Duff & Phelps Seminar - Michael Hodson, Director of Asset Management Supervision

Good afternoon ladies and gentlemen. I want to thank you for the invitation to speak at today’s event which has been kindly organised by our hosts Duff & Phelps.  I have had the opportunity to review the fifth annual outlook report and I want to commend the authors and editors of this document as there is much food for thought.

Today I will address a number of important topics relevant to the Irish Asset Management industry including MiFID II and Brexit which I note are both referred to in the 2017 Outlook Report.

Central Bank Supervision and Industry Engagement

But first, I want to take a few moments to speak on the Central Bank’s extensive supervisory work programme and our engagement with industry.

One area of focus during 2016 was the Outsourcing of Fund Administration Activities. The Central Bank regularly reviews the controls and procedures in place surrounding outsourcing arrangements to assess compliance with the Outsourcing Requirements and to evaluate best practice in the industry.  During the first half of 2016, the Central Bank carried out a focussed review of outsourcing arrangements concentrating on the following areas (i) the extent to which larger Fund Administrators outsource their activities and (ii) the relevant control environment (governance and oversight arrangements) in place within these Fund Administrators in Ireland.

Levels of between 48% and 61% of fund administration activities were carried out by Full Time Equivalents (FTEs) located in Outsourcing Service Providers as at 31 December 2015 based on the five firms that formed part of this review. Other key observations included firms under review (i) outsourcing on average to 10 locations and (ii) outsourcing primarily to other group entities.  Concerns also arose regarding the standards / arrangements that are in place to adequately oversee all outsourced activities including (i) a lack of comprehensive outsourcing records being maintained and (ii) no tolerance levels being set in respect of the amount of outsourcing permitted.  

Following the completion of this review, a letter setting out observations and recommendations was issued. We outlined examples of good practice, aiming to support the development of consistent industry practices to assist in ensuring compliance by firms with the Outsourcing Requirements. In addition, a review by the Central Bank of outsourcing across all financial sectors is ongoing, indeed our colleagues in Credit Union supervision issued a report on this very topic only last week.                

It should also be noted that the Central Bank will now consider proposed outsourcing submissions by Fund Administrators on the basis of the cumulative effect / impact (i.e. the level of activities carried out by OSPs) the proposed outsourcing arrangement will have on the relevant firm when reviewed in conjunction with all current operating outsourcing models. The Central Bank’s view is that the level of outsourcing observed in this review is likely to be at or close to the outer limit of what is appropriate for this industry;

Moving onto CP86, since early 2014, the Central Bank has engaged in a body of work to examine and enhance fund management company effectiveness. This has entailed three separate consultations on governance, compliance and effective supervision. Work in this area concluded in December 2016 with the publication of the final package of measures. We also published detailed guidance which sets out how fund management companies should operate.

This broke new ground for us as we had never previously been so explicit in setting out our expectations of how directors and management of fund management companies should carry out their roles. The guidance sets the bar high but we feel that this is appropriate given the key role which directors and management have to play in protecting the interests of investors.

I would like to take this opportunity to remind you that 30 June 2017 is the deadline for fund management companies having a designated email address in place. This email address is important as it will assist the Central Bank in effectively supervising fund management companies by ensuring an efficient direct channel through which letters, meeting requests, surveys and so on, can be communicated to a fund management company. The email address must be monitored on a daily basis and further information is contained in the Guidance that we published in December 2016.

IT and Cybersecurity Risks: I note from the 2017 Outlook Report that 86% of firms surveyed intend to focus more resources and time on cybersecurity this year. This is also an area of key priority to the Central Bank.

Over the past several years, the Central Bank has sharpened its focus on IT related risks in supervised firms and in 2016 published Cross Industry Guidance on Information Technology and Cybersecurity Risks. The Guidance provides a clear articulation of our current expectations in relation to the governance and management of IT and cyber related risks by firms and sets out good practices in these areas.

Applying across all regulated sectors, the Guidance was designed with proportionality in mind -  it will have different implications for larger complex firms than for smaller and simpler ones. It’s important to say that the Guidance doesn’t address all aspects of the management of IT and cybersecurity but focusses on the areas that we deemed pertinent at this point in time. Indeed, no guidance from the Central Bank can cover all risks and necessary actions for regulated firms. 

