efama’s response to the european commission green paper on shadow … response... · 2012. 7....

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EFAMA’s RESPONSE TO THE EUROPEAN COMMISSION GREEN PAPER ON SHADOW BANKING

EFAMA1 welcomes the opportunity to submit its views on the policy considerations developed by the European Commission in its Green Paper on Shadow Banking. Key comments 1) Representing the European investment fund industry, an already highly regulated part of the

financial sector, EFAMA is fully supportive of the objectives pursued by the European Commission and other international bodies such as the Financial Stability Board (FSB) and the IOSCO to identify and close any regulatory gaps as well as inefficiencies in the supervision of the financial sector in general, with a view to mitigating systemic risks and reducing the possibilities of regulatory arbitrage.

2) The concept of “shadow banking”, however, carries a negative connotation and seems to imply that the targeted entities and activities are somehow less legitimate or less transparent than banking activities. It fails to describe the diversity of entities and activities targeted in the Green Paper and does not properly reflect the important role played by those activities in funding the real economy as well as contributing to the liquidity and stability of financial markets. If the Commission believes there is a need to capture these activities and entities under a single definition for an indefinite period, we would then strongly encourage the use of a more positive label.

3) We also believe that the definition of shadow banking proposed by the European Commission is too broad. Indeed, compared to the FSB definition, it lacks the decisive limitation to activities raising particular concerns in terms of systemic risk and/or regulatory arbitrage.

4) We therefore encourage the Commission to narrow the scope of the shadow banking debate by following more closely the FSB definition, and to focus its attention primarily on unregulated activities potentially threatening the stability of the financial system and creating opportunities for regulatory arbitrage and distortions.

5) In this context, we are very concerned by the emphasis that the Green Paper puts on investment funds in general, and on money market funds and ETFs in particular, as possible shadow banking entities. Because of the tight regulatory framework and strong supervision to which they are

1 EFAMA is the representative association for the European investment management industry. EFAMA represents through its 26 member associations and 59 corporate members approximately EUR 14 trillion in assets under management of which EUR 7.9 trillion was managed by approximately 54,000 funds at end March 2012. Just above 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. For more information about EFAMA, please visit www.efama.org.

2 EFAMA’s reply to the EU Commission Green Paper on Shadow Banking

already subject or will be subject in a near future (as further detailed in our answers below), we are indeed convinced that European investment funds do not create significant systemic risks or opportunities for regulatory arbitrage.

6) Should the Commission nevertheless insist on maintaining the broad scope of the debate, we consider it extremely important that any regulatory measures deemed necessary for European investment funds should be consistent with the regulation already in place, in particular the UCITS and AIFM Directives.

7) Finally, we find it extremely important that the Commission aims at gathering a complete overview of the interconnectedness between all possible shadow banking entities and activities and the regular banking system, and a good understanding of the potential impact and possible unintended consequences of targeted proposals of new regulations on the other activities and players in general, and on the financing of the real economy, in particular. If, as a result of this fact‐finding and comprehensive monitoring process, systemic risks were identified in relation to shadow banking activities or entities they should be regulated in a way that best addresses these risks without threatening the existence of these activities or entities. In this context, it is essential to bear in mind that the macro‐prudential approach applying to the supervision and regulation of banking activities is not necessarily suitable for other types of activities such as asset management activities which are fundamentally different in a number of ways.

What is Shadow Banking? a) Do you agree with the proposed definition of shadow banking? We believe that the definition of shadow banking proposed by the Commission does not sufficiently reflect the two‐step approach suggested by the FSB and therefore is too broad. More specifically, in its April 2011 report the FSB concluded that authorities should first cast the net wide (step 1) but then narrow down their focus (step 2) to the portion of the shadow banking system that can be defined as “a system of credit intermediation that involves entities and activities outside the regular banking system, and raises i) systemic risk concerns, in particular by maturity/liquidity transformation, leverage and flawed credit risk transfer, and/or ii) regulatory arbitrage concerns”2. We believe that the definition proposed by the Commission misses the second step in the FSB approach (narrowing of the definition to entities and activities raising systemic risks or regulatory arbitrage concerns) with the consequence that many entities (including a large proportion of investment funds) and activities would be caught in the shadow banking debate when in fact they do not raise significant concerns in terms of systemic risks or regulatory arbitrage.

