Investment funds, securities lending, and European capital markets - Gerry Cross, Director of Policy & Risk

14 November 2017 Speech

Central Bank of Ireland

Speech delivered to International Securities Lending Association Securities Lending Roundtable


Thank you for inviting me to make some remarks at the close of this roundtable event. Events such as these are important to inform perspectives on the role of securities lending in a funds environment.

Before I turn to more substantive commentary, let me mention the helpful contribution that both ISLA and Irish Funds have made to the development of well-informed policy making in this area. Our interaction with ISLA in relation to securities lending goes back a number of years. Prior to 2012, there were no European rules in this area and it was necessary for the Central Bank to impose securities lending related requirements under Irish domestic legislation. These national rules, which were originally introduced in the very early 1990s, were expanded on and developed over time. ISLA engaged in a constructive manner with the Central Bank in that regard providing technical insights to help us in our role of designing and implementing a financial conduct framework in this area supporting fair, orderly and well-functioning financial markets.

Securities Lending by Investment Funds

You have heard today how funds, particularly index-based funds, appear to be natural companions for a securities lending platform; and how securities lending can contribute valuable income to a fund. You have also been discussing some of the challenges involved, including those coming from the regulatory side.

Let me say something about this aspect. As regulators interested in financial services and markets, which operate soundly and fairly in support of the economy, we are fully aware of the benefits of well-functioning securities lending market. To achieve these objectives, it is of course essential that any use, or re-use of fund assets, is conducted in a transparent manner and within a robust governance framework which operates to the benefit of investors. This is the focus of the Central Bank as a funds regulator with a mandate for safeguarding the interests of investors. The interaction between funds and securities lending activity is complex. It is a delicate balance between ensuring integrity of fund assets, generating revenue and returns for investors in an equitable and transparent manner and facilitating the operation of an effective securities lending market. Of course, funds are seen as a natural repository of available securities for lending. This is particularly so in the case of UCITS because their assets are more likely to be of high quality and will be liquid.

In 2012, ESMA published its Guidelines on ETFs and other UCITS issues, which included the very important section XII on collateral. Many of these collateral related guidelines were similar to the Central Bank’s requirements. For example, we had a long-standing rule, which said that UCITS could not sell, pledge or re-invest non-cash collateral, and the extent to which cash collateral could be invested was limited. We required that UCITS could not enter into securities lending agreements unless the UCITS had the right to terminate the arrangement at any time and to demand the return of any or all of the securities loaned. As is generally our practice, the ESMA guidelines were incorporated into our domestic rulebook and so applied to Irish UCITS as regulatory requirements. However, given the similarity with the Central Bank’s prevailing regime, the challenges in application of these were possibly not as great as for those UCITS in other Member States.

We understand that ISLA has concerns with some of these rules. These concerns have been raised with us directly and also with the European Commission, in response to their Capital Markets Union related consultation. ISLA note in that context that there is a significant gap between securities held by UCITS, which are available for lending and the amount of securities, which they have on loan. They have highlighted to us that investment funds including UCITS account for 45% of all securities available for lending but have only 15% of available assets on loan. Proportionately funds lend less than other market participants and moreover ISLA has observed that lending by funds has declined over the last number of years. Indeed ISLA observed that less than 20% of Irish UCITS participate in this activity. This is, it is argued, at least in part attributed to a restrictive regulatory requirement for lending securities including the inability for UCITS to agree to term loans and an apparent preference for title transfer arrangements.

Taking these points in turn, the rules that prohibit term loans are seen as incompatible with the Basle III framework. ISLA has highlighted that securities lending programmes can provide a source of High Quality Liquid Assets (HQLA) as defined under Basel III. However a bank borrower must hold an asset for 30 days at a minimum, on a title transfer basis, in order for this asset to quality as HQLA. That of course represents one side of the question. The other side is that of investor protection, which must not be undermined. UCITS are open-ended funds and as such are required to invest in liquid assets in order to meet with investor redemption requests. Securities lending arrangements pursuant to which the UCITS assets are effectively locked up for a period of 30 days would not seem compatible with the UCITS framework.

