Asset Management & Investment Funds: EU & International Developments – July 2023

AIFMD/UCITS Directive revisions

The Council of the EU announced that it reached political agreement with the European Parliament on the proposed Directive amending the AIFMD and the UCITS Directive.

More specifically agreement has been reached on requirements that will:

• increase European harmonisation of liquidity management tools (LMTs), with new requirements for managers to provide for the use of LMTs
• establish an EU framework for funds originating loans (meaning funds that provide credit to companies) supplemented with requirements aimed at alleviating risks to financial stability and to ensure an appropriate level of investor protection
• enhance the rules for delegation, with no restrictions placed on either intra or extra EU delegation and with additional harmonised reporting on delegation.

Mairead McGuinness, Commissioner for Financial Services, Financial Stability and Capital Markets Union, said:

“Yesterday’s achievement is another important step towards delivering on the capital markets union. The reform will better integrate the market for alternative investment funds, improve access to additional sources of financing for the European economy, and strengthen investor protection. This reform, and in particular the new framework on liquidity management tools, will also improve the resilience of investment funds and the management of financial stability risks.”

The political agreement is subject to the approval of the Council and Parliament before going through the formal adoption procedure. The agreed text has not yet been published.

ESMA CSA on sustainability-related disclosures and the integration of sustainability risks.

The European Securities and Markets Authority (ESMA) launched a Common Supervisory Action (CSA) with National Competent Authorities (NCAs) on sustainability-related disclosures and the integration of sustainability risks. The CSA will run until Q3 2024.

The goal is to assess the compliance of supervised asset managers with the relevant provisions in the Sustainable Finance Disclosure Regulation (SFDR), the Taxonomy Regulation and relevant implementing measures, including the relevant UCITS and AIFMD provisions on the integration of sustainability risks.

Using a common methodology developed by ESMA, NCAs will share knowledge and experiences on how to foster convergence in supervising sustainability related disclosures. The main objectives include:

• to assess whether market participants comply with applicable rules and standards in practice
• to gather information on greenwashing risks in the investment management sector
• to identify further relevant supervisory and regulatory intervention to address the issue

ESMA aims to promote convergence in the supervision of risks stemming from incorrect and misleading disclosures (which is identified as one of the Union Strategic Supervisory Priorities for NCAs). Also, findings on the identification of greenwashing risks at entity and product level will provide insights for ESMA’s final report on greenwashing.

​EU/ UK memorandum of understanding on regulatory cooperation in the area of financial services

Mairead McGuinness, EU Commissioner for Financial Services, Financial Stability and Capital Markets Union signed, on behalf of the European Commission, a Memorandum of Understanding (MoU) establishing a framework for structured regulatory cooperation in the area of financial services with the United Kingdom. Commissioner McGuinness delivered opening remarks after the signature of the EU-UK MoU.

This follows on from the Joint Declaration on Financial Services Regulatory Cooperation between the European Union and the United Kingdom – which accompanies the Trade and Cooperation Agreement (TCA). The MoU creates the administrative framework for voluntary regulatory cooperation in the area of financial services between the EU and the UK, outside of the TCA structures. This includes the establishment of a Joint EU-UK Financial Regulatory Forum, which will serve as a platform to facilitate structured dialogue on issues related to financial services, similar to what the Commission has with other third country jurisdictions, such as the United States.

Money market fund regulation report

The European Commission published a report on the adequacy of the Regulation on money market funds (MMFs) (MMFR) from a prudential and economic point of view.

The Commission concludes that the MMFR successfully passed the test of liquidity stress experienced by MMFs during the COVID-19 related market turmoil of March 2020, the recent interest rate increases, and related financial asset re-pricing.

The Commission identifies shortcomings in the MMF regulation that should be assessed further:

• there is scope to further increase the resilience of EU MMFs, particularly by decoupling the potential activation of LMTs from regulatory liquidity thresholds
• structural problems exist which are external to MMFs, and consequently also to the MMFR, including those linked to the underlying short-term markets. The Commission references Financial Stability Board (FSB) work on this topic (see below).

The Commission also considers that MMFs will benefit from the reforms to be made by its November 2021 legislative proposal for a Directive amending the AIFMD and UCITS Directive (see above).

The Commission does not intend to propose revisions to the MMFR at present.

FSB proposals to address structural vulnerabilities from liquidity mismatch in open-ended funds

The FSB published a consultation report seeking comments on its proposed revisions to the FSB’s 2017 Policy Recommendations to address structural vulnerabilities from asset management activities (the 2017 recommendations) in relation to liquidity mismatch in open-ended funds (OEFs).