2 Shadow Banking: Scoping the issues, A background note of the Financial Stability Board, 12 April 2011, pp. 2‐ 3


Furthermore, we agree with the FSB that the definition of shadow banking should not explicitly refer to activities accepting funding with deposit‐like characteristics because these activities could only raise systemic risk if they are involved in sufficiently large scale maturity transformation in the sense defined by the FSB, i.e. activities of issuing short term liabilities (such as deposits) and transforming them into medium–long term assets (such as loans), and large scale liquidity transformation in the sense defined by the FSB, i.e. activities of issuing of liquid liabilities to finance illiquid assets. We therefore urge the Commission to better focus the scope of the current debate by following more closely the definition developed by the FSB. b) Do you agree with the preliminary list of shadow banking entities and activities? Should more entities and/or activities be analysed? If so, which ones? We consider that the list of entities and activities proposed by the Commission is a preliminary basis to better define the boundaries of the shadow banking system. However, in order to decide whether or not these entities and activities are indeed part of the shadow banking system, the authorities should continue their work on the characteristics of these entities and activities and the degree of potential systemic risk and regulatory arbitrage that they pose to the system. We would also encourage the Commission to wait until the FSB work is completed before finalizing its list of shadow banking activities/entities. Finally, we firmly believe that the strong regulatory and supervisory framework to which European investment funds (be they UCITS or AIFs) are already subject or will be subject in a near future (as further detailed in our answers below) ensures that these funds do not raise systemic risk concerns and/or regulatory arbitrage concerns. What are the risks and benefits related to shadow banking? c) Do you agree that shadow banking can contribute positively to the financial system? Are there other beneficial aspects from these activities that should be retained and promoted in the future? We strongly agree with the list of benefits related to shadow banking identified by the Commission, i.e. they • provide alternatives for investors to bank deposits; • channel resources towards specific needs more efficiently due to increased specialization; • constitute alternative funding for the real economy, which is particularly useful when traditional

banking or market channels become temporarily impaired; and • constitute a possible source of risk diversification away from the banking system. We would like to stress the following points:


• We strongly agree with the view expressed by Commissioner Barnier at his speech at the conference on the shadow banking system on 27 April that financial intermediation should not be left entirely and solely in the hands of banks. Indeed, alternative sources of financing have an important role to play in these difficult times for the European economy, where the banks have to adhere to more stringent prudential ratios.

• Along the same line of thinking, we concur with what Jean‐Pierre Jouyet, the AMF President, said at the same Conference when he emphasized that “we need non bank credit; we need vibrant and active financial markets, be it securities or derivatives markets, and various and numerous financial intermediaries and vehicles, to ensure a smooth functioning of our capital markets.”

• We also agree with Lord Turner’s statement in the Rostov lecture “It is clearly not the case that an optimal financial intermediation system requires all credit to pass through the banking system, and indeed it never has. Indeed there is a strong case in theory for favouring a considerable role for non‐bank credit intermediation – including, for instance, the direct purchase of medium and long‐term credit securities by long‐term investors such as pension funds or insurance companies – since this reduces the maturity transformation burden imposed on the banking system, and can limit the introduction of leverage within the intermediation system.”

• Investment funds play a key role in the management of long‐term savings and pension schemes for the benefit of millions of European citizens;

• As far as money market funds are concerned, in addition to the functions outlined above, they also (i) provide segregation of assets; (ii) allow corporate treasurers and other institutional investors to manage deposit credit risk through diversification, thereby avoiding the risk associated with the concentration of deposits in a few select banks and the absence of unlimited deposit guarantee schemes; (iii) to outsource the analysis of credit and counterparty risks to professional cash management teams; (iv) offer companies possibilities to diversify their financing from bank loans to securities, by maintaining a certain level of demand for securities issued by companies.

• Securities lending generates income for investors whose securities are lent. In addition, the availability of securities through lending arrangements translates into liquidity for the financial markets.

d) Do you agree with the description of channels through which shadow banking activities are creating new risks or transferring them to other parts of the financial system? We consider that investment funds (be they money market funds, ETFs, investment funds providing credit or other types of investment funds) do not create systemic risks through the channels described in section 4 of the Green Paper, for reasons explained below.