Let me also take this opportunity to clarify some questions in relation to the Central Bank approach to collateral requirements for investment funds.

It appears that there may be an impression amongst some market participants of a regulatory preference for title transfer arrangements to apply to securities lending collateral arrangements. Title transfer arrangements are of course optimal from the perspective of collateral receivers to protect against counterparty failure and the Central Bank requires that collateral received should be capable of being fully enforced by the UCITS at any time without reference to or approval from the counterparty. However, title transfer arrangements are not mandated by the ESMA guidelines or indeed by the Central Bank. Rather, the guidelines (and the Central Bank UCITS Regulations) provide for the possibility of pledge arrangements with the proviso that the collateral be held by a third party custodian who is unrelated to the collateral provider and is subject to prudential supervision. As this pledge model is already being used in the context of derivatives clearing through CCPs, it is not clear from where this uncertainty originates.

We have also heard concerns that the Central Bank requires collateral received by a UCITS to adhere to certain ratings. While this was the case in the past, it is not the current approach. Our domestic requirements for eligible collateral are consistent with ESMA guidelines and require that collateral is “of a high quality”. High quality is not defined and, as such, that determination is made by the UCITS, although where issuers are rated by an external Credit Rating Agency, that rating must be taken into account in the credit assessment process. Moreover, if an issuer is downgraded below the two highest short-term credit ratings of a CRA, the UCITS must immediately carry out a new credit assessment.

While the ESMA guidelines as implemented in our Central Bank UCITS Regulations in 2013 provide for a number of process and disclosure related rules, they also introduced a new approach regard to with regard to revenue generated by securities lending. In short, all revenues arising from securities lending transactions, net of direct and indirect operational costs should be returned to the UCITS (and these costs and fees should not include hidden revenue.) This rule was designed in order to move away from the traditional revenue sharing or fee split model to a more transparent and fairer arrangement where the UCITS (and investors) are appropriately remunerated for lending their assets. Fee splits were deemed to be arbitrary arrangements where irrespective of costs the UCITS earned a pre-defined proportion of revenues and the proportion often favoured the service providers to the potential disadvantage of investors. The approach to revenue as set out in the ESMA Guidelines is accompanied by a requirement to disclose the policies regarding operational costs and the identity of the payees (fund manager, investment manager, or securities lending agents) including disclosure of the nature of the relationship between the payee(s) and the UCITS, its manager or depositary.

Three years later, two developments will assist us in considering whether the ESMA guidelines are achieving their objective. Firstly, ESMA has signalled a peer review on the implementation of the guidelines by NCAs. ESMA has also signalled an intention to develop Regulatory Technical Standards under the Securities Financing Transaction Regulation. I know for many of you here, the reporting obligations under that Regulation may be foremost in your minds. However, this Regulation also includes quite detailed disclosure requirements, which build on those in the UCITS Directive and indeed in AIFMD. Regulatory Technical Standards can provide further direction with regard to expected disclosures and the level of granularity that should be provided. They will assist us all in ensuring that the transparency obligations, first identified in the ESMA guidelines, is applied in the manner intended and the Central Bank very much welcomes both initiatives.

The ESMA guidelines also require disclosure of the “type and amount of collateral received by UCITS”. I am not sure however that in all cases investors can have a full understanding of the nature of the collateral held by a UCITS from their review of periodic reports as some UCITS tend to provide generic reporting on all collateral received which does not go to the type of granularity necessary to assess the collateral related exposures. Regulatory Technical Standards developed by ESMA can therefore ensure that the intention behind the Guidelines, to provide investors with a good understanding of the fees generated and the risks related to collateral received, is applied in practice.

