Address by Martin Moloney, Head of Markets Policy, Central Bank of Ireland to the International Bar Association

02 October 2012 Speech

Continuity and Change in the Regulation of Investment Funds in Ireland and Europe

I am very happy to be here to talk to you this morning about some of the issues in the regulation of UCITS which your eminent panel will be discussing later in the morning. I also want to touch on some non-UCITS issues as I understand there is another panel discussion tomorrow on that area.

I cannot cover all the topics which are currently on the regulatory agenda. I will confine myself to some of the more significant points, though, of course every point is significant to someone.

If anything, the financial crisis has increased the importance of UCITS as an investment product particularly for institutional investors, apparently attracted by the regulatory standards attaching to this class of product.

What we see here is investors themselves, voting with their funds for an investment option that does not place all the emphasis on disclosure to investors and the role of ‘caveat emptor’, but which has hard-wired a number of protections into the structure of the product.

It is striking that many of the investors who have chosen to place funds in this highly regulated product are sophisticated investors who also have easy access to less regulated alternatives which promise higher returns and lower costs. It is clear to me that there is a robust place in the market, even among sophisticated investors, for a highly regulated product.

The introduction of the AIFMD will allow us to differentiate more effectively between that more regulated product, the UCITS, and the less (but still firmly) regulated product, the Alternative Investment Fund, or AIF. In the fullness of time, the AIFMD and UCITS regime are likely to have common elements which provide investor protection whilst at the same time accommodating investors with different capabilities and risk appetites. By establishing a European regulatory framework for the regulation of managers of an AIF, the EU facilitates countries like Ireland to refine our domestic non-UCITS funds regulatory regime in order to create a more coherent, layered set of regulatory regimes for investment funds. I have noticed an increasing amount of comment about how the UCITS regime and the AIFMD regime are likely to influence each other. I think that is correct in some respects. Sometimes one regime will set a standard that the other should conform to. But we must also recognise that sometimes one regime will set a standard that the other need not conform to. Each adopting a different approach can at times facilitate different investor preferences.

Forthcoming Legislation – UCITS V

Indeed, UCITS V in many ways replicates some of the standards set out in the AIFMD. Some in industry worry that the UCITS legislation and AIFMD legislation will begin to chase each other up an ever higher scale of regulation, commencing with tightened regulations for UCITS because they have already been tightened for AIFs or AIFMs and proceeding then with the tightening of rules for AIFMs because they have been tightened for UCITS.

I do not wish to see such an escalating pattern. It would not be sensible. Of course, emotive arguments comparing the regulation of one type of investment fund to the other will be made. But we need to be clear that there are as strong arguments for applying different standards as there are for applying the same standards. We in the Central Bank will continue to be sensitive to those arguments.

The fact that we support the bulk of the UCITS V proposals does not count against that. The clarifications on the meaning of the duty of safe-keeping and the duty of supervision and monitoring on the part of the depositary are mostly sensible. The requirements on cash monitoring are also reasonable. We also strongly support the proposals on sanctioning which, in our view, is an essential part of an effective regulatory model.

One area where we think there is further work to do on UCITS V is in the area of eligibility to act as a depositary. Both in UCITS IV and in the AIFMD, entities subject to prudential supervision may act as depositaries. UCITS V seeks to limit this category to MiFID Firms and EU Credit Institutions. We have in this country a well-established regime which has long placed huge emphasis on the responsibilities of depositaries. It has not been our experience that they need to be either banks or MiFID firms to act effectively as depositaries. On the contrary, many of our most responsible and effective depositaries are neither.

I don’t propose to discuss either the remuneration proposals of UCITS V or the liability rules for depositaries. The debate seems to me settled by the AIFMD discussions. The challenge I see is an operational one for industry to spread the increased risk and ensure reward appropriately follows risks assumed.


I have no doubt the real debate over the next period will be on UCITS VI. Among many questions posed by the EU Commission in its consultation on UCITS VI, the key ones are probably those relating to eligible assets, leverage and collateral.

We see a significant portion of the more complex investment strategies in some Irish UCITS and it is hard to criticise the Commission for the questions they ask. I think there is some scope to move away from some of the more complex investment strategies which have emerged in recent years, where those more complex strategies either go along with higher risk or where such strategies are unlikely to be understood by their target audience.