• Deposit‐like funding structures may lead to “runs”: It would be inappropriate to assume that money market funds are entities that are exposed to similar financial risks as banks, without being subject to comparable constraints imposed by banking regulation and supervision. Indeed, the liquidity transformation performed by money market funds is an order of magnitude significantly less than that performed by banks, and is subject to tight controls. The asset/liability maturity mismatch of money market funds is very limited and the credit quality of their portfolio is high. Furthermore, money market funds do not make loans or use other forms of debt forms of debt financing, but instead invest in marketable securities. More generally, European investment funds managers are subject to high standards of liquidity risk management. All UCITS managers are required to employ an appropriate liquidity risk management process in order to ensure that the funds they manage are able to meet redemption requests from investors. This liquidity risk management process is part of the permanent risk management function that UCITS management companies must establish which must be functionally and hierarchically independent from other departments within the management company. Managers are required to measure and manage at any the risks to which the fund is or might be exposed, including the risk of massive and unexpected redemptions. It should therefore be emphasized that risk management in UCITS is already state‐of‐the art and has been further enhanced by the entry into force of the UCITS IV Directive in July 2011 which has introduced even more detailed provisions on internal control mechanisms for the UCITS management company. In the AIFMD the Risk Management function, including the management of liquidity risks will be functionally and hierarchically separated from the operating units of the AIFM. The robust liquidity risk management processes put in place by European investment fund managers certainly explains for a large part that the vast majority of European investment funds went through the global financial crisis in 2008 without major problems. Lastly, it is worth mentioning that in exceptional circumstances where – despite the liquidity management process in place ‐ a fund would temporarily be unable to meet the redemption requests from investors, the fund manager still has the possibility to temporarily suspend redemptions in the interest of its unit holders (as foreseen in Article 84 of the UCITS directive) or to use other tools such as ‘gates’ to manage redemption requests in an orderly manner.

• Build‐up of high, hidden leverage: We believe that the risks arising from the build‐up of high and hidden leverage has already been well addressed by European legislation: 1) For UCITS, there are limits to the allowable leverage level from both the use of

derivatives using either the commitment approach or VaR measures and temporary


borrowing (UCITS are not allowed to borrow more than 10% of their net asset value, only on a temporary basis and not for investment purposes3). Furthermore, since the entry into force of the UCITS IV Directive in July 2011, all UCITS are under the obligation to disclose in their annual report the amount of commitments arising from financial derivatives instruments. UCITS management companies are also under the obligation to report regularly to their competent authorities in regard to the type of derivative instruments, the underlying risks, the quantitative limits and the methods which are chosen in order to estimate the risks associated with transactions in derivative instruments regarding each managed UCITS.

2) Under the AIFMD, European funds other than UCITS will be under the obligation to

define a maximum limit in terms of leverage which shall be disclosed to investors as part of the offering documents. The manager must be able to demonstrate to the authorities that the defined limits have been observed at all times. The overall level of leverage employed by each AIF must also be reported to authorities on a regular basis. More stringent reporting and transparency requirements are also applicable to funds employing leverage on a substantial basis.

• Circumvention of rules and regulatory arbitrage:

Because fund management activities are highly regulated and subject to close supervision, we believe that it is very unlikely that investment funds could be used as a vehicle to circumvent banking regulations.

• Disorderly failures affecting the banking system: In its Green Paper, the Commission points to the fact that shadow banking activities are often closely linked to the banking sector and that “under distress or severe uncertainty conditions, risks taken by the shadow banks can easily be transmitted to the banking sector through several channels: (a) direct borrowing from the banking system and banking contingent liabilities (credit enhancement and liquidity lines; and, (b) massive sales of assets with repercussions on prices of financial and real assets.”4 In relation to investment funds, it should be noted however that: o Investment funds in general and money market funds in particular, do not borrow from

banks, and do not use committed lines of credit from banks.

o Moreover, the risk of massive sales having repercussions on market prices are not specific to shadow banking entities but are inherent to trading activities of all financial market players, including banks. In our view, this risk must be tackled by appropriate market regulation involving in particular suitable trading control mechanisms (e.g. trading halts, volatility interruptions,…) to face volatile market conditions.

