Including updates on industry concerns about AIFMD and a 200 billion euro hole in banks’ capital base


Industry highlight concerns on the implementation of AIFMD

New reporting requirements under the Alternative Investment Fund Managers Directive (AIFMD) are onerous, according to Blackrock, State Street and a host of other market players. The industry sees the quarterly reporting requirements for AIFM, whether systemically important or not, as costly with little or no value in terms of reducing systemic risk, who believe that reporting should be on an annual basis, supplemented by supervisors having discretion to request more frequent reports when necessary.

The European Securities and Markets Authority (ESMA) has received over 90 consultation responses on implementing Article 3 on AIFMD, which show a general consensus that the new reporting regime — enhanced document procedures, maintenance of independent functions and more frequent reporting — may result in unnecessary costs, further restrict returns and limit investment opportunities, especially for smaller fund managers.

Respondents believe that EU supervisors should coordinate with international supervisors, particularly the US regulators, on reporting requirements to avoid duplication, maintain a level playing field and limit the possibility of regulatory arbitrage to aid regulators in their oversight of systemic risk.

Industry concerns around greater disclosure requirements seem reasonable. AIFMD is primarily directed at professional investors, who should be able to influence the determination of the policies and procedures implemented by their fund managers. Respondents feel ESMA needs to prove that these extra requirements will actually enhance investor protection in the long-run, which it hasn’t done thus far.

Industry players remain deeply concerned about other areas of AIFMD as well:
  • Intra-regulatory coordination: respondents want ESMA to ensure that there is cooperation between the respective working groups on MiFID II, UCITS V, CRD IV and EMIR along with the AIFMD to ensure that a coordinated and appropriate European regulatory framework comes into force.
  • Depositary liability: more clarity on the level of liability depositaries will have for their sub-custodians’ actions are required, and that automatic imposition of liability is inappropriate.
  • Voting rights: respondents feel any regulation of voting rights needs to be unambiguous and not put a blanket obligation on an AIFM to exercise voting rights held in any AIF. Separately, ESMA has recently published a call for evidence on the extent to which empty voting practices (having voting rights without the corresponding economic interest) exist in practice in the EU and the effects of such practices.
  • Additional Own Funds and Professional Indemnity Insurance: respondents warned that the new regime goes beyond current UCITS requirements, and the risk that such policies may be required to cover, amongst other things, fraud, is not consistent with other professional standards. While such coverage might be obtainable, the costs may be prohibitive.
  • Leverage disclosure: respondents broadly support ESMA’s endeavours to promote greater disclosure around leverage, but some suggested that the regulator’s reliance on the use of gross leverage plays too large a role. Instead, ESMA should define an industry standard net exposure regime as a means of monitoring leverage.
The number and extent of responses to this consultation reaffirms how significant a challenge AIFMD is to the asset management industry. ESMA and the European Commission will need to thoroughly evaluate the industry’s feedback and take these into account in shaping the Level 2 measures for AIFMD, as the choices they make at this stage will very significant long-term implications for our markets and investors.


IMF expose 200 billion euro hole in banks’ capital base

European banks face a 200 billion euro capital shortfall amid continuing sovereign stress in the eurozone, according to the International Monetary Fund (IMF). In its biannual global financial stability report, the IMF does not quantify how much additional capital European banks need to withstand future losses — calling for credible stress tests to identify this figure — but its calculations do illustrate the gravity of the situation facing the already fragile banking sector.

Overall, risks to global financial stability have increased markedly in the last six months, signalling a partial reversal in progress in the health of the financial system since 2008. The failure to stem contagion risks and credibly address sovereign and banking system concerns has led to a wide-scale pullback in risky assets, stoked fears of recession, and sent investors rushing towards safe investments such as in gold and Swiss francs.

Of the 200 billion euro capital shortfall, the IMF estimates that European banks have lost around 40 billion euros through their exposures in Greek sovereign debt, 20 billion euros each due to Irish and Portuguese national debt, and the remaining 120 billion euros attributable to banks exposure to sovereign debt in Belgium, Spain and Italy. Banks have also been affected by sovereign risks on the liability side of their balance sheet as implicit government guarantees have been eroded, the value of government bonds used as collateral has fallen, margin calls have risen, and bank ratings downgrades have followed cuts to sovereign ratings.

European officials, according to reports from the FT, have questioned IMF’s calculations, particularly around the use of the Bank for International Settlement’s data on sovereign debt exposures. Jose Vinals, director of the IMF's Monetary and Capital Markets Department, believes it is unclear whether banks in Europe have already factored in their risk exposure to sovereign default, calling for greater transparency in the way banks treat sovereign risk.

