Address by Director of Markets Supervision, Gareth Murphy, to the 5th Annual Funds Congress

10 February 2016 Speech


Good afternoon ladies and gentlemen.   I am grateful to the organisers for the invitation to speak today.

Today, I would like to talk about supervision.  Supervision matters in the funds industry.  I will talk about which matters are most current and why supervisors have a particular role to play at this juncture. [1] 

Change in the European funds industry, over the last 5 years has been dominated by an alphabet soup of regulation: AIFMD, EMIR, UCITS V, MiFID II, PRIIPs, MMFR, SFTR, PRIIPs, EuVECA, EuSEF and ELTIF some of which are still to be finalised.  These instruments alone cover thousands of pages of directives, delegated acts, technical standards, guidelines, opinions, statements and Q&A documents.  Whilst regulatory policy developments have garnered significant, and at times critical, attention, supervisors are getting on with their work deploying a range of tools which include:

(i)    pre-planned on-site inspections and risk assessments,

(ii)  reactive supervisory investigations,

(iii) analysis of regulatory returns,

(iv) thematic reviews, and

(v)  fitness and probity assessments. 

Supervision is typically unseen and unglamorous work.  But supervisory engagement can be very effective at steering firms on the straight and narrow.  And it plays a critical role ensuring that risks are identified, that investors are protected as well as informing ongoing policy debates at various fora including ESMA, the ESRB, IOSCO and the FSB. 

This afternoon, I will focus on four areas of current supervisory focus:

  • IT and cyber risk;
  • Disclosure of investment fund fees;
  • Leverage; and
  • Stress-testing of investment funds.

1. IT and Cyber Risk

Let's start with IT and cyber risk.

The basic economic proposition of new technologies is speed, efficiency and convenience.  Some of the most interesting areas to benefit from technological innovation relate to (a) payments and settlement, (b) information and distribution, (c) securities registration and (d) identity verification.  These are all areas of interest to the funds industry.  But new technologies also pose risks – especially the threat of cyber attack.  

Not a day goes by when the issue of cyber risk is out of the newswires.  The threats are insidious and particularly challenging since there are many ‘unknown unknowns‘.

Back in 2014, the Central Bank identified the threat of cyber attack as a major risk area for investment firms, fund service providers and asset managers.[2]] Early in 2015, a themed inspection of a sample of these firms was concluded.  The early phase of that themed inspection involved a survey of firms‘ arrangements for tackling cyber risk.  Whilst the aim of the questionnaire was to enable the Central Bank to frame the next, on-site, phase of the themed inspection, in the event, given the topical nature of the issue, the survey questionnaire was recycled by professional services firms and redistributed to the industry at large as a framework for assessing cyber risk.   This was timely, especially since one of the main conclusions of the themed inspection was that firms needed to embed a broader awareness of cyber risk amongst their staff and that this culture of risk awareness needed to be driven from the board.

Moving beyond the development of a risk culture, one of the biggest challenges is determining the nature and scale of the investment required to counter cyber risk.  Tackling this threat requires people, systems and vigilance.  This requires an ongoing commitment from both financial authorities and regulated entities as the threat adapts and evolves.  For sure, this will be an area of supervisory concern for years to come as technological change drives business change. 

2. Disclosure of investment fund fees

Another topical area of discussion is the question of investment fund fees.  At the heart of this discussion, there are concerns about the efficiency of pricing in investment fund markets. 

Put simply, "are investors getting what they think they are paying for?" 

This is a significant question in view of the important role that investment funds play intermediating the supply and demand for capital and, in particular, in facilitating pension planning where small variations in annual fees can compound into significant impacts in retirement.

Effective disclosure is at the heart of investor protection.  With the prospectus and the KIID, there is a clear framework for funds to make these disclosures.  However, more work needs to be done to assess whether the communication of this information is leading to an outcome whereby investors are efficiently discriminating between funds. 

Indeed, it is perhaps not surprising that in a market environment where there are a large number of investment funds to choose from and where comparisons between funds can be challenging, investors may struggle to efficiently process the information they receive. [3]Sometimes too much choice and too much variety can be overwhelming, especially for non-professional clients.      

Various financial authorities have conducted supervisory work looking at aspects of this issue, such as closet index tracking[4] and value for money[5].  The Central Bank announced a themed-inspection amongst its 2016 supervisory programme which will look at Total Expense Ratios.   Using funds' regulatory returns, a statistical analysis will be conducted relating Total Expense Ratios with various characteristics of Irish- domiciled funds.  The aim of this exercise is (a) to build up a data-driven approach to understanding Total Expense Ratios and (b) to identify funds that are outliers.  This is a resource-efficient approach to filtering through a large population of funds and to identify those that warrant follow-up supervisory engagement.