3 Article 83.2 of Directive 2009/65/EC 4 EU Commission Green Paper on Shadow Banking, page 5.


o Sponsor support may be provided on a voluntary and occasional basis to MMFs or other

types of funds. However, investors should not be encouraged to expect sponsors to support their MMFs against losses. In other words, it should be clear to investors that the risks they are taking when investing in a MMF cannot be transferred to a third‐party.

e) Should other channels be considered through which shadow banking activities are creating new risks or transferring them to other parts of the financial system? We don’t believe there are other channels than those mentioned in the Green Paper. What are the challenges for supervisory and regulatory authorities? f) Do you agree with the need for stricter monitoring and regulation of shadow banking entities and activities? We believe that the authorities should have an appropriate system‐wide oversight framework in place to gain a comprehensive picture of the shadow banking system and of the risks that it poses to the entire financial system. We agree that the authorities should put in place an appropriate monitoring process built on the three steps proposed by the FSB: • Step 1: Scanning and mapping of the overall shadow banking system • Step 2: Identification of the aspects of the shadow banking system posing systemic risk or

regulatory arbitrage concerns • Step 3: Detailed assessment of systemic risk and/or regulatory arbitrage concerns Step 2 is particularly important to help authorities narrowing down the focus to entities and activities that pose systemic risks and/or arbitrage, whereas step 3 is essential to allow the authorities to assess the potential impact certain shadow banking entities/activities would pose to the system. g) Do you agree with the suggestions regarding identification and monitoring of the relevant entities and their activities? Do you think that the EU needs permanent processes for the collection and exchange of information on identification and supervisory practices between all EU supervisors, the Commission, the ECB and other central banks? We agree that the authorities need to draw on high quality, consistent data on bank and non‐bank financial sectors’ assets and liabilities. EFAMA would however strongly welcome a global approach across legislative initiative and across countries in terms of reporting. In order to avoid important development bearing significant costs


that would impact final investors, we strongly advocate for the creation of standard criteria applicable across legislations. We would strongly support a global approach to this issue such that there are no differences in the reporting obligations of market participants in the major markets of the world. As regards investment funds in particular, we would like to outline the fact that the European Central Bank (ECB) has considered that it needed high‐quality statistical information on the business of investment funds in order to fulfill its tasks. Consequently, it adopted a regulation (ECB/2007/8) to start collecting data on the population of investment funds resident in the euro area on a quarterly and monthly basis, covering assets and liabilities on a fund‐by‐fund basis. We trust that the European Commission will cooperate with the ECB, and possibly other central banks, instead of setting up an alternative process for the collection of data on investment funds. Furthermore, we firmly believe that the extensive reporting requirements (both in terms of frequency and level of details) to which European investment funds (be they UCITS or AIFs) are already subject or will be subject to in a near future (when the AIFMD will come into effect in July 2013) provide competent authorities with the information they need to perform their tasks of macro‐economic supervision5. We therefore believe that there is no need for additional measures in order to ensure effective supervision of investment funds. Lastly, in order to facilitate the bottom up collection of micro‐data on systemic risk in the financial markets it is important to be able to uniquely identify counterparties and their transactions on a global scale. To this end, EFAMA strongly supports the work of the FSB and IOSCO on introducing a unique global Legal Entity Identifier (LEI). Additionally, work need to continue on a unique global identifier for instruments and transactions. EFAMA supports the use of ISIN (ISO Standard 6166) for this purpose. h) Do you agree with the general principles for the supervision of shadow banking set out above? i) Do you agree with the general principles for regulatory responses set out above? We agree with the high‐level principles that have been identified by the Commission and the FSB. In this context, we would like to stress the following points:

• Focus: when designing the regulatory measures, the European Commission should be mindful of their possible unintended consequences and potential impact, in particular on the real economy. In this respect, we fully agree with Commissioner Barnier when he declared at the conference on the shadow banking system on 27 April 2012 that the European Commission “will be very careful not to call into question the alternative financing chains, which complement bank lending and are of direct benefit to the real economy”. We also

5 For further details, please refer in particular to Article 51 of UCITS Directive as well as to Articles 24 and 25 of the AIFMD.


share Jean‐Pierre Jouyet’s statement at the same conference when he said that “when prudential regulations tend to make all banks hold the same assets and mimic each other, the flexibility allowed to non‐bank entities is welcome since it allows the financial system to breathe in and out more freely.”

