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April 2020

In response to the impact of COVID-19 on capital markets, regulated firms and consumers, regulators are issuing statements regarding concessions to current requirements, new restrictions, and delays to the timelines for ongoing work and open consultations. Firms need to stay abreast of these announcements while they cope with the many operational challenges caused by current restrictions.

At the same time, regulators continue to issue new consultations and guidelines. In the last six weeks alone, and in addition to the many publications relating to the capital markets provisions as part of the MiFID II review (see the next edition of KPMG Regulatory Horizons), twelve non-COVID-19 publications have been issued that have a direct bearing on asset managers and investment funds. They fall into three broad areas:

  • systemic risk and market data  - stress testing of and reporting by money market funds (MMFs), use of leverage in AIFs, use of benchmarks and credit ratings
  • costs & charges - disclosures, performance fees, impact of costs on returns, inducements
  • cross border activity  - within the EU, third countries, UK regime for EU funds

The message is clear: despite the serious challenges caused by current social and working restrictions to contain the spread of COVID-19, regulators continue to progress their agendas and supervisory priorities relating to systemic risk, data and investor protection, with particular focus on regulatory reporting and the disclosure and level of costs and charges. Brief summaries of the publications falling into the first two categories are provided below. Developments in the third category will be covered in a future edition.

Firms also need to keep a close eye on developments under the European Commission's Green Finance Strategy. The latest publication (PDF 972 KB) includes high level questions on standards for green bonds, an eco-label for EU investment products and “short-termism”, and asks whether retail investors should systematically be offered ESG products. Meanwhile, work continues on Level 2 measures to underpin the ESG-related Disclosures and Taxonomy Regulations.

Systemic risk and market data

In current market conditions, there is an understandable focus, by regulators and firms, on governance and controls, the fair pricing of assets and fund shares/units, and liquidity management in open-ended funds. The IMF's latest Global Financial Stability Report calls on regulators to allow fund managers to make full use of available liquidity management tools. In addition, regulators continue their work on other topics.

In early March, ESMA issued the official translations of its final guidelines on stress testing of MMFs. NCAs have until 3 May to notify ESMA whether they comply or intend to comply. The MMF Regulation specifies that managers should have in place “sound stress testing processes that identify possible events or future changes in economic conditions which could have unfavourable effects on the MMF”. The hypothetical factors that should be taken into account are liquidity and credit risk of fund assets, interest and exchange rate movements, redemption levels, changes to spreads among indices to which the interest rates of portfolio assets are tied, and macro-systemic shocks. The guidelines set out in some detail how these factors and the phrase “unfavourable effects” are to be understood. Managers must also conduct certain “common reference” stress test scenarios, for which the formulae to be applied and the 2019 calibration are prescribed.

On 31 March, ESMA announced that the first reports by MMF managers under the MMF Regulation should be submitted in September 2020, rather than April. Some commentators described this as a COVID-19 related delay. In fact, the delay is because ESMA has amended its XML reporting schemas and recognised that it needed to allow managers time to incorporate these technical changes.

In response to the April 2018 recommendation by the European Systemic Risk Board (ESRB), ESMA is consulting until 1 September 2020 on draft guidelines to encourage supervisory convergence among NCAs in assessing leverage risks in the AIF sector and designing, calibrating and implementing macro-prudential leverage limits. The guidelines include: a common minimum set of indicators to be taken into account by NCAs during their assessment; the calculation of these indicators based on the AIFMD Article 24 reports; and qualitative and, where appropriate, quantitative descriptions of the interpretation of the indicators. In particular, they set out the two-step assessment approach recommended (PDF 113 KB) by IOSCO and the imposition of leverage limits.

The European Commission's consultation (PDF 308 KB) on the review of the Benchmark Regulation focused on the benchmark administrators, the determination of critical benchmarks and climate-related benchmarks. It also considered whether supervised entities other than benchmark administrators are prepared for the cessation or material change of a benchmark, and whether they should be required to have contingency plans in place and be able to continue to use non-compliant benchmarks (eg where authorisation has been withdrawn) in legacy contracts. The Commission asked whether the Regulation should cover the use of non-EEA benchmarks by supervised entities in non-deliverable forward contracts entered into by non-financial counterparties for hedging purposes, beyond the transition period.

Feedback will inform the Commission's report to the European Parliament and Council.  Meanwhile, there is no delay to the deadline for transition from IBORs to new risk-free rates.

ESMA is consulting (PDF 308 KB) until 3 August on how credit ratings are used. It wishes to map the principal activities (regulatory or otherwise) undertaken by users of such information, including asset managers and funds, and to understand their data needs. It has observed a very low level of traffic through its “European Rating Platform” and that unsupervised subsidiaries of some CRAs and third parties are offering data feeds, for which they charge.

Costs and charges

While firms cope with additional operational challenges and significant falls in income (due to the fall in asset values), the regulators' focus on costs borne by retail investors has increased. Reporting and disclosure are at the top of the regulatory agenda.

