Including updates on AIFMD, central counterparties and macroprudential supervision


ESMA publishes detailed rules on possible AIFMD implementing measures

ESMA published its long-awaited final technical advice on the implementing measures for the Alternative Investment Fund Managers Directive (AIFMD) on 16 November, a significant milestone in agreeing the final text of the legislation. Although not required to adopt all the technical advice, the European Commission is expected to adhere closely to it in developing the Level 2 measures.

At 500 pages, the technical advice represents a significant body of work and given the ‘framework’ nature of the AIFMD itself, provides much needed clarity on a number of important issues. ESMA has made significant progress, for example, on the definition of external losses for depository liability and the application of the thresholds that determine the AIFMD’s scope. On other elements of AIFMD such as remuneration, ESMA has kept with its draft guidelines. Much of this advice will be converted into Commission Regulations which, because of their binding nature, will facilitate the creation of the ‘single rule book’ for alternative asset managers. However, the transposition of AIFMD into national law may still create opportunities for inconsistencies or misinterpretations which will distort the desired level playing field. Also, concerns remain about how AIFMD will interact with other proposed regulations, some of which have not yet been issued.

Overall, ESMA’s advice touches on four main areas: depositary, leverage, transparency and third countries. On the former area, ESMA’s advice provides a framework making depositaries accountable for due diligence on sub-custodians and also oversight of alternative investment fund managers. Principally, depositaries will be responsible for tracking cash and the ownership of assets, and will be liable to repay any financial assets held by them or their sub-custodians which subsequently are lost. The possibility for depositaries to transfer their liability to sub-custodians is envisaged only under certain strict conditions. Additionally, the guidelines sets out provisions regarding depositary liability generally and, more particularly, looks at ‘external events’ for which depositaries can no longer be held liable.

The advice also defines ‘leverage’, both how it is to be calculated and the circumstances in which national regulators can impose a specific leverage limit. ESMA has essentially retained its initial position, ignoring industry’s call for a Value-at-Risk (VaR) approach, because it considers that such an approach ‘utilises correlations that have a propensity to break-down in stressed market conditions’. In line with its consultation paper, ESMA envisages three methods for calculating leverage: the mandatory gross and commitment methods and an optional method, the ‘advanced method’, which can be used in certain circumstances and upon notification to the national supervisor. However, the industry remains concerned about these methods. Firstly, many believe that the gross method will not provide a clear overview of the amount of leverage in an alternative investment fund, thus making the value of this method questionable. Although the commitment method recognises some netting and hedging arrangements, the rules applicable to these arrangements are viewed by some as too restrictive. The advanced method is more promising, but its optional use puts its value into question (particularly if it is only used to supplement the two mandatory methods).

AIFMD has three main categories of disclosures to meet the transparency requirements:
  • Annual report: ESMA’s advice outlines minimum requirements which reflect recognised ‘best practice’ in the context of relevant accounting standards and rules.
  • Disclosures to investors: ESMA provides advice in relation to the appropriate frequency, content and format of certain key disclosure obligations on alternative investment fund managers (liquidity management, risk profile, risk management systems, level of leverage, etc.).
  • Reporting to regulatory authorities: ESMA recommends that the reporting frequency should depend on the number of assets managed by the alternative investment fund manager and on the size of each fund.
Finally, ESMA focuses on four areas regarding the third countries:
  • delegation of portfolio or risk management to third country undertakings
  • appointment of a depositary based in a third country
  • cooperation arrangements between EU and third-country competent authorities in connection with the management and marketing of third-country (or third-country managed) alternative investment funds
  • determination of the Member State of reference.
In each of these areas, ESMA reiterates a number of themes, like the form, substance, negotiation and establishment of cooperation arrangements between EU and third country authorities, and requirements for equivalence in some cases. Helpfully, for delegation of portfolio and risk management, ESMA has given up the notion of equivalence but retains it for the appointment of a depositary based in a third country.

In light of the feedback to its two consultation papers, ESMA took into account some of the concerns of the respondents. However, its interpretation of the Level 1 directive remains relatively conservative and it appears it still goes beyond Level 1 directive’s requirements in some areas. Overall, the advice does not contain any real surprises and market reaction has been generally neutral. Nevertheless, on areas such as equivalence tests of third-countries and UCITS comparisons, firms have generally welcomed EMSA’s less rigid approach.