To date, industry feedback to the Guidance has been positive with firms welcoming the additional clarity provided on the Central Bank’s expectations in this area. We recently hosted a cross industry seminar on the theme of IT and cybersecurity risks, the purpose of which was to stimulate discussion on the challenges facing the financial services industry in responding to these risks and share insights and practical experience to assist industry in responding to these risks. Going forward, the Central Bank will continue to engage in open dialogue with firms and industry stakeholders in order to inform future policy development in this area.

Another matter on the horizon is the publication of a discussion paper on exchange traded funds, publication of which is imminent. The discussion paper is designed to inform the Central Bank’s participation in international and European discussions on the topic and its publication will provide an opportunity for interested parties to feed into the wider debate on ETFs, a topic that the Central Bank is playing an important part in advancing discussions.

Regarding the Capital Markets Union, the European Commission identified in the recent mid-term review that they have delivered more than half of their initial 33 proposals as laid out in the Action Plan.  Some of which are due to be finalised shortly include:

• Agreement on simplification of prospectuses;
• Legislative and non-legislative actions on venture capital; and
• Securitisations legislation (expected to be finalised at the end of the Maltese Presidency)

Moreover, in a recent European Commission speech on the mid-term review, Vice-President Dombrovskis highlighted that “the EU economy needs more advanced capital markets more than ever to complement bank lending with other sources of funding”.  This is all the more important in light of Brexit, given that the UK accounts for between 25% and 75% of activity in most sectors of EU capital markets. The Central Bank supports the aim of the Capital Markets Union and is committed to playing its part in delivering a safe and efficient capital markets in Europe.

One of the European Commission’s aims set out in the Action Plan was the removal of barriers to cross border distribution. The EU investment funds sector, is a key part of the EU Capital Markets. To achieve this, there are a number of challenges to overcome which are currently causing difficulties. These challenges include:

• The differing definitions of professional investors across member states;
• The interpretation of marketing and pre-marketing; and
• The fact that in many cases, the NCAs apply a notification fee or impose various administration arrangements for the processing of cross border notifications.

As long as Member States impose differing requirements, it will be more difficult to achieve a general harmonisation in this regard.

Vice President Dombrovskis has highlighted that in order to address this notification matter, it may be that legislative proposals will be required to address remaining sources of friction to cross border passporting of funds.

The Central Bank has a separate Anti-Money Laundering division and compliance with AML rules continues to be a priority for the Central Bank, as demonstrated by the recent fine of €2.275 million imposed on AIB for compliance failures. The Central Bank expects that designated persons have robust AML controls in place including having an adequate risk assessment and risk management controls appropriate to the nature, scale and complexity of the firm’s business.  These will be a key focus of the 70 plus inspections that the Central Bank's Anti-Money Laundering Division plans to conduct during 2017.

MiFID II

Let me now turn to the pressing matter that is MiFID II.

MiFID II contains new EU-wide rules governing investment firms, credit institutions, trading venues and market structures, as well as third-country firms providing investment services or activities in the EU. It significantly broadens the scope of MiFID by bringing new activities into scope, removing or narrowing exemptions (e.g. dealing on own account) and covering new financial instruments and products (e.g. emission allowances, commodity derivatives and structured deposits). Consequently, some firms that are currently outside the scope of MiFID will need to apply for authorisation. Other changes include the introduction of a new category of trading venue, the Organised Trading Facility, along with new transparency and reporting requirements.

MiFIR calls for the reporting of additional transaction data. New firms and instruments will come within the scope for reporting to such an extent that the amount of data received by the Central Bank set to quadruple. Thus, firms will require enhanced systems to be able to generate and submit accurate transaction reports within the stipulated deadlines. 

Enhanced conduct of business rules will strengthen investor protection, formalise requirements in relation to product governance, create new requirements around inducements and increase obligations on firms with regard to suitability and appropriateness testing.