In our view, the way this debate should progress is to focus on the least transparent and highest risk exposures. I think there is a case for looking very carefully at the role of indices in the structuring of UCITS investment strategies. Many will think that the recent guidelines issued by ESMA address concerns arising from the use of indices. I have heard it suggested that there is no need for further work. These guidelines have addressed the transparency of indices, but they have not been able to deal with the underlying question of the extent of exposure through indices to ineligible assets. They have attempted to deal with the issue of bespoke indices, but they are untested in that regard.

There is an interesting cross-reference here to the AIFMD situation. UCITS cannot currently invest directly in commodities. But I do see a case for investment by retail AIFs in at least some commodities, particularly those which benefit from a structured, liquid market. We would need to see a careful risk analysis of the issues around liquidity, safekeeping arrangements and valuation. But we are happy to engage with people to discuss these kinds of strategies.

The UCITS VI consultation also raises the question of use of collateral. Here again we think the ESMA guidelines have made a lot of progress in the right direction, although the ESMA guidelines did not go as far as our domestic regime. We require the full collateralisation of securities lending transactions. We believe that a good outcome from the UCITS VI discussions would be for Europe as a whole to move to this position. Securities lending should be, in effect, a relatively risk-free benefit to investors.

However, we do not believe that improved rules in relation to eligible assets or collateral are sufficient. Product rules will always give rise to anomalies. UCITS can have indirect exposures to many ineligible assets, for example by investing in the shares of corporations who are commodity producers. We believe that perhaps the most important questions asked by the UCITS VI consultation relate to the question of leverage and in particular how leverage is measured, for example should it be risk-adjusted leverage. What facilitates the current scale of leverage is the ability of UCITS to apply a VaR approach to the calculation of global exposure in lieu of the often more apt but somewhat more restrictive Commitment Approach.

We are not convinced that UCITS VI can meet the underlying concern about overly complex investment strategies without facing up to the issue of leverage. And if an attempt were made to do so without facing up to that question, there is a danger that we will see overly restrictive eligible asset rules emerge.

If we do not face this problem in a granular way, I think it is inevitable that the Commission will end up revisiting the ‘look through’ rule in its entirety. The obligation is on the industry itself to come forward in a constructive way with solutions which deal with the heart of the Commission’s legitimate concerns.


Another important set of issues in the consultation relate to Exchange Traded Funds. The heart of the issue in relation to ETFs is their success. There are concerns surrounding both liquidity and collateral transformation. The significant growth in ETFs, including the increased growth in those which provide exposure to less traditional non-equity indices, must be considered carefully, not least because of the potential impact on retail investors if an ETF suffers a large sell off to the extent that the market makers are unable to provide the necessary liquidity.

The original concept behind an ETF is a sound one and providing retail investors with flexible and relatively cheaper access to an underlying index should be defended. However the increased use of ETFs by non-retail investors and the potential illiquidity of underlying indices which ETFs increasingly provide exposure to are subjects which should be reviewed and UCITS VI provides the opportunity to do so. The IOSCO Principles on the Regulation of ETFs published in March this year have highlighted the particular conflicts of interest which can arise in an ETF from the involvement of affiliates and these require careful consideration.

The transparency rules to be applied to ETFs arising from MiFID II will assist this debate, by ensuring that secondary market trading is appropriately reported.

Money Market Funds

If I turn now to the questions concerning money market funds in the UCITS VI consultation, it is important, I think, to see the questions posed as part of the shadow banking debate, on which the EU Commission also held a more broad ranging consultation earlier in the year and on which IOSCO and the Financial Stability Board have a number of work streams on-going.

Let me first make some general observations about the shadow banking debate before turning to the specifics of the issues raised concerning money market funds. It seems to me that there is still a lot of uncertainty around the objectives of this debate. We are trying to tackle the contribution of shadow banking to financial instability. That contribution is closely connected to the ways in which leverage and maturity transformation can be achieved without intermediation by banks. The relevant processes are distributed processes, not conducted by single institutions and many of those processes are currently subject to securities regulation.

That leads to difficult problems for regulators. Securities regulators are focused on investor protection. They are not well armed to design regulatory frameworks with other objectives. But the purpose of regulation of the shadow banking system is not investor protection, it is financial stability. Secondly, prudential regulators are focused on the regulation of firms and strengthening the stability of the system by setting capital, liquidity and organisational requirements which make firms more robust.

