Good afternoon, ladies and gentlemen. I am grateful for the opportunity to speak to you today about the Central Bank’s consultation in relation to the regulation of non-UCITS funds.
• Explain the Central Bank’s thinking when we embarked upon a review of our non-UCITS rule book;
• Give some pointers to our supervisory approach in the future after the new rule book becomes effective.
Let me apologise in advance for the number of acronyms that I am going to use. Hopefully by now you will have read the Central Bank’s consultation document, CP60, and you will not be put off if I refer to AIFs, QIFs, QIAIFs and RIAIFs.
Before I start, I think that it is worth pointing out a few things:
• The Irish funds industry is very significant globally with over EUR 2trn of assets under administration and over EUR 1trn of funds authorised here;
• We appreciate that there are a number of natural advantages which encourage the growth of the funds industry in Ireland such as language, time-zone, taxes, legal system, workforce etc.
That said, we are also mindful of the substantial responsibility that goes with being a regulator in one of the world’s largest fund jurisdictions. Rather than being dazzled in the spotlight, the Central Bank believes that it is important to take a leading role in crafting regulations and implementing a supervisory approach which protects investors and support issuers.
A. Purpose of regulation
I often start with the question “why regulate?” It is not a trivial question and I find that in a time of substantial regulatory change, it is important to keep this at the forefront of our minds. To answer this, it is helpful to address three subsidiary questions:
• what is the economic purpose of the funds industry?
• what does it mean for this industry to work well? and
• how can regulation help?
At its simplest, the funds industry exists because there are those with excess capital who can be matched with those in need of capital. Funds allow investors to (a) access a broad range of investment opportunities and (b) improve the risk/return profile of their portfolio (including cost control) and (c) delegate oversight over their investments. Investors in collective investment schemes benefit from economies of scale which deliver lower set-up and servicing costs.
Fund managers, administrators, custodians, accountants, tax experts and lawyers have a valuable role to play in ensuring that the core relationship between the fund investor and the funds issuer works effectively.
But we know that things can go wrong. The fact that the outcomes for issuers or investors may not be satisfactory is often due to:
• misalignment of incentives between the investor, the fund and the fund service providers;
• information asymmetries between the investor, the fund and the fund service providers, and
• behavioural inefficiencies arising from an environment where quality, volume and frequency of information does not lend itself to easy decision-making.
So it is worth reminding ourselves of the key high-level objectives which we, as regulators, pursue which are:
• Protecting investors;
• Maintaining market integrity, and
• Mitigating systemic risk.
When we have encountered thorny policy issues over the last few months, we invariably came back to testing our ideas against of the delivery of one of more of these high level objectives.
B. Approach to revising the non-UCITS rule book
Let me take some time to outline our approach to the revision of our non-UCITS rule book.
You will recall that our first task was to consider how AIFMD could be implemented in Ireland and in good time before July next year.
B.1 Possible overlap between AIFMD and existing NU Notices
While AIFMD sets out to regulate the AIFM, it crosses over into many areas which relate to investment funds regulation, i.e. regulation of the AIF. These areas include valuation, risk management, safe-keeping of investment fund assets and disclosure requirements. These are all areas where we currently have national requirements. Moreover, there are other areas where the AIFMD rules which are applicable to the AIFM address, indirectly, those areas where we have traditionally imposed specific requirements on the funds, for example in relation to share classes. In making the alternative investment fund manager – the AIFM – the focus of regulatory engagement, it was clear to us that by simply adopting AIFMD without changing our existing regime, we risked creating a situation where we had two rule books overlapping on a number of issues. Not only would this create additional tasks for the Central Bank and for industry, the additional confusion and cost was also likely to adversely impact investors and issuers.
So one of our first objectives was to look at areas of overlap and to trim back our non-UCITS fund regime so that our new regulatory regime for alternative investment funds and our implementation of AIFMD would sit side-by-side and complement each other.
B.2 Rationalising our NU notices
The Central Bank currently has 25 Non-UCITS notices and 13 Non-UCITS Guidance notes in issue. In looking at the overlap, we started to make amendments to each of these documents. This was a valuable exercise as it highlighted the extent of the changes that were to follow. However, we realised at a certain stage that wholesale tinkering with the fabric of the building - to use a construction analogy - would lead to a less stable building. Therefore it made more sense to pull the building down and start again from the ground up. This is one of the reasons why are currently consulting on a revised handbook which is logically structured over six sections. It is also important to emphasise that we see this new handbook as an organic document which will evolve and develop over time.
B.3 Timing issues
Implementing AIFMD is a multi-facetted task which goes beyond writing a new rule book. There are also issues in terms of updating existing legislation, devising new authorisation processes, being prepared to implement the reporting requirements under AIFMD and adapting our supervisory approach for the future. Conscious of the time that this would take and also the increased workload on staff at the Central Bank, Department of Finance and the Office of the Attorney General arising from Ireland’s imminent role as President of the EU Council, we saw the urgency to do much of the preparatory work this year. We were attentive to industry representations to the effect that AIFMD ushered a period of uncertainty which could be best resolved by consulting as early as possible with the policy positions which would be incorporated into our new rule book. On this point, both the Central Bank and industry were aligned.