3. Leverage

I'll say a few words about investment fund leverage. 

Under AIFMD:

  • Leverage is currently defined as anything that increases the exposure of an AIF;[6] and
  • National authorities are empowered to impose limits on the level of leverage that AIFMs employ so as (i) to curb the contribution of this leverage to the build-up of systemic risk in the financial system or (ii) to mitigate the risk of disorderly markets.[7]

As financial authorities consider the development of macro prudential powers across different financial sectors, the question arises as to what such powers may look like for the European alternative investment fund industry. 

Let's not forget, that concerns about the investment funds industry relate, in particular, (i) to its interconnectedness with other parts of the financial system, (ii) to the orderly functioning of markets (iii) as well as the risk of interruptions to the flow of finance to the real economy. 

Investment fund liabilities are predominantly equity subscriptions from unit-holders.  They are fundamentally different from banks or insurance liabilities.  However investment firms can borrow in different ways and leverage is an accelerant - excessive leverage can exacerbate these systemic risks.

My concern is that the concept of leverage in AIFMD is too broad and it is not aligned with metrics in other contexts such as in the banking regulations.[8]  Specifically, the various leverage metrics mandated under AIFMD (and UCITS) - namely the 'commitment' method[9]and the 'gross' method[10] - embrace a broader set of risks than those associated with external credit finance such as (a) margin financing, (b) collateralised swap payoffs and (c) borrowing.

If I could offer an example that harks back to my trading days, a long out-of-the-money put option position runs the risk that the put option premium will be lost as the option expires out-of-the-money.  But that is a completely different to the risk of being short the same out-of-the-money put option where the adverse scenario is that the option expires in-the-money.  It is the difference between buying insurance and writing insurance.  And yet the 'gross' calculation method treats both of these positions as being the same. 

As I have said on a number of previous occasions, alternative investment funds have many risks;  not all of these risks may be the same and one should not attempt to measure all of these risks under the banner of a broadly defined concept of leverage. 

As work progresses to develop a procedure to exercise macro prudential powers to limit leverage, it is clear that the definitional question of 'leverage' which I have just highlighted needs to be addressed.   There is scope for this to be refined in the context of the review of AIFMD which must be completed by the European Commission by 22 July 2017 (under Article 69 of the directive).  This review may also provide an opportunity to seek a broader alignment with other financial sectors and with other jurisdictions. 

In the light of the data being gathered under AIFMD, EMIR and (in due course) SFTR, supervisors have an important role to play here as they seek to answer questions such as whether funds with high metrics under the 'commitment' and 'gross' calculation methods have high levels of external credit finance.  This analysis needs to inform the important debates on these definitional and procedural questions around leverage.

4. Stress-testing of investment funds

The final topic I would like to discuss this afternoon is the stress-testing of investment funds.

The first thing to say is that the adverse outcomes for banks and investment funds under stress scenarios are very different. 

  • An adverse outcome in a bank stress event may be a capital shortfall which may even lead to an insolvency or resolution trigger event. 
  • In an adverse outcome in an investment fund stress event, one of two things may happen: either underlying assets become dislocated or the fund is gated, or both.  In effect, the investment fund could become illiquid for a period of time.   

The issue of investment fund stress testing is topical for a number of reasons:

  • first, it is a natural extension of the debate which has already taken place over the last two years in relation to the risks of non-bank, non-insurance systemically important financial institutions (NBNI-SIFI);
  • second, at a time when markets are becoming more volatile and when asset prices have suffered a correction over the last few months, the ability of investment funds to meet redemption requests is an issue of increasing supervisory focus;
  • third, research into the theoretical mechanism of investment fund runs is ongoing and is yet to fully inform the broader policy debate;[11]and
  • fourth, this area (of investment funds stress testing) is an interesting illustration of the value of the data which firms are now required to file.   

So what role can supervision play in this area?

The starting point is the large amounts of data that are being collected about investment funds.  In Europe, national regulators receive various regulatory returns.  The Central Bank of Ireland, draws on three particular regulatory returns to build a picture of funds at a micro- and macro-level.  These are the

  • Annex IV report (required by AIFMD),
  • Sub-fund profile return (which is a national requirement),
  • OFI II return (which is collected under national and ECB regulations).

There are three essential pieces of information in these returns which are necessary for an understanding of run-risk at a system level, these are:

  • the categorisation of the funds,
  • the profile of the fund by liquidity buckets, and
  • a granular composition of the fund portfolios.