• Proportionality: to assess the potential negative impact on the system, it is particularly important to pay particular attention to the size given that the negative impact is proportionate to the size of the shadow banking entity/activity. In other words, the smaller the size of the shadow banking entity/activity, the smaller the negative impact would be, and therefore the less likely a cost‐benefit analysis would justify new regulatory measures.

• Forward‐looking and adaptable: when certain shadow banking entities/activities and their potential risks appear small, the authorities could agree to adopt a wait‐and‐see attitude whereby they would decide to take action in the future in light of the evolution of the size and risks.

• Effectiveness: we fully share the view that a right balance has to be found between the objective of international consistency and the need to take into account differences between financial structures and systems across jurisdictions.

• Assessment and review: we support the need to assess the effectiveness of the regulatory measures after implementation.

j) What measures could be envisaged to ensure international consistency in the treatment of shadow banking and avoid global regulatory arbitrage? We believe that any regulatory measures taken to address shadow banking issues should be closely coordinated at international level, under the auspices of the FSB and other international committees such as the IOSCO. In particular, we believe that the criteria used to identify shadow banking entities or activities should, as much as possible, be aligned at international level, to reduce the potential for regulatory arbitrage. This being said, we would like to note that the regulation of investment funds differs significantly between the different regions of the globe. By way of illustration, it is well recognized that the UCITS Directive and the U.S. Investment Company Act are quite different pieces of legislations. Furthermore, there are important regional and national specificities that explain the different regulations and features of MMFs across the world as well as the different services that they bring to investors. Against this background, we don’t think it realistic and necessary to converge towards identical regulation of MMFs across the globe.


What regulatory measures apply to shadow banking in the EU? k) What are your views on the current measures already taken at the EU level to deal with shadow banking issues? As already illustrated in our answer to the previous questions, we are of the opinion that the existing EU regulatory framework, in particular the UCITS and AIFMD Directives, already address to a very large extent the concerns raised by the Commission in its Green Paper in relation to investment funds in general, and to Money Market Funds and ETFs in particular. More specifically regarding ETFs and MMFs we would like to point out the following: a) ETFs: First of all, we wish to underline the fact that the vast majority of ETFs in the European Union are nothing more but nothing less than UCITS that are listed on a regulated market. As such, ETFs in the European Union – like any other UCITS ‐ are already subject to one of the most respected and widely recognized frameworks for public investment funds. This robust product regulation already addresses to a very large extent the concerns raised by the Commission and the FSB in relation to ETFs regarding potential conflicts of interest, synthetic exposure, securities lending and the use of collateral (as further detailed in EFAMA’s reply to the Financial Stability Board’s Note on Potential financial stability issues arising from recent trends in Exchange Traded Funds – please refer to Annex 4). Furthermore, we support the current review of the UCITS framework carried out by ESMA aiming at introducing common EU standards for securities lending by UCITS and enhancing the requirements for collateral to be delivered to the fund. In our view, this review will further improve the quality of all UCITS products, including UCITS ETFs. However, it is important to note (as the Commission rightly notes in its Green Paper, page 6) that the discussions at ESMA are being led with reference to the UCITS framework in general and are not limited to ETFs. Indeed, investment techniques commonly used by ETFs, in particular securities lending and derivative (swap) transactions are not specific to ETFs and can also be found in other types of investment funds. Hence, the only regulatory measures considered by ESMA in relation to ETFs concern their unequivocal labelling and adequate arrangements to ensure effective redeemability of fund units (which is of little relevance in the context of shadow banking).

b) Money market funds (MMFs):

The implementation of the new CESR/ESMA guidelines, which have taken effect in July 2011, represents a major and decisive step towards greater transparency and increased clarity. The guidelines crystallize the two‐tier approach EFAMA and IMMFA had suggested in their initial proposal by creating two MMF subcategories: “short‐term money market funds” and “money market funds”. They also provide a robust framework to limit the main risks to which MMFs are exposed, i.e.