Debate on the PRIIP KID continues. At the end of February, the European Commission issued (PDF 1.9 MB) the results of its consumer testing, which suggest that final investment decisions are not affected by the version of the KID offered, but that the document's design can play an important role in aiding investors' understanding of the product's features and in contributing to better informed financial decision-making. The testing had some limitations due to the complexity of the questionnaire, but pointed to:

  • inclusion of “probabilistic” performance scenarios is beneficial but only for a small subset of investors
  • inclusion of a simple presentation of past performance was helpful, and investors could distinguish between past and possible future performance, but was not tested independently of inclusion of probabilistic scenarios
  • no significant evidence to support inclusion of illustrative scenarios for structured products, over and above the use of probabilistic scenarios

We understand that the Commission's response to the ESAs' recommendations on changes to the Level 2 rules has underlined a fundamental difference of opinion as to whether changes are needed to the Level 1 text and what can be achieved at Level 2 without such changes. The timeline for any changes is, therefore, uncertain.

However, EIOPA's latest consultation on reporting by providers of pan-European Personal Pensions (PEPPs) to NCAs sets out the templates to be used. Given that investment funds are likely to be the underlying investment components of many PEPPs, PEPP providers will ask fund managers for data to help them complete the templates, requiring look-through to the fund's underlying assets. The definition of transaction cost has changed since EIOPA's December 2019 consultation, which referred to “actual” payments. It is now uncertain whether implicit transaction costs will have to be included. EIOPA proposes that the cost of advice be included within the 1% fee cap, which could severely impact the viability of the product.

On 3 April 2020 ESMA published final guidelines on performance fees in UCITS and retail, open-ended AIFs (that are not EuVECAs, EUSEFs, or investing in venture capital, private equity or real estate). Changes to the draft guidelines proposed in July 2019 include the inclusion of a list of “consistency indicators” to be applied to performance fees based on a benchmark, that excess performance should be calculated net of all costs, that performance fees can be payable if the fund outperforms its benchmark but has an overall negative performance, and additional guidance for new share classes. The guidelines will apply two months after the official translations have been published, but existing performance fee structures will have a further six months to come into compliance.

The aim is standardisation of the circumstances in which and how fund managers charge performance fees to retail investors, and convergence in how performance fee structures are supervised by NCAs. Managers should comply with the principles of acting: honestly and fairly; with due skill, care and diligence; and in the best interest of the fund, to prevent undue costs being charged to the fund and its investors. The guidelines cover five specific areas:

  • the method of calculation
  • consistency between the performance fee model and the fund's investment objectives, strategy and policy
  • frequency for the crystallisation of the performance fee
  • negative performance (loss) recovery
  • disclosure of the performance fee model

ESMA's second annual statistical report (PDF 4.1 MB) on performance and costs of retail investment products, based on data from 2009 to 2018, found that while costs in funds remain stable, performance is highly variable and retail investors continue to pay on average 40% more than institutional investors. Actively-managed UCITS outperformed passively-managed funds and ETFs on a gross basis, but the difference was not enough to compensate for the higher costs charged by active funds. ESMA notes that discrepancies between member states cause data issues. For retail AIFs (mostly open-ended and 16% of the total AIF population), no data were available for costs but gross returns were found to be negative for funds with large retail investor bases (-2.1% for funds of funds and -3.3% for “other”).

The report's findings will encourage continued regulatory focus on the level of costs and charges. It is again notable that lack of data prevented as detailed an analysis for structured products. Readers may also be interested in the findings of EIOPA's report for insurance products.

Finally, the MiFID II review has re-opened the debate about inducements and whether a total ban should be introduced, as exists in the Netherlands and the UK. In its advice to the Commission of 1 April, ESMA finds that the rules have not had the positive impact intended or encouraged the development of independent financial advice, but notes that a total ban would have different impacts between member states and that there should first be a review of the impact of the current inducements regime on distribution.

ESMA supports the current requirements for individualised cost disclosures (on the basis that the MiFID I generic disclosures did not provide sufficient information for clients) and that inducements should be presented as service costs. Also, “MiFID-like investment products, such as certain insurance products, should be subject to similar inducement rules to the MiFID II ones”, it says.

ESMA argues against a new category of “semi-professional” clients, but favours reconsideration of the criteria for opting up to professional status and flexibility for professional investors to opt out of certain disclosures.

Questions for CEOs

  • In the current challenging operational conditions, how do we keep abreast of regulatory developments and consider the potential impacts for our business?
  • Are we maximising the use of liquidity management tools in the best interests of investors and regularly updating our stress testing?
  • What impact might the latest proposals on the use of leverage have on our product range and particular investment strategies?
  • Are we still on track for the transition to risk-free rates?
  • What do we need to do to come into full compliance with the new guidelines on performance fees?

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