Trilogue reaches agreement on EMIR; ESMA starts preparing for ‘Level 2’ text
On 9 February, the Economic and Financial Affairs Council (the Council) reached political agreement with the European Parliament and the EC on ‘Level 1 text’ on the Regulation on over-the-counter derivatives, central counterparties and trade repositories (EMIR). EMIR still requires a formal vote by the European Parliament which is scheduled for 28 March and final endorsement by the Council and will come into force when published thereafter in the Official Journal. According to a recent version of the EMIR text, many of the measures needed to implement the Level 1 text should be in place by 30 June 2012.
Recognising the need for speed, on 16 February, ESMA published a discussion paper on some fundamental issues associated with the regulatory and implementing technical standards required by the Regulation. The discussion paper lists 83 questions, split into three sections covering OTC derivatives, Central Counterparties and Trade Repositories. ESMA is looking for quantitative evidence on the likely costs and benefits associated with the proposed measures in these three areas order to help it undertake a cost-benefit analysis of all its proposals. Recognising the technological challenges ahead, the regulator is also calling on firms to estimate how long they think it will take to implement the necessary arrangements to comply with the Regulation.
ESMA is looking for stakeholder feedback on a whole gamut of issues related to OTC derivatives, including:
- clearing obligations
- types of indirect clearing arrangements
- non-financial counterparties
- clearing thresholds
- timely confirmation
- marking-to-market and marking-to-model
- reconciliation of non-cleared OTC derivative contracts
- portfolio compression
- dispute resolution
- intra-group exemptions.
Some areas are more developed than others. ESMA is clearly at the very early stage of developing proposals around clearing obligations for third-country counterparties and, for these purposes, the test of having a ‘direct, substantial and foreseeable effect’ within the EU. Other areas are more advanced, such as the draft technical standards related to the class of derivatives that should be subject to the clearing obligation.
A full section is dedicated to Central Counterparties (CCP). The discussion paper includes ESMA’s views on CCP organisational requirements, which cover:
- governance arrangements
- compliance policy and procedures
- information technology systems
- reporting lines
- remuneration policy.
ESMA’s is also required to define the type of collateral which can be considered as highly liquid, and the conditions under which banks guarantees may be accepted as collateral. Based on the discussion paper, ESMA will probably consider the following when making judgements on collateral:
- its currency denomination
- the depository institution used
- transferability, credit and market risk
- existence of a liquid and diversified market
- absence of pro-cyclicality or wrong-way risk.
The final section focuses on trade repositories, in particular, the content and format of the information to be reported, the content of the application for registration to ESMA and the information to be made available to the relevant authorities. Annex II to the discussion paper contains tables which outlines what data should be reported by counterparties to trade repositories.
Firms have until 19 March 2012 to respond to this consultation. ESMA has organised a public hearing on 6 March for this discussion paper, to give an opportunity to interested stakeholders to express their preliminary views and to get early feedback.
This discussion paper covers the bulk of the implementing measures required for EMIR; however, a joint discussion paper from ESMA, EIOPA and the European Banking Authority (EBA) is expected in the next few weeks, covering risk mitigation techniques for OTC derivatives that are not cleared by a CCP. There will also be a discussion paper from EBA focusing on capital requirements for CCPs.
EIOPA outlines plans to create a ‘harmonised’ EU pension industry
Concern is mounting about the future viability of defined benefit pension schemes, following the European Insurance and Occupational Pensions Authority (EIOPA) proposal to align the rules in assessing pension schemes more closely to Solvency II rules in the future. Pension industries in Ireland, the Netherlands and the UK would bear the brunt of reforms as they are the only EU member states which have significant employer-based defined benefit provisions.
On 16 February, the European Commission (EC) received final advice from EIOPA on the revision of the Institutions for Occupational Retirement Provision (IORP) Directive in an effort to create a pan-European occupational pensions market. The EC supports the review of the IORP Directive as a further mechanism to promote the EU single market, as mandated by the Solvency II Directive.
