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

Review of the of the UCITS Eligible Assets Directive​

On 16 June 2023, ESMA published a letter (dated 6 June 2023) sent by the European Commission mandating ESMA to deliver technical advice on the operation of the Eligible Assets Directive (2007/16/EC) (EAD).

​The Commission is reviewing the EAD in the context of market practices to ensure that the eligibility rules are implemented uniformly in all Member States and to take account of market and regulatory developments that have occurred over the past 16 years. ​

The Commission mandates ESMA to:

• carry out an assessment of the implementation of the EAD
• analyse whether any divergences have arisen in this area
• provide the Commission with a set of recommendations on how the EAD should be revised to keep it in line with market developments
• analyse the merits of linking certain definitions and concepts to other pieces of the EU legislation (such as MIFID II, EMIR, the Benchmark Regulation, MMFR)
• analyse the consistent application of delta-one instruments related provisions, indices, efficient portfolio management (EPM) techniques, the definition of money market instruments as well as the notion of liquidity and presumption of liquidity for certain transferable securities

Among other things, the Commission requests ESMA to:

• ​propose clarifications on the key definitions and the criteria against which the eligibility of an asset is assessed
• analyse whether and to what extent cross-references to other EU legal frameworks (MIFID II, EMIR, the Benchmark Regulation, MMFR) could improve legal clarity and consistency between these frameworks
• assess the risks and benefits of UCITS gaining exposures to asset classes that are not directly investable for UCITS, e.g. through delta-one instruments, (embedded) derivatives and financial indices
• advise (in relation to EPM) ​on possible legislative clarifications to address the shortcomings identified in the context of its supervisory convergence work, notably the 2018 ESMA Peer Review on the guidelines on ETFs and other UCITS issues, its follow-up work on this topic and the ESMA Common Supervisory Action (CSA) on costs and fees in 2021​
• gather data (with National Competent Authorities (NCAs) and, where appropriate, market participants) on the manner and the extent to which UCITS have gained direct and indirect exposures to certain asset categories that may give rise to divergent interpretations or risk for retail investors (such as structured or leveraged loans, catastrophe bonds, emission allowances, commodities, cryptoassets, unlisted equities and other relevant asset classes)
• make a preliminary assessment of the impacts of the proposed regulatory adjustments, if any, taking into account the characteristics of the underlying market (such as availability of valuation, liquidity, assets safekeeping​ and so on)

The Commission requests ESMA to deliver its technical advice by 31 October 2024.

ESMA Annual Report for 2022

ESMA published its Annual Report for 2022. It sets out ESMA’s key achievements in 2022 which include the following.

• Developing its new strategic orientation for the next five years. ESMA will remain focused on its core mission of enhancing investor protection, promoting orderly financial markets and safeguarding financial stability. Along with increased use of data in ESMA’s work, the areas of sustainable finance and technological innovation will shape ESMA’s work.
• Responses to the consequences of the Russian invasion of Ukraine.
• In terms of supervisory convergence:
  • several CSAs on MiFID II costs and charges, MiFID II product governance rules, valuation of UCITS and open-ended AIFs and costs and fees of investment funds
  • three major peer reviews including supervision of cross-border activities of investment firms Brexit relocation processes and prospectus peer review (under the prospectus directive)
  • ESMA’s first recommendations to a NCA under article 16 of ESMA’s founding regulation (where the NCAs must make every effort to comply with those recommendations)
  • ESMA’s first advice on proposed leverage limits (per AIFMD Article 25) followed CBI’s notification to impose leverage limits on commercial real-estate funds.
• In terms of sustainable finance:
  • ESMA’s 2022–2024 sustainable finance roadmap
  • call for evidence on greenwashing
  • ESG supervisory briefing
  • guidelines on MiFID II suitability requirements
  • consultation on guidelines for ESG or sustainability-related terms used in funds’ names
  • responses to EU and international consultations on corporate reporting sustainability standards
  • interaction with relevant EU and international bodies.

ESMA Q&As on AIFMD/UCITS

ESMA added new Q&As (with answers provided by the European Commission) to its UCITS Q&As.

