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Reg focus on funds is relentless

Regulatory focus on funds is relentless

Fund managers have long been used to specific focus from regulators, especially in relation to retail investment funds. Much of that focus tends to be under the broad banner of “investor protection” and covers a very wide range of issues, including investment strategies, safe-keeping of fund assets, management of conflicts of interest, product governance, management company governance, disclosures to investors and so on.

There is currently EU regulatory activity in many of these areas, with proposals from the European Commission on tackling the remaining barriers to cross-border fund distribution and on segregation of fund assets, and the ongoing debate about issues with the PRIIP KID. Funds are also caught up in the Commission’s proposals on sustainable finance (see our May edition), as well as potentially being impacted by a number of other new rules, such as the Benchmark Regulation.

The spotlight on investment funds is now intensifying further, under the banner of financial stability and systemic risk.

We highlighted in Chapter 2 of EAMR 2018 how the break-down in the post-financial crisis global consensus was being seen especially clearly in regulatory responses to the question whether investment funds are systemically risky. The European institutions, in particular the European Central Bank (ECB), are on the side of the hawks and are proposing more requirements for investment funds. In comparison, US policy makers appear to be adopting a more dove-like approach, pulling back from the introduction of detailed liquidity management rules for mutual funds, for example.

The US Treasury stated in its 2017 report (PDF 2.16 MB) that the term “shadow banking” is inappropriate for registered entities, preferring the term market-based finance. It also observed that the performance of the asset management industry during periods of financial stress demonstrates that the types of industry-wide “runs” that occur in the banking industry during a systemic crisis have not materialised in the asset management industry, outside money market funds (MMFs).

The ECB and the European Systemic Risk board (ESRB) persist with a contrary view. The ESRB has called for the Commission and the European Securities and Markets Authority (ESMA) to introduce more stringent requirements on liquidity risk management and leverage. There are already signs of activity.

ESMA is consulting until 1 December 2018 on draft guidelines on internal stress testing of MMFs. The EU Money Market Funds Regulation requires managers to conduct regular stress tests, identifying how stress events and changes in economic conditions can impact the net asset value and liquidity of the funds. ESMA is seeking views on specifics such as methodology, risk factors, data and the impact calculation. It notes that “While MMFs invest in highly liquid and low risk short-term debt instruments, they play an important role in the financial system and are interconnected with other key market participants.”

Some national regulators are also focussing on this general area. The UK’s Financial Conduct Authority is consulting on illiquid assets and open-ended funds. It notes that “open-ended funds that invest in illiquid assets can encounter difficulties if significant numbers of investors simultaneously try to withdraw their money at short notice.” Following the result of the UK referendum on EU membership in June 2016, for example, several real estate funds temporarily suspended, with dealing resuming before the end of that year. The FCA says it was “pleased that suspensions and other liquidity management tools generally worked as they were intended to and prevented wider market disruption.” However, it considers that improvements could be made in the use of certain liquidity management tools, contingency planning, oversight arrangements and disclosure to retail clients.

Meanwhile, the ECB persists with use of the term shadow banking. Its September Monitor finds the size of the EU sector little changed in 2017, standing at about EUR 42 trillion or 40 percent of the total EU financial system. The report’s focus, though, is on the degree of interconnectedness with the EU banking sector, which provides funding to entities engaged in such activity – for example, by banks holding fund units or through the repo and securities lending markets. Moreover, 60 percent of EU banks’ exposures were to non-EU entities (including 27 percent to US entities).

The ECB’s report also considers risks and vulnerabilities resulting from risk transformation and market activities. In particular, it highlights:

  • liquidity transformation and liquidity risk in bond funds, MMFs and real estate funds;
  • the use of leverage in hedge funds;
  • the use by investors of exchange-traded funds (ETFs) to gain market exposure, including to less liquid investments; and
  • that seven percent of UCITS use credit default swaps. 

ECB also notes that the EU’s largest asset managers are mainly owned by banks, and it calls out the possibility of intra-group contagion.


The ECB sends a clear message that there are data gaps in some areas of the shadow banking sector which prevent more comprehensive risk assessment. This could be leading to the perverse outcome that the more transparent parts of the system are coming under greater scrutiny.

Enhanced rules and greater supervisory scrutiny of investment funds look set to continue well into 2019 and beyond. At EU level, ESMA’s stress testing guidelines, which are expected to be issued in final early in 2019, may be the first hard evidence of the direction of travel. At present there is no indication that Europe will follow the US approach. The “big divide” looks set to continue for the foreseeable future.

Key questions for CEOs:

  • When designing a new fund, how do we determine the appropriate dealing frequency that aligns the underlying asset types with the redemption expectations of investors?
  • What features do we embed to assist with a high level of transparency and disclosure?
  • How will we maintain our funds’ investment strategies and meet redemption requests in stressed market conditions?
  • How do we organise and design liquidity stress tests?
  • What additional liquidity management tools are available to us to protect investors from unfair treatment and to prevent a fund from diverging significantly from its investment strategy?
  • Are we clear about how we would use those tools and when?

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