EIOPA believe that a ‘harmonised balance sheet’ should be adopted as a means of capturing the various adjustment mechanisms (conditional indexation, reduction of accrued rights) and security mechanisms (regulatory own funds, sponsor support, pension protection funds) in a single figure. This requirement is designed to ensure regulatory consistency between sectors and enhance protection of members and beneficiaries.
EIOPA's advice contains proposals to enhance requirements in areas such as governance and risk management modelled on Solvency II. Pension providers would have to drastically modify their investment portfolios and operations and inject significant revenues to reach desired levels of funding if the new regime was implemented.
EIOPA accepts that proposed changes could have dramatic impacts in some member states. The regulator has suggested that reforms should only be implemented following a comprehensive quantitative impact study (QIS), to further explore the possible impact on the financial requirements for pension funds that the holistic balance sheet and the various options within that approach might have. EIOPA is currently preparing a QIS exercise and aims to publish results in the second half of 2012.
This exercise might be a potential roadblock to the EC's plans for creating a harmonised regulatory regime for the occupational pension’s industry. Firms are likely to want to await the results of this assessment before undertaking structural and operational reforms.
ESMA outlines delegated acts on short selling
ESMA launched a consultation on draft technical advice on a number of possible delegated acts on the EU regulation on short selling and certain aspects of credit default swaps (CDS), following the adoption, late last year, of the Regulation which will apply from 1 November 2012.
ESMA provides technical advice on the following issues:
- the definition of when an investor is considered to ‘own’ a financial instrument
- the net position in shares or sovereign debt covering the concept of holding a position and its method of calculation
- CDS hedging against a default risk or decline in asset value
- the initial and incremental levels of the notification thresholds to apply for the reporting of net short positions in sovereign debt
- the parameters and methods for calculating the threshold of liquidity on sovereign debt for suspending restrictions on short sales of sovereign debt
- what constitutes a significant fall in value for various financial instruments and how to calculate such falls
- the criteria and factors to be taken into account by national supervisors and ESMA in determining when adverse events or developments arise.
This is the second consultation on short selling since the start of the year. On 24 January, ESMA launched a consultation on the various technical standards encompassing the Regulation, primarily related to transparency, uncovered short sales and exemptions from disclosure of significant net short positions in shares. Firms were given just three weeks to respond (13 February 2012), given the pressure on ESMA to deliver its guidance in good time for adoption by the EC in June this year.
The same applies here. Firms have until 9 March 2012 to respond to ESMA, after which the regulator will consider the feedback it receives from this consultation and to the open hearing which will be held on 29 February 2012. By mid-April, ESMA expects to publish a final report and submit draft advice on Delegated Acts to the EC.
EBA’s supervisory reporting regime takes a step forward
On 13 February, the EBA published a consultation paper on draft implementing technical standards (ITS) on the supervisory reporting regime relating to the recast of the Capital Requirement Directive (CRD IV) and the Capital Requirement Regulation (CRR).
The draft ITS represents an annex to the EBA's ITS proposals on supervisory reporting requirements, which were published on 20 December 2011. More harmonised reporting requirements (while variable according to the size and complexity of activities undertaken) across Europe are necessary to ensure fair competition between comparable groups of banks and investment firms. Uniform reporting requirements will make institutions more efficient, according to the EBA, and result in a greater convergence of supervisory practices.
The three templates of the proposed supervisory reporting regime, on which the EBA are seeking stakeholder feedback by 26 March 2012, can be viewed here
The new supervisory reporting regime will be implemented alongside the EBA’s common reporting (COREP) regime for prudential returns for banks and large investment firms.
According to the EC proposals, institutions will be required to comply with CRR requirements from the start of 2013. Therefore, the first regular reporting period thereafter is expected to be Q1 2013 with the first reporting reference date being 31 March 2013.
In order to provide for a sufficiently long implementation period the EBA intends to finalise the draft ITS and submit it to the EC by the end of June 2012 – 9 months ahead of the first reporting reference date. According to the current timeline, institutions will have to submit a first set of data related to the reference date of 31 March 2013 to national authorities by 13 May 2013. EBA has launched the process with a view to giving firms sufficient time; however, it may need to revisit its proposals as a result of any changes introduced during the negotiations on the Level 1 text.