Run-risk stress testing must start with a definition of what the stress event is.  For example, the stress event could be (i) a sell-off in emerging markets, (ii) the seizing up of high-yield corporate bond markets or (iii) even the departure of a leading portfolio manager from a large asset management group (as happened with Pimco in 2014).  The key point is that supervisors must have the capacity to interrogate the regulatory returns so as to identify cohorts of funds that can be grouped as being subject to a common stress, as and when such stress events are defined.  Looking back on the various turbulent market episodes of the last thirty years, it is clear that each period of market stress is different and depending on each episode some parts of the investment funds industry were affected more than others.

Beyond the categorisation of funds by a common stress, the next stage of the exercise is to calibrate a stressed redemption event.  Here the duration and depth of the event must be determined and the modelling of interaction between redemption and price impact can be challenging.  Often, extreme episodes of history are useful guides in this calibration exercise. 

The next step is to consider the management of liquid asset buffers: are they run down in response to a redemption request or built up in anticipation of more?   This is an interesting conundrum.  Academics describe proactive liquidity management as (potentially) time-inconsistent.[12]   In a nutshell, liquidity buffers mitigate fire sales today, but the need to rebuild liquidity buffers for tomorrow may trigger runs today.  The supervisory question is: how likely is such an adverse feedback loop and how should such risks be mitigated.

For significant stress events, asset sales will be inevitable.  At this point, the richness of granular portfolio data (such as that collected by the Central Bank under its OFI II regulatory return) comes into its own as it is possible to determine aggregate sales pressure on a security-by-security basis. 

For some securities, like listed equities, it is possible to estimate, using historical data, the impact of asset sales on prices and then to use these price impact calculations to recalculate the NAVs of the investment funds.  This whole supervisory exercise opens up a wide range of possibilities such as:

  • understanding the adequacy of liquid asset buffers at a micro- and macro-level;
  • analysing the potential feedback loop between redemption-driven NAV reductions and subsequent redemptions; and
  • estimating the impact of investment fund redemptions on specific asset markets.

This work on investment funds stress testing still has some way to go.  However, this issue is likely to be quite topical in the near future as a result of (a) supervisory work at national level, (b) exercises such as IMF Financial Sector Assessment Programs and (c) the annual FSB Shadow Banking Monitoring exercises.[13]


Whilst regulatory policy developments have garnered significant and at times critical attention, supervisors are busy getting on with their important work.[14]

If previous years were about major policy debates and new European regulations, the coming years should be about the increased role of supervision: that means greater supervisory convergence across Europe, promoting a stronger culture of compliance in firms focussed on investor outcomes and ensuring that financial authorities have the framework in place to identify risks and take appropriate action.  This will require commitment, experience, skill and data.

[1] It is noteworthy that ESMA’s Strategic Orientation document covering the period from 2016-20 signals a shift from rule-implementation to risk analysis and supervisory convergence.  See

[2] Central Bank publishes findings of Cyber Security Operational Risk Thematic Inspection

[3] See R Dobelli, (2014), "The Art of Thinking Clearly".

[4]Danish, Norwegian and Swedish Authorities:


[5]UK FCA:

[6]AIFMD Art 4(1)(v) defines 'leverage' as  "means any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means".

[7] Article 25(3) says: "...the competent authorities of the home Member State of the AIFM, after having notified ESMA, the ESRB and the competent authorities of the relevant AIF, shall impose limits to the level of leverage that an AIFM are entitled to employ or other restrictions on the management of the AIF with respect to the AIFs under its management to limit the extent to which the use of leverage contributes to the build up of systemic risk in the financial system or risks of disorderly markets..."

[8]For example, Art 4(1)(93) of the Capital Requirements Regulation defines leverage as "the relative size of an institution's assets, off-balance sheet obligations and contingent obligations to pay or to deliver or to provide collateral, including obligations from received funding, made commitments, derivates or repurchase agreements, but excluding obligations which can only be enforced during the liquidation of an institution, compared to that institution's own funds".


[9]See Article 7 of Commission Delegated Regulation (EU) No 231/2013


[10]See Article 8 of Commission Delegated Regulation (EU) No 231/2013

[11] Zeng (2015), "A dynamic theory of mutual fund runs and liquidity management", Working Paper, Harvard University.

[12]See Zeng (2015)

[14] See Moloney K., and  Murphy G., (2013), “The Spectrum of Regulatory Engagement”, Law and Financial Markets Review. Volume 7, Issue 3.