New organisational requirements, stricter systems and controls requirements on firms engaging in algorithmic and high-frequency trading, rules governing third country firms operating in the EU via a branch, new product intervention powers for competent authorities (and ESMA) as well as new supervisory and enforcement powers for competent authorities all pose significant implementation issues for both you the firm and the Central Bank.

TheCentral Bank’s MiFID II Initiatives

With MiFID II representing the largest overhaul of EU legislation for markets in financial instruments in more than a decade, you may ask what steps has the Central Bank taken in preparation for the go-live date of 3 January 2018.

To answer this question, I will refer to a number of initiatives that the Central Bank’s Asset Management Supervision Directorate has undertaken since 2015 to ensure that both the Central Bank and firms are ready for the changes that will be ushered in under MiFID II. For instance:

• We established an internal MiFID II Implementation Project working group which has undertaken a review of the primary legislative texts and all published Level 2 & 3 texts. This has comprised of some 142 Articles, 44 RTS/ITS and several sets of Guidelines and Q&As involving significant staff resources across the organisation. 
• We have engaged with our IT Directorate to augment our Supervision Systems to accommodate the new rules. This process has passed the ‘development’ stage and we envisage that user testing will begin in the coming weeks. This project is separate from our Transaction Reporting project.
• In Q1 of this year our MiFID II subject matter experts provided in-depth training to staff on the key changes MiFID II will bring and on how these changes will impact the firms we supervise.
• A MiFID II questionnaire was issued recently to all supervised firms which contained a number of questions on their implementation of MiFID II. I will refer to this questionnaire in more detail in the next segment of my speech.
• Supervisors are undertaking a heat-mapping exercise to establish how the new rules will impact the business models of the firms we supervise.  These heat-maps are currently being used to guide engagements between Supervisors and our Medium High Impact Investment Firms. 
• Inspectors recently carried out a thematic inspection on the conduct of business client suitability requirements under MiFID. The review was undertaken to assess compliance against the 2012 ESMA Suitability guidelines, and also to measure the level of preparedness of firms, in light of the new stricter Suitability requirements under MiFID II. An industry letter will be issued later this year and this will highlight good practices observed.
• We are continuing our programme of industry engagements with Central Bank representatives speaking at a number of MiFID II round tables and conferences since 2015.
• Our ESMA representatives are engaging at an EU level in relation to the negotiation and finalisation of various ESMA measures and we continue to provide technical advice to the Department of Finance as it enters final preparations for the transposition of MiFID II into Irish Law.
• The Securities and Markets Supervision Division hosted a MiFIR Transaction Reporting Seminar on 7 November 2016 which was attended by representatives from Investment Firms and Credit Institutions. It focused on the status of the transaction reporting legislative framework, the new reporting obligations under MiFIR, and the Central Bank’s planned systems for transaction reporting. Communications on proposed testing timeframes issued in February 2017 and ‘Operational and Technical Arrangements’ for submitting transaction reports were published in March 2017. These communications are available on the Central Bank’s website.
• Finally, in March, we launched our MiFID II authorisation application forms for investment firms and data reporting service providers, both of which are now available on our website. The finalised forms will be available on our website once the Directive is transposed into Irish Law.

Industry preparation for MiFID II:

If I may now turn to industry preparation for MiFID II.

In February 2016, the European Commission extended the MIFID II implementation date to 3 January 2018. This extension was granted to take into account the exceptional implementation challenges faced by regulators and market participants. I want to highlight that at this stage it does not appear that any further extension will be granted.

It is positive to note from the responses to the MiFID II questionnaire that 84% of firms now have a MiFID II implementation project in place. However, this means that 16% of supervised firms do not have a MiFID II implementation project in place with the go-live date now 8 months away.

The responses to the questionnaire also revealed the most significant challenges faced by firms in preparing for MiFID II with:

• 40% of firms highlighting the implementation timeframe;
• 45% referring to the technology changes; and
• 48% stating the timing of Level 3 text.

63% of firms view the mapping of changes to their business model as one of the significant challenges in preparing for MiFID II. In light of this, I strongly encourage all our supervised entities to conduct a heat-mapping exercise which addresses the new rules and the impact on existing business models.