Joint Forum reports on intra-group support measures
The Joint Forum of the Basel Committee on Banking Supervision (Basel Committee), the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) published a report providing an overview and analysis of the types and frequency of intra-group support measures.
The report findings, which are based on a survey of 31 financial institutions headquartered in Europe, North America and Asia, are geared towards helping supervisors to understand the use of intra-group support measures but should also be interesting for market players, particularly as it supplies some useful bench-marking information.
The survey’s main findings include:
- Intra-group support measures can vary from institution to institution, depending on the regulatory, legal and tax environment; the management style of the particular institution; and the cross-border nature of the business. The Joint Forum notes that authorities should be mindful of the complicating effect of these measures on resolution regimes and the recovery process in the event of failure.
- The most common types of intra-group support measures included: committed facilities, subordinated loans and guarantees. This feature was evident across all sectors and participating jurisdictions.
- The majority of financial institutions surveyed have centralised capital and liquidity management systems in place. Having a centralised system promotes the efficient management of a group’s overall capital level and helps maximise liquidity while reducing the cost of funds, according to respondents. However, those firms that favour a ‘self-sufficiency’ approach pointed out that the centralised approach increases contagion risk within a group in the event of distress at any subsidiaries.
- Internal support measures generally were provided on a one-way basis (usually downstream from parent to a subsidiary). However, loans and borrowings were provided in some groups on a reciprocal basis. Intra-support measures were generally provided both to international and domestic entities.
- There was no evidence of intra-group support measures either a) being implemented on anything other than an arm’s length basis, or b) resulting in the inappropriate transfer of capital, income or assets from regulated entities or in a way which led to ‘double-gearing’ of capital.
- Firms generally have certain internal policies and procedures to manage and restrict internal transactions despite limited regulatory requirements for such.
The survey findings are useful, coming at a time when supervisors are increasingly focused on ways to ensure that banks and other financial entities can be wound-down in an orderly manner in times of distress. The results should feed into ongoing thematic work by the Financial Stability Board on systemic risk and, more generally, with the EU crisis management regime which the EC expects to issue soon (and other structural and resolution regimes adopted locally).
IOSCO outline principles for the valuation of CIS
IOSCO’s Technical Committee Standing Committee on Investment Management (TCSC5) issued draft principles for the valuation of Collective Investment Schemes (CIS) on 16 February 2012. IOSCO believes that a revision to the 1999 Principles is necessary given market developments over the past decade or so.
IOSCO believes that the growth of complex and hard-to-value securities which, in some cases, require internal valuation techniques (mark-to-model) based on (subjective) managerial judgement increases regulatory risks and could result in unsatisfactory outcomes for investors.
From a European perspective, addressing the conflicts for interest
conundrum between those who value the assets and CIS investors has proven difficult. Unsurprisingly, IOSCO outlines that the responsible firm should define and maintain a conflict of interest’s policy which is designed to mitigate conflicts associated with the valuation process. This can be achieved by implementing one, or a combination, of the following types of reviews:
- Risk management review: the risk management function of the CIS could review the valuation provided by the CIS operator. Under this model, the risk management function would be ‘hierarchically and functionally’ independent of the CIS portfolio management function (echoing certain requirements under the Alternative Investment Fund Managers Directive (AIFMD).
- Portfolio management review: the portfolio management function could be separated from the valuation and/or pricing function, and thus not permit the CIS operator or portfolio manager to determine the valuations, although the CIS operator may be able to provide input, as appropriate.
- CIS depositary review: the CIS depositary could seek to ensure that the CIS operator carries out the valuation of the CIS appropriately, therefore providing an independent check on the valuation policy and the way it is implemented.
- Independent firm review: the CIS could retain independent pricing services or other experts to assist them in obtaining independent valuations, as appropriate.