That said, given the points I have made earlier about AIFMD and our new AIF rule book complementing each other, the new AIF handbook will not be effective before July 2013.
B.4 Further regulatory change
Regulatory change affecting the funds industry does not stop with AIFMD. Further changes are expected to the UCITS regime in relation to depository requirements and remuneration. Also, the lively debate on shadow banking reform is likely to lead to recommendations from the European Commission in relation to money market funds early next year. Matthew Elderfield covered these points in his speech at the IFIA Annual Conference last September.
One of the issues which continues to challenge financial regulators when it comes to the authorisation of UCITS funds is the diversity of the types of fund which are being authorised. Looking across the population of UCITS funds, I see great diversity in terms of the use of leverage, the types of assets being invested in, the derivatives strategies being employed, the types of indices being referenced and variations in the use yield enhancement techniques. And the trend is mostly one way in terms of greater complexity.
More and more, I can see that less sophisticated investors (whether retail or otherwise) will struggle to unravel the risks and complexities of some UCITS products. Mindful of this, and the potential for regulatory reform to address these concerns, we saw the revisions to our non-UCITS rule book as a genuine opportunity to create a regulated non-UCITS product which might be more appropriate for more complex funds that are currently being authorised under the UCITS framework.
B.5 Catering for investor diversity
In time, we believe that the AIF handbook may be seen as a crucial step in creating a range of funds products which span the spectrum of investors measured in terms of sophistication and investor capability.
You will be aware that ‘disclosure based regulation’ has come under the spotlight in recent years. In the past, strong arguments were made that comprehensive disclosure would discharge issuers of their obligations to protect investors. It is clear that investors are not always protected if they cannot assimilate the messages hidden in large prospectuses, information memoranda and offering circulars. That said, the extreme alternative to disclosure-based regulation is merit-based regulation where the financial authority acts a filter for what is to be issued. One sensible and practical approach to addressing the weaknesses in disclosure-based regulation is to attempt to align investor capability with the types of regulated fund. The current consultation is a response to this. From July 2013, we expect that there will be three types of Irish authorised funds – UCITS, RIAIF and QIAIF – catering for three distinct segments of the investor population.
C. Challenges encountered along the way
Allow me to talk about some of the key policy issues which we considered in preparing our draft AIF rule book:
1. Promoter requirement: It is currently not possible to establish an Irish AIF unless the promoter has been accepted by the Central Bank and acceptance is based, amongst other things, on matters such as regulatory status and amount of capital. In the past we have relied on this promoter requirement to ensure that there is a party who can step in and work with the Central Bank when the board of a fund ceases to function in the interests of investors. In the light of the future regulation of the AIFM we believe that this requirement can be removed. The consultation plays an important role in clarifying the obligations of directors under the Fitness and Probity Standards when funds get into difficulties.
2. Circumventing the AIFMD regime: When we introduced the QIF regime in Ireland some years ago, we realised that it would be necessary to impose certain eligible asset restrictions around QIFs investing in other funds. There was, and is, little point in devising a regulatory regime which can be easily circumvented where investment is channeled through another unregulated vehicle. AIFMD does not address this point, as such. This is less an issue about feeder funds as defined in AIFMD and more an issue of which sort of assets should be eligible. Therefore, we have replicated the current QIF requirements and indeed clarified them somewhat.
3. Liquidity - fairness to all investors: I mentioned at the outset that there are elements of the AIFMD which will impact on areas of fund regulation which are currently subject to prescriptive rules by the Central Bank. The way in which we have regulated share classes is a case in point. To date we have required that all share classes within an investment fund (or within a sub-fund in the case of an umbrella fund) should be subject to the same dealing arrangements. In the light of the requirements of AIFMD in relation to fair treatment of investors and conflicts of interest, we accept that investors in QIAIFs (as distinct from RIAIFs) should be able to grasp the impact of investing in a share class which has different dealing frequencies to other share classes.
4. Use of side-pockets: The credit crises showed that the use of side pockets can be a useful tool for fund managers in the case of distressed assets. I would draw you attention to the FSB report on Shadow Banking (released two days ago) which also raises the possibility of using side-pockets to mitigate runs. We currently prohibit all funds, including QIAIFs from allocating newly acquired assets to side-pockets. There are calls for a relaxation of this prohibition. The consultation paper sets out the questions we have in this regard. We would encourage your considered response to this.
5. AIFs with AIFMs below the threshold: In drafting the AIF Handbook, one of our key decisions has been to place reliance on various requirements originating from the AIFMD and this has led to the removal of a number of overlapping requirements which have previously applied our domestic regime. But that leaves opens the question as to how those RIAIFs and QIAIFs with AIFMs which fall below the AIFMD thresholds should be treated. It was undesirable that there should be two categories of funds depending on whether the AIFM is above or below the threshold implying two sets of requirements in relation to transparency, depositories, valuations etc. Having given the matter some thought, we are proposing that all RIAIFs and QIAIFs should be subject to equivalent requirements. Therefore, where we have relied on the AIFMD to justify waiving certain domestic requirements on AIFs, we are proposing to extend AIFMD-like requirements to all RIAIFs and QIAIFs.