interest rate risk, credit/credit spread risk and liquidity risk. Among other things, the reduction in the weighted average maturity (to no more than 60 days for Short‐term MMFs and 120 days for MMFs) limits the overall sensitivity of the funds’ NAV to changing interest rates, and the reduction of the weighted average life (to no more than 6 months for Short‐Term MMFs and no more than 1 year for MMFs) limits credit and credit spread risk. Overall, the requirement to invest in high quality money market instruments reduces credit risks. In practice, the requirements from the CESR/ESMA guidelines and the UCITS Directive oblige MMF managers to keep high‐quality and liquid portfolios to avoid running into liquidity difficulties. According to the European Central Bank, the change in the definition brought about by the CESR/ESMA guidelines had a significant impact on the size of the MMF industry. In particular, in Ireland and Luxembourg, the redefined MMF industry was approximately 28% and 22% smaller respectively in terms of the total net asset value. The overall impact of changes to the reporting population in the euro area amounts to a reduction of EUR 193.7 billion (18%) of the MMF sector’s total net asset value since July 2001.6 The chart below confirms this by showing the impact of the CESR/ESMA guidelines on the net assets and number of MMFs domiciled and/or distributed in Germany (including MMFs domiciled in Luxembourg).

The CESR/ESMA guidelines also require managers of MMFs to draw investors’ attention to the difference between the MMF and investment in a bank deposit. It should be clear, for example, that an objective to preserve capital is not a capital guarantee. Enhancing investor awareness about the exact nature of MMFs will strengthen MMFs’ resilience in crises. It should also be noted that the vast majority of MMFs are UCITS. This means that their managers must, amongst others, employ a risk management process which enables them to monitor and measure at any time the risk of the positions and their contribution to the overall risk profile of the portfolio.7 For a MMF, this includes a prudent approach to the management of currency, credit, interest rate, and liquidity risk and a proactive stress‐testing regime. In addition, managers of MMFs must have appropriate expertise and experience in managing these types of funds.

6 See ECB Monthly Bulletin April 2012. 7 See Article 51 of the UCITS Directive.

256 247 246 237 232213 207

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60

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MMFs domiciled/distributed in GermanyNet assets (EUR billion)


We would like to conclude this section by quoting Willem Buiter, a highly respected economist: “Liquidity is not a substance but a property of financial instruments. It is subject to network‐externalities, and is fundamentally a matter of beliefs and trust. With confidence, optimism and trust, any security will be liquid. Without these, nothing is liquid. Therefore, for both funding liquidity and market liquidity, the provider of the ultimate, unquestioned source of (domestic currency) liquidity is a necessary participant in any socially efficient arrangement.”8

The provider of the liquidity should be the central banks. By standing ready to act as the ultimate source of funding liquidity (as lender of last resort) and as the ultimate provider of market liquidity (as market maker of last resort), central banks can address or at least mitigate the risk that the market for short‐term credit ceases to function. We fully agree with Buiter’s analysis. The reform of MMF regulation should not develop into a quest for the Holy Grail. Liquidity plays a crucial role in financial markets. Without some liquidity, financial markets cannot work properly. As soon as investors are more concerned about protecting themselves from liquidity risk than they are with making money, they start moving cash out of assets likely to be hurt by the loss of liquidity. When the flight to safety is broad based, it can set in motion a process of vanishing liquidity. In those market circumstances, the best remedy is to restore investor confidence. In the intervening period, the main objective of MMF reform should be to ensure that funds have appropriate liquidity risk management in place. We would also like to draw the Commission’s attention to Table 1 in Annex 1, which provides an assessment of the existing regulatory framework as a line of defense against key systemic and run risks. Outstanding Issues l) Do you agree with the analysis of the issues currently covered by the five key areas where the Commission is further investigating options? a) Asset management regulations

b.1 ETFs

Referring to our answer to question q a) above, we believe that the existing UCITS regulation, completed by the ESMA guidelines in preparation, provide an adequate answer to the risks and issues outlined in this Green Paper. We therefore do not see the need for additional modifications to the current EU regulatory framework. In this respect, we wish to underline that the FSB, in its latest publications on shadow banking (“FSB report with recommendations to strengthen oversight and regulation of shadow banking”9 published

8 See “The role of central banks in financial stability: how has it changed”, Willem H. Buiter (London School of Economics and CEPR), CEPR Discussion Paper No. 8780, January 2012. 9 http://www.financialstabilityboard.org/publications/r_111027a.pdf


in October 2011 and “Progress report to the G20 on strengthening the oversight and regulation of shadow banking”10 published in April 2012) does not make any recommendation of regulatory actions in relation specifically to ETFs. We therefore urge the Commission to follow the same approach.