• Management of AIFs and pension schemes by UCITS ManCos.
  • UCITS ManCos may manage sub-threshold AIFs.
  • UCITS ManCos may manage pension schemes, where authorised by national legislation implementing the UCITS Directive. Member States can authorise UCITS ManCos, in addition to the management of UCITS, to manage investment portfolios of pension funds only on a mandate basis, acting as service providers and not as investment managers of the pension funds.
• De-notifying marketing arrangements for UCITS. Even where there are no investors in a host Member State, UCITS wishing to de-notify must comply with Article 93a (1) of the UCITS Directive (making sure that there are no investors uninformed about the UCITS’ market exit, that all marketing is publicly terminated and any marketing arrangements with third parties are terminated or modified to prevent any further marketing of the de-notified UCITS).
• Scope of passported UCITS ManCo activities. A UCITS ManCo may not passport only the administration or marketing functions referred to in Annex II of the UCITS Directive, without also passporting investment management functions (whether directly or through a branch).

ESMA added new Q&As (with answers provided by the European Commission) to its AIFMD Q&As.

• Pre-marketing notifications.
  • Where an investment strategy is developed by a third party (the fund initiator), such third party is subject to the conditions for pre-marketing set out in Article 30a AIFMD.
  • Registered AIFMs, which do not qualify as a EuSEF manager or EuVECA manager, are not subject to the obligation to notify pre-marketing pursuant to Article 30a(1) AIFMD. Sub-threshold EU AIFMs covered by Article 3(2) AIFMD, which have not opted in under Article 3(4) AIFMD, are referred to as registered AIFMs in AIFMD, which do not have the EU-wide AIFM passport to exert asset management activities across the borders. Except for Article 3(3) and (4) and Article 46 AIFMD, activities of sub-threshold EU AIFMs are governed by the national rules, including those on pre-marketing.
• De- notifying marketing arrangements. Even where there are no investors in a host Member State, AIFMs wishing to de-notify must comply with the obligations set out in Article 32a(1) of the AIFMD, making sure that there are no investors uninformed about the AIFM’s market exit, that all marketing is publicly terminated and any marketing arrangements with the third parties are terminated or modified to prevent any further marketing of the de-notified AIF. Also, the AIFM must cease any new or further marketing of units or shares of the AIF it manages in the Member State in respect of which it has submitted a de-notification.
• Calculation of leverage. When calculating the leverage of an AIF whose core investment policy is to invest in real estate directly or indirectly, the AIFM must include the exposure contained in financial or legal structures involving third parties controlled by that AIF. This results in a look-though of SPVs for leverage calculation in real estate funds. Real estate funds may not avail of carve-outs which are available to VC or PE funds.
• Scope of AIFM passported activities. An AIFM may not passport the additional functions that an AIFM may perform, without also passporting investment management functions (whether directly or through a branch).

Please speak with your usual contact on the ALG Asset Management & Investment Funds team for more detail on the practical implications of these changes.

NCAs should continue monitoring ​​EPM costs – ​​ESMA follow-up report to the peer review on the Guidelines on ETFs and other UCITS issues​

ESMA published its follow-up report to the peer review on the Guidelines on ETFs and other UCITS issues.

The report shows that:

• The three NCAs, BaFin (DE), EFSA (EE), and CSSF (LU), identified in the original peer report as needing to improve practices have strengthened their supervisory practices, enhanced internal and external guidance, and performed supervisory work in the area of ETFs and other UCITS since 2018.
• Four NCAs, AMF (FR), BaFin, CBoI (IE), and CSSF, carried out ad hoc supervisory work in relation to the attribution of revenues and costs derived from securities lending by UCITS. This followed on from the findings of a Better Finance* research paper published after the peer review. The Better Finance report had found a large variation (from 51% to 95%) in the gross revenues generated by securities lending transactions that were returned to UCITS investors in some jurisdictions.
• NCAs should continue monitoring the effective application of the guidelines and the effectiveness of the supervisory practices implemented.
• There are cases where EPM costs charged to some UCITS are significantly higher in comparison to other UCITS, especially where EPM techniques are carried out by the UCITS management company itself or by their related parties. This is an area of concern from an investor protection perspective and NCAs should continue monitoring it.

*BETTER FINANCE is the European Federation of Investors and Financial Services Users, a public interest non-governmental organisation. It was established to advocate and defend the interests of European citizens as financial services users at European level to lawmakers and the public in order to promote research, information and training on investments, savings and personal finances. The Better Finance report noted a large variation (from 51% to 95%) in the gross revenues generated by securities lending transactions that were returned to UCITS investors in some jurisdictions (DE, FR, IE, LU). This raised concerns with regards to the compliance with the Guidelines.​

​Money market funds stress tests – overall resilience whilst LVNAVs exceed threshold in liquidity and credit risk scenarios

ESMA published an article on the results of the Money Market Funds (MMFs) stress tests reported to ESMA.

