i.e. audit, risk, and nominations committees) should be closely involved in this review.

The guidelines also provide detailed orientations on establishing and operating a remuneration committee (RemCo). ESMA argues that AIFMs that are “significant in terms of their size or the size of the AIFs they manage, internal organisation and the nature, scope and complexity of their activities” should establish a RemCo. It follows from this principle that AIFMs which are not significant according to these criteria are not required to set up a RemCo. Nevertheless, it could be considered as a good practice for these AIFMs as well.

ESMA’s consultation draws from remuneration guidelines issued by the Committee of European Banking Supervisors (CEBS, the forerunner to the European Banking Authority) as part of the Capital Requirements Directive III. However, the new guidelines include some significant differences. This variation from CRD III may be seen as unnecessary―heaping further change and complexity on already over-burdened universal financial groups.

In principal, sound remuneration principles should work consistently across industries, from nuclear power stations to tulip producers. However, the financial industry is different, and distinctions within sub-sectors are important. In banking, remuneration policies are supposed to be designed to ensure the alignment of interests between market operators and their bank employer for financial stability reasons (i.e. to avoid excessive risk taking which could threaten the bank and, subsequently, the financial system).

In the asset management industry, remuneration policies should principally address alignment of interests between clients/investors (and so the funds) and the portfolio managers who make investment decisions on behalf of the funds. Indeed, losses from excessive risk taking are likely to damage the fund and its investors, while there may be little or no impact on the AIFM itself aside from reputational damage.

The closing date for this consultation is 27 September 2012. The final text of these guidelines is expected by the end of the year. Concurrently, ESMA will consult on a separate set of guidelines focusing on remuneration policies of investment firms from an investor protection perspective in the coming months.


Basel Committee seeks to improve IT systems at banks

The fragility of banks’ information technology (IT) systems and data architectures was exposed during the 2007 financial crisis.

Banks’ IT systems are systemic. Weak risk data aggregation capabilities and risk reporting practices can make it difficult for banks to manage their risks accurately at the bank group level, across business lines and between legal entities. Failure of payments systems, particularly during periods of volatility, can spook customers and could even result in a run on a bank.

The Basel Committee on Banking Supervision (Basel Committee) has done some work in this area since the crisis. It believes that more formal and coherent guidance is now needed to enhance banks’ ability to identify and manage bank-wide risks.

On 26 June, the Basel Committee published a consultation paper on draft principles for effective risk aggregation and risk reporting. These principles are initially addressed to systemically important banks and apply at both the banking group level and on a solo basis.

The Basel Committee put forward 14 principles, grouped together into four sections:
  • overarching governance and infrastructure
  • risk data aggregation capabilities
  • risk reporting practices
  • supervisory review, tools and co-operation.
The guidelines hold that banks’ data architecture and IT infrastructure needs to fully support its risk data aggregation capabilities and risk reporting practices, not only in normal times, but also during times of stress or crisis. The system should be able to generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy requirements by capturing all material risk data across the banking group. Moreover, the system should be nimble and adaptable: a bank should be able to generate aggregate risk data to meet a broad range of on-demand, ad hoc risk management reporting requests, including requests during crisis situations, requests due to changing internal needs and requests to meet supervisory queries.

The Basel Committee recommend that a bank’s risk data aggregation capabilities and risk reporting practices should be subject to strong governance arrangements. The board and senior management (or other recipients as appropriate) should set the frequency of risk management report production and distribution. Ongoing supervision is important. Supervisors should periodically review and evaluate a bank’s compliance with these principles. Supervisors should use appropriate tools and resources to require effective and timely remedial action by a bank to address deficiencies in its risk data aggregation capabilities and risk reporting practices.

The Basel Committee believes that the long-term benefits of improved risk data aggregation capabilities and risk reporting practices will outweigh the initial investment costs incurred by banks. Enacting these principles should improve decision-making process throughout a bank; reduce the probability and severity of losses resulting from risk management weaknesses; and improve an organisation’s quality of strategic planning and the ability to manage the risk of new products and services.

Supervisory expectations are high but throwing money at IT systems will not work. Building robust IT systems and data architectures is very challenging, and capturing all risks in any organisation is well-nigh impossible. The belief that a system will work effectively in the next crisis - the character of which is obviously unknown - stretches credulity. Bearing in mind the old adage ‘garbage in, garbage out’, in addition to beefing up their IT capabilities, firms also need to invest in people and culture to continuously challenge assumptions used. Regular communication between management and staff is also essential. A spreadsheet can only tell you so much.