But the appropriate method of regulation of shadow banking might not be the imposition of prudential requirements on firms; it is more likely to be the regulation of the complex, distributed securities market activities which create an intermediation effect, although no one sector or activity constitutes the singular heart of that process. What we need to do is to impose controls within those complex intermediation processes which make it more difficult for them to unwind in a crisis. Therefore, neither school of regulators is well placed to tackle this problem. The danger we face is that faith will be placed in measures which either improve investor protection or measures which improve the financial stability of individual firms. Neither outcome is likely to fit the problem well.

I think we see these challenges in the overall shadow banking debate reflected in the consideration of the money market funds issue. Money market funds are certainly part of the problem. The funds they raise finance a range of activities through the bank deposits and short term securities they invest in. Nor is this is not just an American problem, just because the U.S. sector is almost three times the size of the EU sector. As has been pointed out, European banks have been large receivers of short-term dollar funding from US money market funds, and at the same time European bank have been large investors in US securitised credit, thus intermediating between US investors and US borrowers.

Concerns about ‘run risk’ in this sector are well grounded. During the week of September 15, 2008 over $300 billion was withdrawn from prime money market funds in the U.S.

It has been widely observed that there is an additional incentive for Constant Net Asset Value or ‘CNAV’ fund investors to withdraw their funds in this kind of circumstance. A lot of attention has been focused on fixing that CNAV problem. Fixing the CNAV problem works well as an objective for securities regulators because we prefer transparent pricing and valuation. Imposing capital requirements fits well with the thinking of prudential regulators because it is what they know. Could it be, that by focusing on the CNAV problem and advocating either conversion to VNAV or capital requirements, we are adopting solutions which prove attractive because they allow us regulators to focus on options we understand and are comfortable with? We need to be sure we are making progress on the underlying issue.

Let us not fall into the trap of focusing disproportionately on CNAV funds just because something must be done. I have heard such a sentiment expressed and it seems to me very unwise. Let us also consider carefully how much or how little is achieved by eliminating such CNAV-specific incentives. Even if the CNAV issue were eliminated, there remain obstacles to investors in VNAV funds being well informed because many of the instruments in which they invest are not capable of being valued on an open market basis.

The threat of a run on money market funds by well informed investors remains even if all those problems have been fixed. This is the fundamental issue. It is not enough to eliminate perverse incentives to a run; we must also recognise the importance of rational incentives to run in a crisis.

One lesson of 2008 appears to be that there are circumstances in which investors in prime money market funds will consider that investment strategy too risky and will move to safer investments. At that point in a crisis, there is a conflict of interest between investors in money market funds and the overall public interest in maintaining financial stability. We need to be sure that we have taken steps which make it likely that the potential impact of such a rational, informed ‘flight to quality’ when the risks inherent in CP programs and bank deposits are actually rising, will be tackled very quickly and firmly. If and when such a scenario emerges, there will be only hours, days at most, to organise a coherent international response. We will not have time to devise those solutions then.

This is not the way we securities regulators usually pose regulatory problems. Usually we are trying to facilitate the rational, well informed investor. In the shadow banking debate, perhaps that is no longer the case.

A second problem which concerns me is the need to coordinate our approaches to this issue. By all means, let us fix the incentive to run which is inherent in CNAV funds, but let us do so in a manner which is based on strong international consensus and which is viable for the massive U.S.-based CNAV industry. The reality is that the SEC did issue the exemptive rule, known as rule 2a-7 back in 1983 and until mid-1986 Regulation Q did limit bank deposit interest rates in a way which gave the money market mutual funds a huge initial regulatory advantage. We might not have wanted to start from here, but with that initial regulatory boost, this is now an international industry and the changes to be made now need to be proportionate, appropriately gradual and reduce the incentive to run while being minimally disruptive.

In a year or so’s time, when this debate on the shadow banking implications of money market funds has run its course, it would be well-worth asking ourselves if we have either formulated proposals to deal with this underlying threat of a run by rational, well-informed investors or established clearly that it is not a problem.

Meanwhile, the publication of IOSCO’s policy recommendations is an important next step, which should inform the UCITS VI debate. We look forward to that. What will be disruptive is if the U.S. and the EU go down substantially different paths. This is a point we have already made in response to the original EU Commission consultation on shadow banking. We will continue to play our part within IOSCO and ESMA, emphasising that point and the potential we see for the development of a shared or at least mutually consistent approach focused around the fundamental issues.