It might also be useful for me at this junction to mention another collateral related issue and the Central Banks approach to types of collateral. Many of you will know that the Central Bank published a Discussion Paper on ETFs in May. The aim of this Discussion Paper, was not to put forward regulatory proposals. Rather we wanted to spur a genuine discussion amongst all interested parties as to developments and dynamics in the ETFs sector given its ever-increasing importance, and given the fact that Ireland is home to a large proportion of European ETFs. We want to promote an all-sides discussion about the detailed operation of the ETFs markets, the benefits, the possible risks, and how these are managed and mitigated. We have been very pleased to find that this approach has been welcomed on all sides and is seen as valuable in underpinning deeper understanding of this important component of present and future financial markets.

We have received a good number of responses to the Discussion Paper. These are in general of high quality with a good deal of effort and insight deployed in a meaningful engagement with the issues. We very much welcome this. We are reviewing the responses received and have published nearly all of these on our website meanwhile. As part of our work in relation to the ETFs Discussion Paper we are hosting an international conference in Dublin on the 29th of this month.

Concerning our topic today, the Discussion Paper addresses a number of issues related to ETFs including collateral received by these funds given their significant securities lending activities. In discussing types of collateral received, the Discussion Paper referenced certain academic literature and research, which suggest that it may be preferable for collateral received by an ETF to be correlated with the underlying index on which a particular ETF might be based. We think that the question of counterparty risk and its mitigation is an important one to be discussed in the context of ETFs. However, to be clear we have no a priori views on the matter and no current intention to propose a regulatory requirement.

Capital Markets Union

Let me now turn to the wider issue of the European Capital Markets Union.

With the European Commission having published its CMU mid-term report during the summer and with a number of important developments underway, it is an appropriate moment to make a few comments from a regulatory perspective.

As I and others have said before, the Central Bank of Ireland is very supportive of the CMU project.

Capital Market Union seeks to:

  • improve access to financing for all businesses and infrastructure across Europe'
  • increase and diversify sources of funding
  • enhance opportunities for investors
  • make markets work more effectively and efficiently especially cross border.

The effective functioning of the economy depends upon the efficient deployment of savings and credit in the funding of economic activity. Capital Markets Union is designed to enhance the extent to which this is successfully achieved. So on those grounds alone the project would be a worthwhile one.

However, from the point of view of a financial regulator, there are other reasons to be supportive of the project. From a financial stability perspective, the more diversified the sources of funding the more resilient is the system to stress shocks. This is not only because different types of funding provider are likely to be impacted differently by different types of shock. In addition, because the better functioning that capital markets are, the more private risk sharing that will be achieved thus reducing the risk of material impact on sovereigns.

More prosaically at the heart of any sound well-performing financial sector is sustainable levels of profitability of financial firms. Without this, it becomes increasingly challenging over time for financial services firms to fulfil their function in the economy. CMU should contribute to the sound functioning of the European economy and thus to the context in which financial firms can carry out their roles soundly and in a high quality way.

In terms of where we have got to, some good progress has been made.

The agreement on the Simple Transparent and Standardised (STS) securitisation package is welcome. While there are one or two aspects that we would have done differently, overall the identification of a mode of securitisation which is high quality, non-complex, and transparent and which can therefore deserve a preferential treatment is very much to be welcomed. This should allow banks’ balance sheets to be optimally, and of course safely, used in providing funding to the economy.

In respect of prospectus requirements, the revisions to the level one framework have been agreed. Things have now moved onto level 2. There the challenge continues to arrive at an approach, which balances well proportionality on the one hand, and appropriate investor protection in respect of investments, which do of course have material risks associated with them on the other.

Under Solvency II, a new asset class of "qualifying infrastructure investments" has been developed and established. Such investments can provide stable, lower risk, and longer-term investment profiles for undertakings. To reflect this a preferential treatment has been provided for under the Solvency II rules. This is welcome because it is an approach grounded in the accurate reflection of the risks. As the CMU project moves forward it needs to remain on this risk-reflective line. The temptation needs to be resisted to prioritise short-term gains at the cost of longer-term soundness. We have seen where that can lead.

Capital Markets Union was always going to be a programme of incremental progress across a wide swathe of subject areas. In this respect, I would say that we are seeing what we would have hoped and expected to see. Therefore looking forward it is a question of “steady as she goes”.