The FSB is proposing to amend the 2017 recommendations 3,4,5 and 8 and make minor changes to recommendation 2. ​The report should be read in conjunction with the recent IOSCO consultation report on guidance on anti-dilution LMTs (discussed below).

Revised OEFs FSB policy recommendations addressed to supervisory authorities:

• Recommendation 1: authorities should collect information on the liquidity profile of OEFs proportionate to their financial stability risks. They should review existing reporting requirements and enhance them as appropriate to ensure they are adequate and that reporting is sufficiently granular and frequent.
• Recommendation 2: review investor disclosure requirements to require clearer public disclosures from OEF managers on the availability and use of LMTs in normal and stressed market conditions.
• Recommendation 3: to reduce material structural liquidity mismatches, authorities should have requirements or guidance on funds’ liquidity risk management stating that funds’ investment strategies and liquidity of assets should be consistent with the terms and conditions governing fund unit redemptions at the time of designing and on an ongoing basis. Redemption terms should be based on the liquidity of asset holdings in normal and stressed market conditions.
• Recommendation 4: emphasises the need for authorities to ensure the availability of a broad set of anti-dilution and quantity-based LMTs for use in normal and stressed market conditions.
• Recommendation 5: amendments to achieve i) greater inclusion of anti-dilution LMTs in OEF constitutional documents and (ii) greater use of, and greater consistency in the use of, anti-dilution LMTs in normal and stressed market conditions. Ensure that OEFs consider and use LMTs to mitigate first-mover advantage from structural liquidity mismatch, ensure that investors bear the costs of liquidity associated with redemptions and subscriptions and arrive at a more consistent approach to the use of LMTs.
• Recommendation 6: require and/or provide guidance on stress testing at the level of individual OEFs to support liquidity risk management to mitigate financial stability risk. These should address the need for stress testing and how it could be done.
• Recommendation 7: promote, through regulatory requirements or guidance, clear decision-making processes for OEFs use of quantity-based LMTs and other liquidity management measures, particularly in stressed market conditions.
• Recommendation 8: provide clear guidance on the use of LMTs and other liquidity management measures. If appropriate, authorities should also provide direction in stressed market conditions regarding use of such tools and measures, taking into account the costs and benefits of such action from a financial stability perspective.
• Recommendation 9: where relevant, give consideration to system-wide stress testing.​

In relation to the above recommendations, the FSB recommends that IOSCO review its 2018 recommendations and, as appropriate, enhance them.

It is not proposed to apply the revised FSB recommendations to exchange-traded funds (ETFs).

Deadline: Comments should be sent to the FSB by 4 September 2023.

IOSCO proposals for anti-dilution liquidity management tools

The International Organization of Securities Commissions (IOSCO) published a consultation report on anti-dilution LMTs.

The report sets out proposed guidance for effective implementation of its 2018 recommendations for liquidity risk management for collective investment schemes. The aim of the guidance is to support greater and more consistent use of anti-dilution LMTs by responsible entities for OEFs, in both normal and stressed market conditions.

Well-calibrated anti-dilution LMTs aim to pass on to transacting OEF investors the costs of liquidity otherwise borne by the portfolio. This is done by adjusting the price at which they transact to account for explicit and implicit costs of trading. In a stressed market scenario, the deployment of well-calibrated anti-dilution LMTs can also dampen the impact of OEF buying and selling activities in underlying asset markets (including those associated with a potential first mover advantage), and therefore support financial stability.

The report should be read in conjunction with the FSB’s report (discussed above).

FSB held a public event jointly with IOSCO on their proposals on 12 July 2023. IOSCO plans to publish its final report in late 2023.

Deadline: Comments should be sent to IOSCO by 4 September 2023.

ESRB report on recommendation on leverage and liquidity in investment funds

The European Systemic Risk Board (ESRB) published a compliance report on its recommendation relating to liquidity and leverage risks in investment funds (ESRB recommendation).

The ESRB recommendation cover:

• liquidity management tools for redemptions (addressed to the Commission)
• additional provisions to reduce the likelihood of excessive liquidity mismatches (addressed to the Commission)
• stress testing (addressed to ESMA)
• UCITS reporting (addressed to the Commission)
• guidance on Article 25 of the AIFMD (addressed to ESMA)

The report finds that implementation of recommendations addressed to the Commission is largely compliant and implementation of recommendations addressed to ESMA is fully compliant.

​ESMA’s second report on the cross-border distribution of funds regime

​ESMA issued its second report on national rules governing marketing of investment funds under the regulation on cross-border distribution of funds (CBDF) to the European Parliament, the Council and the European Commission.