• ESMA guidelines on MMF stress tests provide risk parameters to fund managers, which are updated on an annual basis according to an adverse scenario designed by the European Systemic Risk Board (ESRB) and the European Central bank (ECB).
• MMF managers in the EU are required to undertake stress tests in accordance with these rules and report the results of their simulations back to their national authorities and ESMA as part of their regular regulatory reporting.
• This article presents the results of the stress tests reported at the end of 2021, drawing lessons from the stress episode affecting MMFs in March 2020 in a context of deep global recession caused by the COVID-19 pandemic.

Press release is here.

ESMA summarises

“The results show that liquidity and credit risks would be the most impactful for MMFs, in the context of the adverse scenario.

The different redemption scenarios tested however show the capability of MMFs to meet redemption requests under adverse circumstances, despite a calibration reflecting the intensity of the March 2020 stress episode.

In the article ESMA also highlights the relative proximity of the LVNAV 20 bps threshold, which would be exceeded in the liquidity and credit risk scenarios. While this possibility is foreseen in the MMF Regulation, these findings support the concerns expressed in the ESMA opinion regarding the consequences of funds breaching the threshold.”

NCAs use MMF stress test results for supervision purposes. Evidence from this article will inform future enhancements of the MMF stress testing framework, in 2023 and onwards.​

Greenwashing in the financial sector: ​Progress Reports from ESMA, EBA and EIOPA

The European Supervisory Authorities (ESAs) each published progress reports on greenwashing in the financial sector.

• ESMA’s report is here.
• See also EBA, EIOPA, reports.
• In these reports, the ESAs put forward a common high-level understanding of greenwashing applicable to market participants across their respective remits – banking, insurance and pensions and financial markets.

ESAs common high-level understanding of greenwashing

• The ESAs understand greenwashing as a practice where sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. This practice may be misleading to consumers, investors, or other market participants.
• The ESAs also highlight that sustainability-related misleading claims can occur and spread either intentionally or unintentionally and in relation to entities and products that are either within or outside the remit of the EU regulatory framework.
• The NCAs and the ESAs are, therefore, working to meet expectations from stakeholders to ensure consumer and investor protection, support market integrity and maintain a trusted environment for sustainable finance. Given the integrated nature of the financial system, the ESAs work in a coordinated manner to address greenwashing.

ESMA Progress Report

The ESMA Progress Report helps to better understand greenwashing and provides market participants and regulators with a shared reference point in dealing with this phenomenon.

Risk areas

• In the report, ESMA assesses which areas of the sustainable investment value chain (SIVC) are more exposed to the risk of greenwashing. This assessment is meant to help market participants in preventing and mitigating greenwashing, and to support ESMA and NCAs in prioritising supervisory actions and regulatory intervention.
• The findings show that misleading claims may relate to all key aspects of the sustainability profile of a product or an entity – from governance aspects to sustainability strategy, targets and metrics or claims about impact. The report also provides sector-specific assessments for key sectors under ESMA’s remit such as issuers, investment managers, benchmark administrators and investment service providers.

The causes of greenwashing

Greenwashing is the result of multiple inter-related drivers. Market participants across the SIVC face challenges in implementing the necessary governance processes and tools that support high-quality sustainability disclosures and transition efforts. In this context, market participants also have difficulties in producing and accessing relevant, high-quality sustainability data. Furthermore, a fast-moving regulatory framework has created implementation challenges for both market participants and for NCAs and highlighted the need to build sustainability expertise.

Preliminary remediation actions

• To mitigate greenwashing risks, market participants across the SIVC have to live up to their responsibility to make substantiated claims and communicate on sustainability in a balanced manner. Comprehensibility of sustainability disclosures to retail investors needs to be improved, including by establishing a reliable and well-designed labelling scheme for financial products. Finally, the regulatory framework needs to gain in maturity, key concepts need to be clarified and sustainability impact or engagement better integrated.
• This report lays the ground for mitigating greenwashing risks in the future, throughout the SIVC and in key sectors under ESMA’s remit.

Next steps

• The ESAs will publish final greenwashing reports in May 2024 and will consider final recommendations, including on possible changes to the EU regulatory framework.
• You can watch ESMA’s explainer video here.