b.2 Money market funds (MMFs)

MMFs are highly regulated investment products, which invest only in very short‐term, high quality, marketable debt instruments. As UCITS, MMFs may borrow up to only 10% of its assets, as long as these are temporary borrowings and such borrowings may not be used for investment purposes.11 This possibility, which is not used by all MMFs, can be considered as a first line of action to allow MMFs to cope with larger‐than‐expected withdrawals. MMFs in Europe have not taken a central role in maturity transformation in Europe. Their assets remain low compared to the banks’ balance sheets, and given the CESR/ESMA guidelines, the asset/liability maturity mismatch is very limited and the credit quality of the MMF portfolio is high. Furthermore, MMFs do not make loans or use other forms of debt forms of debt financing, but instead invest in marketable securities.

The lack of a common definition following the bursting of the subprime crisis highlighted the importance of a uniform European definition of MMFs based on defensive portfolio strategies and liquidity risk management system for being prepared for a long‐lasting liquidity shock. The CESR/ESMA guidelines have rightly addressed this concern on a pan‐European basis. In summary, while we understand the FSB’s position that “maturity/liquidity transformation within the shadow banking system, especially if combined with high leverage, raises systemic concerns for authorities because of the risk that short‐term deposit‐like funding in the shadow banking system can create “modern bank‐runs” if undertaken on a sufficiently large scale”12, we consider that MMFs are not “shadow banks”. The risks they pose to the financial system in Europe are extremely limited. They have not reached a systemic size and the recently reinforced regulatory framework provides a sound base for limiting the MMFs’ susceptibility to runs or other systemic risks. Annex 2 provides more information about the size of MMFs and reviews the impact of the subprime crisis, the global financial crisis and the European sovereign debt crisis on this segment of the European investment fund market.

10 http://www.financialstabilityboard.org/publications/r_120420c.pdf 11 See Article 83 of the UCITS Directive. 12 See FSB report of 12 April 2011, p. 4.


b) Securities lending and repurchase agreements The conditions under which investment funds may engage in securities lending or repurchase agreements are already partly covered by the UCITS directive, supplemented in many European countries by additional rules applicable at national level. Furthermore, ESMA is currently developing guidelines aiming at defining common provisions for securities lending and repurchase agreements for all UCITS. This being said, in order to maintain a level playing field and given the global nature of securities lending and repo activities and the interest by regulators in multiple jurisdictions, we recommend an internationally coordinated approach to standards and regulation.. In this area, like in others, we therefore strongly encourage the Commission to collaborate with the FSB in order to achieve a high level of consistency at international level. In this respect, we wish to draw the Commission’s attention to our comments on the recently published Interim Report of the FSB Workstream on Securities Lending and Repos13

c) Other shadow banking entities We support the approach taken by the FSB Task Force (WS3) which has undertaken to narrow the scope of the possible “other shadow banking entities” to certain types of entities that may need policy responses. We strongly believe that the Commission should wait until the FSB work is completed before determining which other activities/entities are part of the shadow banking system. In the meantime, we strongly disagree that investment funds that provide credit (bond funds) should be considered as Shadow Banking Entities (please refer to Annex 3 for further explanations on this point). n) What modifications to the current EU regulatory framework, if any, would be necessary properly to address the risks and issues outlined above? As far as MMFs are concerned, we believe that some regulators have already imposed reforms to strengthen the resilience of MMFs, such as the SEC’s 2010 rule amendments and the CESR guidelines on a common definition of European money market funds. Hence, at this stage, the reform of MMFs should focus on the fund's internal liquidity risk, including by requiring money market funds to adhere to certain liquidity requirements, i.e. minimum holdings of assets held in assets that would be accessible within one day and within one week, and to know their clients by taking into account client concentration and client segments, industry sectors and instruments, and market liquidity positions. We have strong reservations against suggestions that MMFs should be regulated like banks, presumably because of the functional similarities between MMF shares and bank deposits. This is