However, the Commission is not obliged to take ESMA’s advice in full, and a number of politically sensitive issues (particularly in relation to depositories) could result in further amendments. Once the Commission has drafted the Level 2 proposals, it may release these again for stakeholder review. Once finalised, its proposals are passed to the European Parliament and Council of Ministers who will review the measures to ensure that the Commission has not surpassed its mandate in any way. The Council or the European Parliament can require amendments to the measures on this basis; they can also reject the Commission’s proposals. Once they have reviewed and approved the proposals, the Commission will adopt them. They become EU law once published in the Official Journal of the European Union.

Ongoing work on the Level 2 measures will continue in parallel with national transposition work on the framework directive. Each Member State has to incorporate the Level 1 requirements – and any Level 2 measures that are not regulations –into national law by July 2013. The Commission will only assess the quality of transposition at the end of this period and yet, it is during this period that misinterpretations of the requirements could lead to regulatory distortions, and possibilities of regulatory arbitrage. Ongoing industry involvement at the European and national level is needed to ensure the process sets the appropriate foundation for the single rule book.


BIS report calls for further access to CCPs

Expanding direct access to central counterparties (CCPs) may reduce the concentration of risk in the largest global dealers, according to a report by the Bank for International Settlements (BIS) Committee on the Global Financial System. The Committee, which is chaired by Mark Carney, the new chairman of the Financial Stability Board, suggests that expanding access to CCPs will also increase competition among direct clearers, with the potential to yield efficiency benefits through greater choice and lower fees for indirect users. However, the report notes that as direct access is broadened, it is essential that CCPs' risk management procedures are adapted appropriately to ensure their continued effectiveness.

Interestingly, the report concludes that the creation of domestic CCPs for some types of OTC derivatives may become an important part in this expansion, going against previous conventional wisdom on the dangers of fragmentation and regulatory arbitrage. According to the report, a domestic CCP could enhance the ability of local authorities ‘to exercise oversight and regulation of derivatives trading activity in their own jurisdictions, as well as to perform crisis management and resolution if needed’. However, this approach can only be effective if sound global standards are adopted by international players and ongoing cross-border monitoring of infrastructure and participants are enforced.

CCPs are likely to play an enhanced role in the future global financial architecture. The G20 Leaders’ commitment that all standardised OTC derivatives should be centrally cleared by the end of 2012 underpins this, highlighting the important function CCPs will play in terms of increasing the safety and resilience of the global financial system (but only if global standards are adopted internationally, otherwise, CCPs could concentrate risk, rather than mitigating it). Achieving these objectives depends on the arrangements through which market participants obtain access to central clearing, and the BIS report provides “relevant and timely input” to international initiatives related to CCP access arrangements and configurations, according to Carney.


Role of macroprudential supervision and central banks remains uncertain

No clear framework for organising macroprudential supervision has emerged, according to two separate speeches by executive members of the European Central Bank (ECB), Peter Praet and Jürgen Stark. Three years on from the financial crisis, still no consensus exists as to what role central banks should take in the new supervisory framework, notwithstanding how their governance structures and monetary policy strategies should interact with macroprudential supervision.

Undoubtedly central banks should assume important roles in macroprudential supervision, given their expertise in analysing financial systems from an aggregate perspective. The European Systemic Risk Board (ESRB), the main body responsible for macroprudential monitoring of the EU financial system, already relies on the logistical, analytical and statistical support from the ECB and other central banks. Moreover, central bankers hold the majority in the ESRB’s decision-making body, the General Board, further cementing their important position in assessing systemic risk in the EU.

However, the ECB’s contribution to achieving and maintaining financial stability is much more fundamental than just an oversight and surveillance role. As we have seen with the recent sovereign debt crisis, monetary policy and financial stability policy are intrinsically linked, given the close interaction between financial and economic conditions. Many suggest that the ECB is the only institution that can effectively restore stability in the EU financial system by acting as the ‘lender of last resort’ and purchasing government bonds of weak eurozone countries in an effort to reduce their borrowing costs. Under such conditions, the ECB should pursue price stability and financial stability as equally important objectives in the future.

However, Stark argues that such an arrangement has inherent tensions in terms of diluting the ECB’s prized independence from Member States by effectively giving it a quasi-political role; achieving financial and price stability policy aims can be directly at odds with each other. In terms of the current crisis, a quantitative easing programme could achieve some semblance of financial stability, but the increase in money supply would push up inflation and reduce the overall competitiveness of the eurozone.

Macroprudential regulation is much more than just policy tools and countercyclical buffers; it requires a fundamental shift in the way all relevant authorities coalesce to supervise the financial system. Given the current stresses in the eurozone, if policymakers want to credibly design an effective macroprudential supervisory framework, the role of the ECB and other national central banks needs to be addressed. A clear division of responsibilities and reporting lines between institutions is an essential condition for an effective macroprudential policy.