Christine Lagarde drew criticism from Brussels last month after stating that European banks required “urgent” and “substantial” recapitalisation. However, European officials seem to be coming around to the IMF’s position. Its chief economist, Olivier Blanchard, said last week that European countries are starting to understand the necessity for an urgent capital boost in their banks. Defending the pan-European stress tests, Commissioner Almunia said they were “serious operations”, however, the deepening of the credit crisis had meant that more banks needed recapitalisation than in July when the tests were conducted. Moreover, the Commissioner signalled that stricter rules on state aid for banks — which were originally planned to expire in 2010 — will now not be introduced until at least the end of 2011. Prolonging the exemptions given to governments to support their banking system is necessary given continued tensions in funding markets, doing otherwise would not be “safe” according to Commissioner Almunia.

Overall, the IMF’s stability report paints a very gloomy picture of the current state of the global financial system, particularly in Europe. The IMF believes that markets are now “losing patience” with the patchwork attempts to repair and reform the EU financial system. The stability report also warned about contagion concerns. The eurozone sovereign crisis is not only infecting European and US banks, and their respective economies, but now is spilling over to emerging markets. Low interest rates could lead to excesses as the “search for yield” exacerbating credit cycle (and possibly leading to credit bubbles) especially in emerging market. The IMF has called on policymakers to speed-up their actions to address longstanding financial weaknesses both in their economies and banking systems.


Regulating commodity derivatives

The Technical Committee of the International Organization of Securities Commissions (IOSCO) has released a series of principles for commodity derivative markets, and presented detailed explanatory information on how regulators should apply these standards, in a recent report. The principles address:
  • Design of Physical Commodity Derivatives Contracts: establishing design concepts for futures contracts
  • Surveillance of Commodity Derivatives Markets: introducing a basic framework for surveillance, powers needed to access information for both on-exchange, OTC, and cash market transactions, emphasises the importance of monitoring large positions
  • Disorderly Markets: sets out the powers needed by market authorities to intervene in the markets to address disorderly conditions
  • Enforcement and Information Sharing: addresses the basic framework for a successful enforcement program, including required powers
  • Enhancing Price Discovery and Transparency: establishing formalised systems to allow regulators to impose position limits and the promotion of the reporting of OTC derivatives to trade repositories.
The principles are aimed at promoting a harmonised approach to the oversight of commodity derivatives markets which should hopefully deliver effective supervision, combat market manipulation and improve price transparency. The principles are not a panacea to addressing price volatility in an underlying physical commodity, but rather seek to enhanced price discovery in commodity derivative markets.

To further mitigate market abuse in the wholesale energy market, the European Parliament has published the resolution it passed on the proposed regulation on Energy Market Integrity and Transparency (REMIT). The rules would ban the use of insider information and market manipulation practices in the wholesale energy market. A team of about 15 market supervisors, located at the Agency for the Cooperation of Energy Regulators (ACER) in Slovenia, would be responsible for ensuring market compliance with REMIT. The legislation would give ACER supervisors extensive powers to collect market data and investigate instances of market abuse in an industry which was believed to be worth in excess of 500 billion euros in 2010.

The increased focus on the commodity derivatives markets is borne, in part, from heightened (and sometimes irrational) price volatility in underlying commodities experienced in recent years. The use of commodity derivatives by producers and consumers of commodities and raw materials to hedge against prices variations has grown in importance in the last decade. During the 2007/2008 food crisis, many believed that speculation in these markets exacerbated price volatility skewing the commodity markets and disrupting the process of price discovery to such a degree that both producers and consumers were negatively affected. Financial markets regulators found it difficult to detect market abuse due to a lack of transparency in the physical commodity markets. French President Nicolas Sarkozy last week suggested that the recent record volatility of prices for raw materials was due, in part, to the increased financialisation of commodity markets. Moreover, in October 2008, the UN Conference on Trade and Development suggested that, “stricter regulatory measures that help contain speculation on commodity markets could be one important step” in moderating price instability that effects economic growth, financial stability and regulation.


UK government to sue ECB over planned restrictions on clearing houses

The UK government is to mount a legal challenge against the European Central Bank (ECB) over its proposals to prevent some euro-denominated securities from being cleared outside the eurozone.

The ECB’s proposals, released this summer, require clearing houses which handle more than 5% of the market in a euro-denominated financial product to be located inside the eurozone. The ECB believes it can only provide financial support to clearing houses in times of crisis if the clearing house was located inside the eurozone. Recently, European Union governments have discussed giving clearing houses access to ECB liquidity as a way to prevent them from collapsing and causing a financial crisis. However, the ECB made similar proposals more than a decade ago, long before talk of providing liquidity support to clearing houses was first mooted.

However, the UK government believes that such restrictions go against the ethos of the European Union single market by restricting the free movement of capital between member states and their right to establish cross-border businesses across a multicurrency European Union. HM Treasury are also concerned about the position of the City of London, as a powerhouse in euro trades.

Both camps appear intransigent on this issue and confident of winning the court case. If the case goes ahead, it will be the first of its kind and particularly relevant given the possibility of a two tier Europe developing as a result of closer fiscal and monetary integration amongst eurozone members.