Over the past year, Europe’s markets regulator has stepped up its use of data with a focus on the asset management industry. The reasons are clear enough. Although assets under management in Europe have doubled in the decade since the financial crisis, these firms have not been subject to the level of scrutiny directed at banks over the same period – until now.
Central to this drive are beefed-up powers under the European Market Infrastructure Regulation: “[Emir] puts supervisors directly on the ground, able to exactly identify transactions and positions in individual entities,” says Steffen Kern, head of risk analysis at the European Securities and Markets Authority.
“It puts supervisors in a position to have very meaningful discussions with those entities on portfolio risks – something that 10 or 15 years ago, we would only have been able to dream of,” he adds.
With the renewed focus on asset management, Kern and his colleagues at Esma are hoping to establish a clearer framework for identifying risks in the sector, which can then help supervisors across the European Union to act more cohesively.
Adding spice to the mix is Brexit. Esma has long fretted that competition among EU members to lure asset management business from the soon-to-depart UK could lead to a race to the bottom on supervisory standards, hence the greater urgency for harmonisation. Some of this work is already under way, but there are areas where the law may need to change to rubber-stamp the required data collection and supervisory powers.
The legislative process started with a review of the powers held by Esma and the other two European supervisory authorities (ESAs), which was agreed by lawmakers in March 2019. The review provides an opportunity to home in on the convergence of supervision of asset managers, says Kern.
“The new provisions under the ESA review are a great opportunity for us to corroborate our supervisory convergence work even more systematically and in a quantitative way, identifying where the real areas of divergence are, and where risks are also embedded in the market,” says Kern.
Esma published two significant papers in September last year. The first was a stress simulation for bond funds and the second was an analysis of derivatives usage by equity funds. Both papers focused on funds issued under the Undertakings for Collective Investment in Transferable Securities Directive (Ucits).
The studies were a source of mixed news. The results of the analysis on equity funds were, in general, reassuring, says Kern’s colleague, Christian Winkler, who leads Esma’s markets and investors team. Drawing heavily on Emir data, part of the aim was to understand how far funds were using derivatives as a means to generate synthetic leverage.
In practice, this was a rare occurrence, with less than 30% of more than 5,000 equity Ucits making any use of derivatives. And, even for those funds that did trade derivatives, by far the largest exposure was in the form of currency forwards, mainly to hedge the risk of buying equities in a different currency from the fund’s denomination.
“That was comforting, because the bulk of assets are in Ucits, and that is where risks for investors could resurface,” says Winkler. “The evidence that we have so far is that, overall, these risks seem to be relatively limited. There can obviously be individual Ucits, which much more heavily use derivatives, and that is something to be addressed from a supervisory perspective.”
The stress simulation on bond funds raised more cause for concern. Ucits typically have daily redemption profiles, so heavy exposure to highly illiquid assets poses clear liquidity risks for the funds. Based on a redemption assumption of 8.2%, the simulation found that more than 40% of 297 high-yield bond funds would not be able to meet redemptions.
More broadly, Emir has drawn fire from many market participants for perceived flaws in the quality of resulting data on derivatives. Kern is keen to rebut this criticism, heaping praise on the “fantastic” benefits of Emir.
“It is a system that provides super-granular data across the entire EU,” he says.
Of necessity, the Ucits bond fund simulation was unable to factor in all of the possible tools available to Ucits for managing liquidity stress, such as gating outflows or swing pricing, which aim to reduce first-mover advantage during heavy redemptions. Also, regulators were working with limited information because the Ucits directive does not require funds to provide data on end-investors.
“We have made this first step in terms of stress simulations. We do not have the level of sophistication and modelling that allows us to factor in individual liquidity management tools. We are not in a position yet to factor in individual commitments of clients in these funds. That may be something we will hopefully be able to do in the future,” says Kern.
In particular, he wants to be able to adjust simulation scenarios to examine the impact on different types of funds of specific sources of stress – for example, problems in real estate markets or the effect of so-called “fallen angels”; namely, bond issuers whose ratings have slipped from investment grade to junk.
The European Systemic Risk Board also suggested in December 2017 that more harmonised reporting requirements should be introduced for Ucits funds, specifically on liquidity risk and leverage. This recommendation came into sharper focus last year, when several Ucits funds run by Woodford Investment Management and H2O AM suffered squeezes on liquidity amid heavy redemptions.
Of course, there is always room for national supervisors to go beyond the existing requirements and to ask for something more whenever needed
Antonio Barattelli, Esma
Unlike Ucits, funds regulated under the Alternative Investment Fund Managers Directive (AIFMD) must report the share held by the top five largest investors to help identify concentration risk if one of those large investors pulls out.
Antonio Barattelli, the leader of Esma’s investment management team, says AIFMD is more sophisticated than Ucits in its reporting requirements, mainly because it was a later piece of legislation. Esma would welcome the extension to Ucits of something akin to the AIFMD obligation to report data on fund holdings in order to monitor liquidity risk more thoroughly.