I want to be clear that the Central Bank will not be issuing guidance or feedback papers on MiFID II. However, there are a number of resources that may be of assistance in preparing for MiFID II, including ESMA guidelines, ESMA Q&A publications and external support. Indeed, ESMA has launched its Q&A tool which allows interested parties to submit questions directly for consideration. This is an excellent resource and industry participants should take advantage of this direct line to rule makers in ESMA.

In summary, the Central Bank recognises that each firm will have its own specific challenges in terms of structure, technology and conflicting priorities. However, it is for senior management and the board to ensure their firms are prepared for MiFID II. 

Brexit

Today marked the publication of the Central Bank’s Annual Report 2016 and Annual Performance Statement 2016-2017. The Performance Statement provides information on our key financial regulation outcomes in 2016, how these outcomes were achieved and also outlines our strategic priorities for 2017.

At this afternoon’s address, Governor Lane highlighted that the Central Bank continues to assess and analyse the implications of the UK’s decision to leave the EU; this includes the potential for a more diverse range of firms and business models that would require the Central Bank’s authorisation and supervision.

It is interesting to note that the majority of firms included in the survey undertaken by Duff and Phelps expect Brexit to have some impact on their compliance arrangements whether it be immediate, the next 18 months or over the longer term. 

In light of this and the fact that a number of Duff and Phelps clients may be considering Ireland as a destination of choice in a post-brexit world, I would like to provide an insight into our approach to engaging with and potentially authorising and supervising financial firms.

To date, Central Bank staff have engaged with a substantial number of firms regarding potential relocation decisions and the resulting authorisation process. At meetings we have held so far, I have found firms expecting and indeed wanting high quality and challenging supervision that is in line with best standards.

We are receiving enquiries from many different firm types, in some cases, these firms will be similar to those already operating in Ireland. However, we may also be presented with new firm types, new business models or new pieces of market infrastructure.

Of course this will present challenges, both for the Central Bank and industry; and as part of our preparations for Brexit, we have allocated additional resources that will be dedicated to Brexit related authorisations.

To any potential applicants present at today’s seminar, you will find that the Central Bank is an open, engaging and constructive regulatory body which maintains the highest regulatory standards and is committed to providing transparency, consistency and predictability in our regulatory decisions. The Central Bank has considerable experience in dealing with authorisations and where we are asked to consider the authorisation of a firm in Ireland, we will want to be satisfied that we are authorising a business or line of business that will be run from Ireland and which we can effectively supervise. We accept that outsourcing is a part of many business models, however it is important that a firm is not outsourcing to the extent that it is effectively hollowing out an important part of the regulated activity. 

While on the subject of Brexit, you may be aware that ESMA is currently working towards developing a convergent position on key issues to be taken into account when market participants move some of their activities from the UK to member states. In a recent speech on the Capital Markets Union, Steven Maijoor, the Chairman of ESMA, outlined ESMA’s intention to publish a general opinion before the summer which will address issues such as how NCAs should ensure on-going effective supervision of re-located activity, in particular when certain functions are subject to outsourcing and delegation. Potential limitations to outsourcing and delegation will also be discussed. 

Finally, the ECB has a Relocating to the Euro Area FAQ page on its website. A number of topics are addressed including internal governance and risk management, internal models and issues related to ongoing supervision. This is relevant for non-bank entities as our approach is to seek to ensure that to a very large extent there is European supervisory convergence and that relocation decisions are based on factors other than regulatory/ supervisory stance. This also informs our approach across sectors, such that there is broad consistency in the principles being applied on the key cross-sectoral issues and that is why the ECB guidance is relevant, accepting however that proportionality plays its part in any such deliberations.

Key Message

At this juncture, let me conclude by once again thanking our organisers for the opportunity to address you today.

It is clear that that the future will present many challenges and opportunities, including MiFID II, Brexit, cyber risk and many more. My overall message is that firms need to be planning and devoting sufficient time to meet these challenges. By making these painstaking efforts now, firms will benefit in the long run.

They also present challenges to us as regulators. The Central Bank is actively planning and working to ensure we deliver on our mandate in all its forms. All our actions are driven by our overarching mission of protecting consumers and safeguarding stability.