D. Future supervision of funds and funds service providers
I would like to take a few moments to talk about the supervision of funds and fund service providers.
Last June, I had the opportunity to present to many of you the Central Bank’s new approach to the supervision of funds and funds service providers. For those you who may not have been at that breakfast briefing, I explained how the Central Bank's new risk-based supervisory approach - called PRISM - prioritises our supervisory resources. Essentially, this framework divides all of the different types of regulated entity into four impact categories. Impact is measure of the damage or harm which would result from a failure of the firm. The minimum level of supervisory engagement of the Central Bank depends on the impact categorisation. In general, higher impact firms get more supervisory attention, lower impact firms receive less supervisory attention.
For the most part, the funds industry comprises of lower impact entities. However, the Central Bank recognises the funds industry as ‘high impact industry’. This means that while we are concerned about the damaging effects of a regulatory failure at an individual firm, we are also concerned about the damaging effects which such a regulatory failure could have on its peer group in such a high-profile industry. So our supervisory approach has a firm-specific focus (aligned with PRISM) and a sectoral focus based on the scale of the funds industry, its ever-evolving nature and the need to be current with the attention it receives from international policymakers.
For funds and fund service providers, PRISM went live last May. Six months in, many of you may not yet have had the experience of this new approach. For the coming year, supervisors will be especially attentive to (amongst other things) (i) the quality of systems and controls and (ii) the quality of regulatory returns. This will be picked up through full supervisory risk assessments of our medium-high and medium-low impact fund service providers as well as thematic inspections of firms selected from the population of administrators, custodians and fund managers.
The Central Bank is prepared to take decisive action when there are regulatory breaches so as to protect the interests of market participants and/or preserve the integrity of the regulatory system. A risk-based supervisory approach necessarily devotes fewer resources to lower impact regulated entities. The quid pro quo for this supervisory approach is a willingness to impose sanctions where there are failures to follow the rule-book.
More specifically, we have put a lot of effort into building our capability to receive regulatory returns from funds and funds service providers electronically. Accurate and comprehensive data is an efficient way for the Central Bank to monitor the activities of firms whilst focussing our resources where it matters. It is worth mentioning the reporting obligations of the AIFM here. These regulatory returns fulfill three roles: prudential assessment of firms’ financials and operations, informing the Central Bank on key trends and assisting the European Systemic Risk Board in filling out the larger picture of systemic risk across Europe.
As the expression goes: ‘garbage in – garbage out’. We cannot allow poor regulatory returns to undermine the supervisory effort and to ultimately damage the interests of investors and issuers. Where we encounter sloppy approaches to regulatory returns – as with other regulatory breaches – we will be prepared to take enforcement action.
To conclude, a long road has been travelled so that we could issue the consultation on the new AIF regime at the end of October. But the journey continues. There is still a lot of work to do in the coming months and the consultation process offers you all an opportunity to provide constructive input on a new regulatory framework which may endure for a number of years to come. In settling the key policy questions at this stage, we believe that we have provided a clear path to implementing the AIFMD which removes as much uncertainty as possible. I believe that this is good news for all involved in the Irish funds industry.
I urge you all to respond to the Central Bank’s consultation on the implementation of AIFMD. To remind you of the steps to follow, the Central Bank will issue a response to the consultation along with a revised handbook reflecting our considered view on the adjustments which need to be made in light of the responses by end of January. There will then follow a detailed technical review of this handbook to ensure that the policies which have been adopted can be implemented within our supervisory framework and are enforceable. A final version of the AIF handbook - which may look somewhat different but which will, in substance, be the same - will issue after that review has been completed.
I would like to thank IFIA for their positive engagement at crucial junctures during this process. As I have explained, there were a number of issues which the Central Bank considered over the last few months and I am grateful for the constructive approach which was taken in supporting the Central Bank’s work.
Finally, I would remind you that AIFMD is not the last word on regulatory reform in the funds industry. Further changes in relation to MMFs and UCITS will follow. But I am confident that the current consultation charts a path ahead which will complement further changes.
Calvino, N., (2006), “Public Enforcement in the EU: Deterrent Effect and Proportionality of Fines”, European University Institute
Central Bank (2011), “PRISM Explained”
Central Bank (2012), “Proposed changes to the regulatory reporting requirements of Irish authorised collective investment schemes”, Consultation Paper CP59
Central Bank (2012), “Consultation on the implementation of the Alternative Investment Fund Managers Directive”, Consultation Paper CP60
IOSCO (2010), “Objectives and Principles of Securities Regulation”
Jackson, H., (2008), "Variation in the intensity of Financial Regulation: Preliminary Evidence and Financial Implications", Harvard Law School.
Murphy, G., (2012), Address at 3rd Prospectus Directive Conference hosted by Euromoney, London