European Commission measures on improving sustainable finance framework

The European Commission published a package of measures to build on and strengthen the EU sustainable finance framework.

The package aims to ensure that the sustainable finance framework works for companies that want to invest in their transition to sustainability, as well as making the overall framework easier to use. Key elements are set out below.

• A communication summarising how the sustainable finance framework is operating and Commission plans to improve the framework. The Commission will consult on assessing the implementation of the SFDR in autumn 2023.
• Recommendations on transition finance.
• FAQs on interpretation of the Taxonomy Regulation and the SFDR, including clarification that investments in environmentally sustainable economic activities under the Taxonomy Regulation can be qualified as a sustainable investment under the SFDR.
• A proposed regulation on ESG ratings activities which:
  • specifies that ESG rating providers based in the EU must be authorised by ESMA and, following authorisation, subject to ongoing supervision by ESMA
  • imposes requirements on ESG rating providers relating to their internal organisation, disclosures concerning methodologies and mechanisms intended to address conflicts of interest
  • ESG rating providers that are not categorised as small or medium-sized are expected to apply for authorisation within six months after the date of application of the regulation
• The Council of the EU and the European Parliament will now consider the legislative proposal.
• Legislation expanding criteria under the Taxonomy Regulation for economic activities making a substantial contribution to one or more of non-climate environmental objectives.

ESMA’s MiFID II Call for Evidence on sustainability in suitability and product governance

ESMA launched a Call for Evidence (CfE) on integrating sustainability preferences into suitability assessment and product governance arrangements under the Markets in Financial Instruments Directive (MiFID II).

The objective of this CfE is to gather industry feedback that will help better understand the evolution of the market and provide answers as to how firms apply the new MiFID rules on sustainability.

In particular, the CfE aims to help ESMA:

• develop a better understanding of how MiFID II requirements are being implemented and applied by firms across the Union and the challenges firms face in their application
• gain a better understanding of investor experience and reactions to the inclusion of sustainability factors in investment advice and portfolio management services
• collect information, views and data on main trends on aspects related to the provision of sustainable investment products and services to retail clients

ESMA has previously updated its guidelines on suitability and product governance requirements following the inclusion of sustainability-related requirements for investment firms into MiFID II.

ESMA, with the NCAs, will assess the responses to this CfE and continue monitoring the application by firms of the MiFID II requirements on suitability and product governance, including the related ESMA Guidelines.

EMIR bilateral margining framework and equity options

The ESAs published a letter they sent to the European Commission, the European Parliament and the Council of the EU. The ESAs request clarification concerning the bilateral margining framework and equity options under EMIR.

EMIR mandates the ESAs to develop draft regulatory technical standards (RTS) on the risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty (bilateral margin RTS).

The bilateral margin RTS have a deferred date of application for non-centrally cleared OTC derivatives which are single-stock equity options or index options (equity options). This deferred date of application reflects that other jurisdictions have permanently or temporarily exempted these products from bilateral margin requirements. This effective exemption, together with an exemption for intragroup derivative contracts, has been repeatedly extended and is now set to expire on 4 January 2024.

Different views exist on the desirability of an exemption. On the one hand, it can be argued that there are no prudential grounds for an exemption, whether in the EU or in the internationally agreed framework. On the other hand, the equity option exemption would be consistent with the approaches taken in other jurisdictions and preserve the competitiveness of EU counterparties in this area.

The ESAs suggest that the ongoing EMIR review should clarify the issue.

AML/CFT/Sanctions – EU list of high-risk third-country jurisdictions

As flagged in our May AMIF bulletin, Commission Delegated Regulation (EU) 2023/1219 of 17 May 2023 amending Delegated Regulation (EU) 2016/1675 as regards adding Nigeria and South Africa to the list of High Risk Third Countries and deleting Cambodia and Morocco from that list was published in the Official Journal of the EU (OJ) on Monday 26 June 2023.

​This Regulation enters into force on the twentieth day following its publication in the OJ. The Regulation will be directly applicable in all Member States.

As a direct consequence of the adoption of this Delegated Regulation, obliged entities in all Member States are bound to apply enhanced customer due diligence measures in accordance with Article 18a of Directive (EU) 2015/849 (4AMLD) with respect to business relationships or transactions involving countries that are included in the list of High Risk Third Countries.