IOSCO has a strong record of getting to the nub of securities regulation issues and establishing principles which can be very widely agreed and implemented. At this point in time, when there is uncertainty, particularly in the U.S. as to what the correct stance is, it is particularly important that IOSCO put in every effort it can to achieve a shared understanding internationally about the nature of the issue and the best outcomes to aim at.


We are not in a position to talk today about the AIFMD Level II delegated acts, due from the Commission. But I want to say something about the underlying issue, given the speculation there is that whatever emerges as the AIFMD position on the question of delegation is likely to transfer across to the UCITS legislation.

When I first became involved in investment funds policy, one of the first things that struck me was the use in the law of the term ‘letter box entity’. I have had some involvement over many years in writing legislation and the term immediately jumped out at me as inappropriately vague. The term has within it an embedded metaphor which suggests that those who came to rely on it did not have an agreed or well developed understanding of what they were talking about.

I am glad therefore that, the EU Commission have taken the initiative to tackle the problem. Their work on this will bring long needed clarity at a European level as to what problem we are dealing with. It was inevitable that at the margins, it would be controversial.

However, in this jurisdiction we have been working for over twenty years on this issue. Our perspective has evolved as our experience of the regulatory risk has evolved.

Looking back now, our decision some years ago to move away from collective board responsibility towards designated person responsibilities has proven wise. It was not done without difficulty and I’m aware that many directors continue to be uneasy with the level of responsibilities they now have to take on. But it was right to learn from our experience and to continue to develop the regime to ensure that investor protection outcomes were delivered.

We view the debate around the AIFMD Level II delegation provision and the possibility of an impact across to the UCITS regulatory framework against that background.

The next question for us is how we adapt our regime in light of the Level II text. I cannot be definitive about that without seeing the final text. Our central responsibility will be diligently to implement the requirements as finalised. Meanwhile, I can only identify for you some of the elements which will go into our thinking.

Firstly, let me talk about how thinking within ESMA will influence our approach. The collective views of our colleagues are important to us. Prior to the European Commission’s presentation of its draft provision on delegation, ESMA addressed delegation by AIFMs in its Discussion Paper of 23 February last titled – “Key concepts of the AIFMD Directive and types of AIFM”.

ESMA referred to the definitions in the AIFMD of “managing AIFs”, which the Directive defines as performing at least the investment management functions of portfolio management and risk management. The Discussion Paper goes on to provide that “ESMA considers that an AIFM may delegate the two functions (i.e. portfolio management or risk management) either in whole or in part, in the understanding that an AIFM may not delegate both functions in whole at the same time.”

This captures something central to our approach. Irish UCITS management companies are subject to the UCITS regulatory regime which also prohibits delegation of functions to the extent that a management company becomes a letter box entity. The Irish regulatory regime implements the UCITS Directive by describing in detail the functions and responsibilities of the management company. Where the management company delegates activities, Irish rules require that an individual must be identified who will, on a day-to-day basis, monitor and control each of the activities identified as responsibilities of the management company. This regulatory regime is designed to ensure therefore that the UCITS management company functions are never delegated in whole because the UCITS management company is not permitted to delegate senior management functions including the setting of the investment policy and strategy for the UCITS, thereby ensuring that these are complied with and that the risk management system is applied.

Our starting point therefore will be that an AIFM is not permitted to delegate the investment management functions of portfolio and risk management in whole. Secondly, we have to consider the quality of what is retained. What is the substantial margin of delegation which should raise concerns?

Let us consider the test of whether the delegated regime is as robust as an internally based regime. This is surely the toughest reasonable test we can apply. An internally based investment management function will or should be structured with robust corporate governance though which an Investment Committee establishes investment strategy, based on a client mandate, designs tolerance levels and ensures employees act in accordance with their directions by supervision. Normally the Investment Committee does not interfere in the day-to-day investment process. Implementation is the remit of the Chief Investment Officer and his or her team. Within the firm, there is extensive delegation to specialised teams, typically drawn along lines of the main asset classes of interest to the investment firm. This model is replicated down the hierarchy with heads of specific risks (normally geographically or by sector for equities, by currency and credit for bonds), down to the individual fund managers or traders.