The consultation closes on 28 September 2012. The Basel Committee expects national supervisors to start discussions with global systemically important banks (G-SIBs) on implementing the principles in early 2013 and for G-SIBs to implement the principles by 2016.


Basel Committee introduces new disclosure requirements on banks’ capital composition

The Basel Committee released the final disclosure requirements on the composition of banks' capital on 28 June, following a consultation in December 2011.

As in the previous consultation, the requirements are set out in the following sections:
  • Post-1 January 2018 disclosure template: a common template for banks to use to report the breakdown of their regulatory capital when the transition period for the phasing-in of deductions ends on 1 January 2018.
  • Reconciliation requirements: a three step approach to ensure that the Basel III requirement to provide a full reconciliation of all regulatory capital elements back to the published financial statements is met in a consistent manner.
  • Main features template: a common template for banks to use to meet the Basel III requirement to provide a description of the main features of capital instruments.
  • Other disclosure requirements: this section sets out how banks should meet the Basel III requirement to provide the full terms and conditions of capital instruments on their websites and the requirement to report the calculation of any ratios involving components of regulatory capital.
  • Template for transitional period: this is a modified version of the post-1 January 2018 template to be used during the transitional phase.
Disclosure requirements must be implemented no later than 30 June 2013. Banks should comply with the disclosure requirements from the date of publication of their first financial statements on or after 30 June 2013 (with the exception of the post 1 January 2018 template) and publish this disclosure together with their financial statements, regardless of whether or not the financial statements are audited.

Following the move to a unified disclosure regime, supervisors will have a better picture of the capital positions of global banks. Furthermore, the interventions carried out by supervisors should be more effective in the future if capital positions at banks are more transparent across the board.


International consistency on High Frequency Trading?

On 20 June 2012, the U.S. Commodity Futures Trading Commission (CFTC) held a public meeting of their Technology Advisory Committee (TAC). The TAC has been considering in detail the potential definitions, classifications and requirements around high frequency trading (HFT) and the use of algorithms in trading. This initiative is likely to address potential regulatory concerns, relating to the quality of algorithms and also the ability of traders and venues to deal with erroneous trades which, given the speed of HFT , can rapidly spiral out of control and move markets.

In November 2011, ESMA published guidelines on systems and controls for automated trading in relation to MiFID I, including considerations relating to HFT which came into effect on 1 May this year. HFT is also being considered in the ongoing negotiations on both the MiFID and MAD revisions, in order to enhance the regime under MiFID I and address issues related to potential market manipulation, respectively. As both the European and US policies develop, we may not see total consistency between the two approaches.

The TAC public hearing comprised a series of workshop presentations, and at this stage it is premature to determine the exact policy stances the CFTC will ultimately take. Clearly, though, the CFTC is adopting a consultative approach, taking advice from a number of working groups constituted with significant numbers of industry representatives. Whilst the hearing output is not ‘final’ guidance, it gives some indication of possible policy routes.

The clearest of the working group’s outputs was that of the group tasked with considering a definition of HFT. They adopted a deliberately broad definition to include future as well as current practice, to avoid potential regulatory arbitrage through a narrow definition.

The definition is proposed for “high frequency trading” is a form of automated trading that employs:
  • algorithms for decision making, order initiation, generation, routing, or execution, for each individual transaction without human direction
  • low-latency technology that is designed to minimize response times, including proximity and co-location services
  • high speed connections to markets for order entry
  • high message rates (orders, quotes or cancellations).
The definition is described as being deliberately mechanical in approach to achieve neutrality towards trading strategies.

The workshop participants also considered the role of liquidity. They felt that liquidity could be provided, absorbed or balanced by HFT strategies, depending on the approach and method of the trader – perhaps echoing industry sentiment in Europe that a blanket requirement to provide liquidity is inappropriate. However, participants agreed on the need for controls, both in firms and markets, and for further debate surrounding the assessment of algorithms prior to market access.

The CFTC has said it will publish a draft concept release later this summer, addressing the potential risk controls and safeguards for HFT. Those firms with who engage in HFT will need to carefully consider the approach and interaction of their strategies with MiFID, as the Level 1 negotiations progress towards achieving a final compromise text in Europe.