The key findings are:

The report provides an overview of the marketing requirements across Member States, and analyses the effects of national laws, regulations and administrative provisions governing the marketing communications for investment funds. The report is based on responses provided by NCAs to questionnaires prepared by ESMA.

ESMA will submit a further report to the European Parliament, the Council and the Commission in two years. ​

Alternative Investment Funds exposures to commercial real estate

ESMA published data on exposures of AIFs to commercial real estate (CRE) markets in the EU as of 31 December 2021.

At the end of 2021, 2789 AIFs were pursuing a CRE strategy of which 2480 were AIFs marketed and/or managed by authorised EU AIFMs (Net Asset Value of € 543bn). Within this sample, 2002 AIFs were pursuing primarily a CRE strategy, and 478 AIFs were pursuing partially a CRE strategy.

In terms of geographical breakdown of the investments, 88% were EEA, leaving 12% as non- EEA.

ESMA’s expected ESG disclosures in prospectuses under the Prospectus Regulation

​ESMA issued a Public Statement on the sustainability disclosure expected to be included in prospectuses under the Prospectus Regulation (PR).​ In a funds context, this is relevant to listed closed ended funds only.

The statement sets out ESMA’s expectations on how the specific disclosure requirements of the PR in relation to sustainability-related matters in equity and non-equity prospectuses should be satisfied considering the environmental, social and governance (ESG) transition.

• ESMA emphasises the importance of an issuer’s non-financial reporting under the Non-Financial Reporting Directive and the future sustainability reporting under the Corporate Sustainability Reporting Directive, especially because such disclosure may be material under the PR and included in an issuer’s prospectus.
• In addition, regarding non-equity securities advertised as taking into account a specific ESG component or pursuing ESG objectives, the statement clarifies the disclosure required in relation to ‘use of proceeds’ bonds and ‘sustainability-linked’ bonds.
• The public statement also notes that sustainability-related disclosure is sometimes included in advertisements but not in prospectuses themselves and highlights that this disclosure should be included in prospectuses if it is material under the PR.

ESMA and NCAs will continue to monitor the market to determine whether this guidance should be modified, for instance, in cases where new products are introduced to the market or there are changes in the legislation.​

ESMA supervisory briefing on definition of advice under MiFID II

ESMA published a supervisory briefing setting out supervisory expectations by ESMA and NCAs on understanding the definition of advice under MiFID II. The briefing covers:

• The provision of personal recommendations and whether other forms of presenting information such as investment research, filtering, general recommendations, generic advice, presenting multiple products or access to model investment portfolios, could constitute investment advice.
• The presentation of a recommendation as suitable for a client or based on the client’s circumstances. This includes making recommendations to become a client of a particular firm, making recommendations which are clearly unsuitable in the light of knowledge about the client, definitions of a “person’s circumstances” and when recommendations will be viewed as based on a view of a person’s circumstances.
• Perimeter issues around the definition of personal recommendation, including disclaimers to the client and failing to use known client information so as to avoid qualification as investment advice.
• Issues around the form of communication, including whether the internet or apps are always a “distribution channel”, use of social media posts, messages to multiple clients, distinguishing corporate finance and investment advice and whether these are mutually exclusive.

CESR (ESMA’s predecessor) published a Q&A, Understanding the definition of advice under MiFID, in April 2010. While the definition of investment advice is largely unchanged in the MiFID II framework, ESMA has reflected the evolution of business models and technology.

MiFID compliance – ESMA report on peer review of the compliance function under MiFID I

ESMA published its follow-up report to the peer review on certain aspects of the compliance function under MiFID I.

The report shows that, overall, the NCAs assessed improved their practices following the 2017 peer reviews findings and recommendations. The CBI was not included in this follow-up report.​

ESMA statement on its 2022 CSA on disclosure of costs and charges under MIFID II

ESMA published a statement on its 2022 CSA and on the mystery shopping exercise on compliance with disclosure requirements for costs and charges under MIFID II.

Overall, firms comply with most of the elements of the ex-post cost and charges requirements under MiFID II. Not surprisingly, the level of compliance varies across Member States. Based on the results of the CSA and the mystery shopping, ESMA will focus its convergence efforts on:

• development of a limited number of new Q&As, or review of existing Q&As
• development of a possible standardised EU format for the provision of information about costs and charges to clients.

ESMA report following its call for evidence on pre-hedging

ESMA published a report on its July 2022 call for evidence (CfE) on pre-hedging.

Overall, ESMA concludes that pre-hedging is a voluntary market practice that might give rise to conflicts of interest or abusive behaviours. These risks should be considered when issuing any future guidance.