What we see here is an extended hierarchy, strict reporting lines and efficient transmission of orders/strategies from the top to the bottom ensuring consistency, but also preserving the autonomy and expertise of the traders at the coal face to facilitate quick responses within allotted trading limits. Investment Committees do not engage in stock picking. They do not eliminate but rather manage the risk of delegation of tasks. The key protection for investors is the oversight and supervision by the Investment Committee. This is a relevant benchmark.

It is not perfect. Indeed we in the Central Bank are familiar with more than one case of significant losses arising because of the failure of such internal governance frameworks. Even within a firm which delegates nothing to outside entities, there is a significant risk linked to the need for specialised and incentivised front line staff. But the right management technique is a clearly articulated mandate and strategy, comprehensive and timely reporting arrangements and expert and engaged Investment Committee members.

You can, I hope, see my point. It is possible to have a high level of delegation and good control and no delegation with poor controls. How then do we test the matter with individual AIFM?

This brings me to the third factor that will influence us in considering the level II text when it emerges, that is the Report of the Technical Committee of IOSCO on Delegation of Functions. While this document was produced in December, 2000, it continues to be a sensible summary of matters that all regulators should focus on.

It highlighted the need for what would have then been the international equivalent of the AIFM, which it calls the CIS Operator, to have the competence and experience to manage the fund efficiently. It emphasised the importance of the independence of the AIFM. It emphasises the need for the AIFM to have yardsticks to measure the quality of service provided. It warns, in particular, of the dangers of sub-delegation and the need for the AIFM or rather CIS Operator to control sub-delegation.

We will be informed by this guidance in seeking to identify any refinements to our regime which may be necessitated by the AIFMD Level II requirements in their final form.

I have heard it suggested that the multi-manager model may be hit by these provisions. The multi-manager model is one in which a fund engages different portfolio managers to manage its assets in separate accounts, with discrete asset portfolios being allocated for management across those individual portfolio managers. At this point – in advance of the publication of the Level II final text – it seems to me that as long as the arrangements under which those various portfolio managers are appointed are each robust and independently decided on by the AIFM, I do not currently see that there should be a fundamental issue; although we will need to reflect diligently on the Level II requirements when they emerge.

I will say one more thing about this. Whatever the requirements under the AIFMD, the board of any Irish regulated manager of funds must fulfil its responsibilities. Should that job become too onerous, it is important they would make this known to the promoter and other responsible parties and ensure that they have adequate support to do their job. Should they fail to achieve that, that will become evident to us and we would then have to reflect on any such pattern which emerged and take appropriate action.

AIFMD Consultation

Turning to the AIFMD more generally, we are in the process of designing our non-UCITS (or AIF) regime in the context of the implementation of the AIFMD into national law. While a significant number of our existing AIFs are marketed solely to professional investors, as QIFs, we have a number of retail investor AIF. AIFMD implementation is providing an opportunity to consider an appropriate regime for these in particular. In many cases the existing regime for retail investor AIFs, particularly for AIFs investing in equities, bonds and/or money market instruments, is based on UCITS, although the fact that relatively few retail investor AIFs have been authorised in recent times has resulted in little development of retail investor AIF policies.

We believe that there is an argument for retail AIFs to occupy a space, in terms of risk appetite and reliance on disclosure, somewhere between UCITS and Qualifying Investor AIFs. Therefore as a starting point, the extent to which UCITS are permitted to use derivatives should also be open to retail investor AIFs. Our retail investor AIF regime will also provide for asset classes which are not available to UCITS, including real estate and venture or development capital funds. I would like to stress however that the Irish AIF legislation does not prohibit any asset classes for retail investor AIF. Therefore the Central Bank is willing to consider any type of investment fund for retail investors where the proposal presented to us indicates the type of safe-guards which should apply to the particular category.

In this regard, and as I mentioned at the outset, in the light of recent and forthcoming developments which will affect UCITS it may well be that Retail AIFs, where the AIFM is subject to the AIFMD, may well become the product of choice for a number of promoters. This could be a good outcome for investors allowing those which wish to have access to alternative asset classes or strategies, the ability to do so in the knowledge that the AIF does not have all of the protections afforded by UCITS.

Our public consultation on this will come out at the end of this month. It will have a number of key features which we will outline in more detail at the time. For now, I want to emphasise that when this consultation is published, it will not represent the finalised position of the Central Bank. This is a real consultation. We recognise that all these matters are matters of judgement. Therefore we are very much open to hearing views and reflecting carefully on them. I hope that you will take the opportunity to bring your experience to bear by contributing to that consultation.