“We believe [that] would be quite meaningful, especially considering recent events. But this would require legislative change to Ucits in order to be applicable across the EU,” says Barattelli.
However, Esma officials are quick to emphasise there is nothing to stop national supervisors today from going beyond Ucits and demanding higher standards of liquidity management, especially for funds that are large or concentrated in illiquid assets. This stance is a rebuff to criticism from the Financial Conduct Authority, whose chief executive, Andrew Bailey, suggested to a UK parliamentary committee that Ucits rules were inadequate for tackling the risks that materialised in the Woodford case.
“Of course, there is always room for national supervisors to go beyond the existing requirements and to ask for something more whenever needed, based on their own assessment,” says Barattelli.
In any case, Esma’s own stress simulations are just one side of the coin – on the other side, both Ucits and alternative investment funds are mandated to carry out their own internal stress testing. With one eye firmly fixed on its goal of supervisory convergence, Esma published, also in September 2019, final guidelines for internal stress-testing under Ucits and AIFMD.
“In a broader context, what the guidelines show is a growing awareness in the industry and among supervisors that stress testing in the asset management industry is not just a risk management tool that has been provided by regulation, but a tool that needs to be taken very seriously,” says Kern.
Barattelli points out that the September guidelines included a section on the interaction between fund managers and national competent authorities (NCAs), which further clarifies the circumstances in which supervisors can and should go beyond the minimum requirements. For instance, it sets out that NCAs may ask at their discretion for the manager to provide extra information to demonstrate that a fund would be able to meet redemption requests in normal and in stressed conditions.
“Moreover, we included a specific requirement in that section [of the guidelines] for managers to notify their NCAs of material risks and actions that need to be taken to address them – there is always room for national supervisors to ask for more,” says Barattelli.
Where you run into problems is where you have open-ended funds that are relatively illiquid. That is mostly a problem in the real estate world, but also in certain emerging markets and high-yield funds
Christian Winkler, Esma
He adds that the guidelines are issued on a comply-or-explain basis, and Esma already carries out peer reviews of supervisory practices, as well as soliciting feedback such as that used to draft the guidelines on internal stress testing. Esma’s capabilities are enhanced by the ESA review, which Barattelli says should usher in more independent peer reviews with greater involvement by the authority’s own staff.
One of the key questions that AIF managers still had after the release of the September 2019 guidelines was over the frequency of internal stress tests. These are mandated annually under AIFMD, but the guidelines seemed to suggest a more regular process.
“The nuance here is that the legal requirement is to do it on an annual basis, but our recommendation, based on discussion with the NCAs, is to perform it on a more frequent basis, at least quarterly or more frequently,” says Barattelli. “You need to assess on a case-by-case basis to see where it may be required to do it more or less frequently, based on proportionality considerations – the nature, scale, complexity and liquidity profile of the fund.”
Mind the fat tail
As yet, there is insufficient data to track the trends for AIF exposures, because only two years of reported data are available. But Esma has already presented a snapshot of the sector in an annual report on AIFMD, published in January this year, looking for sources of redemption risk in particular.
“Where you run into problems is where you have open-ended funds that are relatively illiquid. That is mostly a problem in the real estate world, but also in certain emerging markets and high yield funds,” says Winkler.
Significantly, Esma found the two categories of AIFs with the greatest liquidity risks – real estate and funds of funds – were also the two with the highest proportion of retail investors. This raises questions about whether asset managers are protecting retail clients adequately, and if these funds should be subject to more regular internal stress testing.
Barattelli says: “It is not the distribution to retail investors per se that requires more stringent stress-testing,” but rather the redemption conditions that the fund allows.
“It is true that when you look at stress conditions, the redemption may come at different frequencies, depending on your investor base. That is something to be taken into account by the fund managers, but not an element to be taken in isolation,” he adds.
The other aspect that Esma examined was the use of derivatives to generate synthetic leverage. Almost all of this is in the hedge funds sector, which accounts for just 6% of the total net asset value for European AIFs. But 67% of AIF derivatives exposure is concentrated in hedge funds, with significant financing risks attached – around one-third of their financing is overnight.
“Even within the cohort of hedge funds there is a fat tail – there are a number of hedge funds that are not so exposed to derivatives, but there are then a number of funds that use derivatives and to a very considerable extent,” says Kern.
As with Ucits, soliciting more granular or consistent data-reporting from AIFs may need legislative changes. There is an early opportunity for that this year, when the European Commission is due to launch a review of AIFMD. The EC carried out a curtain-raising survey in December 2018, which showed that almost half of all respondents felt there was an inconsistent understanding among EU member states over what data needed to be reported under AIFMD.
Kern hopes the progress made already in monitoring fund risks through reporting data will strengthen the case for data-driven supervisory approaches.
“I think, and hope, the first steps we have made will make a strong argument to improve our use and understanding of the statistics and transparency that comes to us from the data reported,” he says.
Editing by Alex Krohn
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