ESMA finds that pre-hedging takes place at a global level and across asset classes. ESMA is in favour of international co-ordination of any future ESMA action on pre-hedging to ensure a level playing field across EU and non-EU jurisdictions.

The report considers how pre-hedging can be analysed from the Market Abuse Regulation perspective as well as the interaction between pre-hedging and MiFID II provisions.

ESMA report and draft revised technical standards for passporting under MiFID II

ESMA published its report, which includes draft revised technical standards, following a review of MiFID II passporting across the EU.

ESMA’s proposals include targeted amendments to add new information requirements to the list of details investment firms have to provide at the passporting stage. In addition, a new investment services and activities passport notification will provide NCAs with further information on a firm’s planned, or existing, cross-border activities.

ESMA submitted the final report and draft revised technical standards to the European Commission for adoption.

ESMA manual on post-trade transparency under MiFID II

ESMA published its manual on post-trade transparency under MiFID II and MiFIR.

The manual aims to promote common approaches and practices in the implementation of the applicable MiFID II and MiFIR post-transparency legal requirements by clarifying the relevant legal provisions for NCAs. It will form part of the interactive Single Rulebook.

The manual consolidates in one document all legal references to:

• level 1 – MiFID II Directive and MiFIR
• level 2 – mainly Commission Delegated Regulation (EU) 2017/587 (RTS 1), Commission Delegated Regulation (EU) 2017/583 (RTS 2), Commission Delegated Regulation (EU) 2017/577 (RTS 3) and Commission Delegated Regulation 2017/567
• level 3 – opinions, guidelines and Q&As.

that constitute the post-trade transparency regime. It also contains further new level 3 guidance.

ESMA reports on sanctions under the UCITS Directive, AIFMD and MiFID II

ESMA published reports on sanctions under the UCITS Directive, AIFMD and MiFID II. In the reports, ESMA provides an overview of the applicable legal framework and information on the sanctions imposed by NCAs from 1 January 2022 to 31 December 2022.

ESMA’s annual report on penalties and measures issued under the UCITS Directive found that, overall, nine NCAs imposed a total of 38 penalties.The report shows that CBI imposed one penalty concerning investor disclosure. The total value of financial penalties imposed amounted to over €97m, with over €95m being imposed by a single NCA. Seven NCAs imposed a total of 18 measures.

ESMA’s annual report on penalties and measures issued under the AIFMD found that overall, ten NCAs imposed a total of 128 penalties. The report shows that CBI imposed no penalty. The total aggregate value of financial penalties imposed amounted to over €2m. Ten NCAs imposed a total of 146 measures, with four NCAs communicating 38, 57, 19 and 16 measures, respectively.

During the relevant period, 16 NCAs did not impose any sanction either under the UCITS Directive or the AIFMD.

ESMA comments that the pattern evidenced by the reports throughout the years (since 2013 for AIFMD and 2016 for UCITS) shows that the sanctioning powers are not equally used among NCAs. Also, other than a limited number of NCAs issuing an increasing number of sanctions, the level of sanctions issued at national level remains stable and generally low, especially relating to penalties.

ESMA also published a report providing an overview of sanctions and measures imposed under MiFID II in 2022. The data reported for 2022 indicates that NCAs activity on imposing sanctions and measures under MiFID II decreased compared to 2021, although both the number of Member States where sanctions and measures were applied and the total amount of imposed administrative fines increased. The report shows that CBI imposed no penalty.

EBA opinion on ML/TF risks affecting EU financial sector

The EBA published its fourth opinion on the risks of money laundering (ML) and terrorist financing (TF) that are affecting the EU’s financial sector.

The EBA’s comments include the following.

• Since the EBA’s third opinion in 2021, geopolitical events and technological advances have had a profound impact on the financial sector’s exposure to financial crime risks. Russia’s invasion of Ukraine led to the imposition by the EU of unprecedented restrictive measures, however national approaches to enforcing these restrictive measures are not harmonised. The risk of financial institutions being used to circumvent sanctions has increased.
• New risks have arisen from the laundering of proceeds from environmental crimes and cybercrimes.
• Legislative developments, including the Regulation on markets in cryptoassets (MiCA) create legal uncertainty and some NCAs and institutions have been hesitant to invest in better financial crime controls.
• The TF risks identified in 2021 still exist, with new risks arising from the changed geopolitical situation and an increase in right-wing extremism and terrorism.
• With certain exceptions, awareness of ML/TF risks has increased.
• The AML/CTF systems and controls institutions have put in place are not always effective. Transaction monitoring and suspicious transaction reporting are particularly weak.

The EBA opinion includes 23 proposals addressed to the EU co-legislators and NCAs to strengthen the EU’s financial crime defences.