Looking forward to the next phase of the CMU project, as well as opportunities there are a number of challenges to be addressed.


The departure of the UK from the EU does make a difference to the CMU project. It does not diminish, indeed it enhances, the importance of the project. However, it creates additional challenges that it will be important to address consciously and well. Let me mention a couple of such challenges.

Because until now the UK has housed the leading financial services centre in the EU, it is also home to a great deal of capital markets expertise, insight, and know how. While such expertise also exists in much abundance in the wider EU, there will nonetheless be the need to ensure that this talent deepens and develops further in the wake of the UK's departure. We should recognise this in the regulatory approaches we develop including in timing issues.

Secondly, of course, there is the more mundane, but no less significant challenge that comes from the fact that important parts of the EU’s capital markets activities currently take place outside what will be the future border of the EU. Part of the answer to this will of course be relocation. However, Brexit-driven relocation is of course something of an artificial phenomenon; it does not represent an organic, market-oriented, development.

This is something that we policymakers should bear in mind as we respond to the challenges of Brexit. We must carefully seek the balance between the response that Brexit demands in terms of safeguarding financial stability and ensuring that European rules and norms apply to business done in Europe on the one hand and limiting as much as possible the degree of unnecessary disruption that is caused on the other.

One of the points that has been made since the inception of CMU is the importance of European capital markets being seamlessly embedded in the global financial system. It should be an open approach developing Europe's position at the heart of a well-regulated global financial system. This is an aspect that has become more challenging in the context of Brexit but it is a key objective, which should be kept to the fore as we move forward.

Changes to the Supervisory Architecture

The European Commission has, as you know, recently put forward a legislative proposal for revision of the structure and mandate of the European Supervisory Authorities and the ESRB.

This is a proposal of much significance as you will all be aware. Time does not allow me to speak about this proposal in any detail today. So instead let me just set out a few principles or considerations that, from a regulatory perspective, I believe it would be helpful to apply when considering what changes should or should not be made in respect of the ESAs. In addition, to be clear this is not an exhaustive list, just a small number of considerations that to me seem important.

Firstly, the European Supervisory architecture that were implemented post-crisis has been shown to be a good one. The ESAs have delivered strongly on their objectives on the basis of a good balance between centralised and local responsibilities. So, that should be the starting point: we currently have something in place that is working well.
Secondly, it is important to be very clear about the goals that we are seeking to achieve. What is done should be designed to enhance our achievement of financial stability, investor protection, and orderly, fair, and optimally functioning European financial markets - all in support of sustainably growing economy. We need to be extremely clear about how any changes proposed will enhance these outcomes. If not we risk that in respect of some areas where the current framework has delivered well we could see regress rather than progress.

Thirdly, while they have done some very good work in the area, the ESAs do not currently have a consistent consumer protection mandate strongly embedded and clearly articulated in Level 1. There is need for a cross-sectoral approach in this regard. We are supportive of measures that would address this weakness.

We should be careful about easy but ultimately false comparisons in this area. For banking union, a strongly centralised supervisory system is necessary in order to break the link between banks and sovereigns. In respect of capital markets, union there is no similar imperative. It is important to bear this in mind when determining the best approach.

There are other important political-level considerations, including the desirable balance between centralising powers and promoting convergence, which I do mention here. I confine myself for now to looking at this question from a purely regulatory perspective. However, whatever the approach, it is very important that the integrity of the decision making process is strongly maintained in order to ensure effectiveness and appropriate accountability. It should be avoided to introduce fragmentation or uncertainty in this regard which leaves any doubt about the decision-making authority in the context of authorisations.


Let me finish there.

I hope that this discussion of some of the specific details of the regulation of securities lending in the funds sector on the one hand and some of the more general aspects of the ongoing evolution of the wider context of European capital markets has been of interest.

I am grateful for your attention and look forward to any questions that you might have.

My thanks to Martina Kelly and Catharine Dwyer for their work on this speech.