It will be interesting to see if IOSCO’s proposals influence ESMA as it continues to map out AIFMD’s main technical provisions. Under AIFMD, the portfolio management and risk management functions within an alternative investment fund manager must be hierarchically and functionally independent from the valuation function and from the risk management function. Many fund managers will need to de-couple certain operational functions, change their procedures for managing conflicts and revise their service provider arrangements to comply with AIFMD. This may be particularly difficult for a small manager, where all functions sit closely under one roof and individuals have responsibility for multiple functions.
IOSCO has a number of other draft principles of ‘best practice’ CIS valuation, which include:
- establishing ‘comprehensive, documented policies and procedures’ to govern the valuation of assets held or employed by a CIS
- disclosing the methodologies that will be used for valuing each type of asset held or employed by the CIS
- ensuring that assets held or employed by CIS are consistently valued according to the policies and procedures
- delineating controls to detect and prevent pricing errors
- conducting a periodic review of the valuation controls to check compliance and appropriateness
- initiating a third-party review of the CIS’s valuation process at least annually
- conducting initial and periodic due diligence on third parties that are appointed to perform valuation services
- ensuring the purchase and redemption of CIS interests should not be effected at historic net asset value (NAV)requiring CIS assets to be valued on any day that CIS units are purchased or redeemed
- assuring that a CIS’s NAV is available to investors at no cost.
The principles’ success rests on the firm’s ability to develop appropriate policies and procedures to appropriately value CIS assets. IOSCO suggests that even though the principles set out a common approach, their implementation may vary from jurisdiction to jurisdiction, depending on local conditions and circumstances.
The consultation closes on 18 May 2012; firms may use this as opportunity to further communicate their perspectives on AIFMD as some of the final principles should trickle down, in some shape or form, into ESMA’s technical standards.
European Parliament publishes study on venture capital
The European Parliament’s Committee on Industry, Research and Energy (ITRE) published a study looking at the ‘Potential of Venture Capital in the European Union’ on 9 February 2012. The study reviews the current status of the venture capital industry in the EU and the problems it currently faces, which include:
- Low demand quality: a low number of prospective high-tech enterprises with potential for high-growth in Europe.
- Low supply quality: problems with demand because of low fundraising from private institutional investors and a low number of qualified, experienced, highly professional and large enough venture capital funds.
- Thin markets: difficulties in matching the objectives of the demand and supply side.
The study highlights that venture capital is not popular in the EU because of low returns, double taxation in some member states, low experience of many venture capital funds and cultural attitudes that inhibit risk (such as having harsh penalties for bankruptcy in firms).
It notes that the recent proposed regulation for a European Venture Capital Fund with a passport may not be totally successful because it does not solve some of the fundamental problems-- particularly double taxation--that can inhibit venture capital investment and venture capital funds in Europe.
The solutions put forward include:
- targeting policy initiatives at creating bigger venture capital funds
- engaging globally with markets, particularly the US which has a mature venture capital industry
- changing rules on taxation and bankruptcy to make it more attractive for firms to seek venture capital investment
- providing EU subsidies for venture capital investment.
Stimulating investment (and jobs) in high-risk/returns sectors (i.e. high-tech, pharmaceuticals and bio-medical industries) is a key priority for Parliament, which believes that a competitive and robust venture capital industry in Europe could help kick-start the sluggish economy. The study highlights the need for alternate sources of investment given the fragile state of European banking system and indications that credit to the real economy will start to dry-up in 2012 but notes that any developments to actually increase the provision of venture capital in Europe are, however, still a long way off and will require significant input at EU level and by local member states.
Using economic parlance, the venture capital industry in Europe is displaying some of the classic signs of ‘market failure’ and the State (or one of its organs) may need to step-in and share some of the risks involved. The study suggests, though, that complex reforms aimed at harmonising taxation and bankruptcy laws should be jettisoned for now; instead, authorities should concentrate on quick-win solutions such as introducing EU subsidies for venture capital investment. If tied with job creation and incumbent EU subsidies on research (and the accompanying institutional framework), it could be the most cost effective and efficient solution for now.