13 http://www.efama.org/index.php?option=com_docman&task=doc_details&gid=1692&Itemid=‐99


not the right approach to strengthen the resilience of MMFs to stressed market conditions. The reform should be going in the opposite direction in order to (i) enhance investor expectations that MMFs are not impervious to losses, (ii) prevent moral hazard by encouraging investors to search for the best MMF, and (iii) encourage MMF sponsors to apply prudent risk management to avoid losing clients. It should also be stressed that capital requirements or insurance coverage would destabilize very much the business model of MMFs, especially in a situation like today where money market rates are at historically low levels. This type of measure would force (i) MMF sponsors to close their MMFs, (ii) lead institutional investors to direct their assets to unregulated instruments; and (iii) reduce the availability of short‐term credit. Finally, we are in favor of maintaining a two‐tier approach based on “short‐term MMFs” (including both CNAV and VNAV MMFs) and “MMFs” as defined by the CESR/ESMA guidelines. Many investors in Europe find it convenient and efficient to have the choice between these categories of MMFs. Prohibiting the use of amortized cost valuation for any securities held by a MMF would sign the death warrant of the CNAV MMFs as currently implemented. In addition, as many money market instruments, for example commercial paper and certificates of deposit, are difficult to price because the market trades OTC, it is important to allow MMFs to continue applying amortized accounting subject to certain tests. We have developed these points in on our response to the Consultation Paper prepared by IOSCO on Money Market Fund Systemic Risk Analysis and Reform Options, which will be available on EFAMA’s website14 at the latest at the closing of the Consultation Period on 29 June 2012. o) What other measures, such as increased monitoring or non‐binding measures should be considered? Binding regulation already covers virtually all aspects of the investment funds industry in Europe. Hence, we do not think there is any room left for non‐binding measures to be considered as an alternative to regulatory action.

14 http://www.efama.org/index.php?option=com_docman&task=doc_details&gid=1693&Itemid=‐99.


Annex 1 Susceptibility of European MMFs to Key Systemic and Run RisksAssessment of the Existing Regulatory Framework as a Line of Defense against these Risks Key Systemic Risk Factors15 Existing Regulatory Framework Maturity transformation The CESR/ESMA guidelines on the MMF portfolio

WAM and WAL restrict very much the degree of maturity divergence between the MMF assets and liabilities.

Credit risk transfer The Basel II enhancement of July 2009 provides a proper framework to address reputational risk/implicit support provided by banks to MMFs.

Leverage The UCITS Directive ensures that MMFs operate with little if any leverage.

Liquidity transformation The CESR/ESMA guidelines and the UCITS Directive ensure that MMFs invest in high‐quality, liquid assets and employ a conservative risk management process and a proactive stress‐testing regime.

Key Run Risk Factors16 Existing Regulatory Framework Liquidity shock & credit event/deterioration The global efforts toward financial reform undertaken

by the G‐20/FSB and the provision of funding liquidity and market liquidity by central banks constitute major steps to address some of the most important financial instability problems.

1st mover advantage The UCITS criterion that MMFs must calculate their NAVS to reflect the market value of their investment portfolios should prevent MMF investors from redeeming without paying the increased cost of liquidity.

Risk aversion of the investor base & flight to safer assets

The CESR/ESMA guidelines have created a high‐quality MMF brand that ensures that the risks associated with MMFs are as low as the risk aversion of the investor base, and lower than the risk associated with other investment vehicles.

Uncertainty regarding availability of sponsor support MMFs are investment funds which are not providing any capital guarantee. Therefore investors should not count on any sponsors to bail them out.

15 Source: FSB report of 27 October 2011, p. 10‐11. 16 Source: IOSCO Document for Discussion in preparation of Industry hearing of 20 January 2012.


Annex 2 Assessment of the Risks posed by Money Market Funds (MMFs)

1. MMFs have not reached a systemic size in Europe

The FSB report dated 27 October 2011 shows that assets in the shadow banking system in a broad sense grew rapidly before the crisis, from $27 trillion in 2002 to $60 trillion in 2007. The total declined slightly to $56 trillion in 2008 but recovered to $60 trillion in 2010. Out of this total, the assets of MMFs domiciled in Europe amounted to €761 million in 2002 and €1,171 million in 2010 constant NAV MMF assets domiciled in Europe totaled €464 million at end 2010. Monetary data from the European Central Bank (ECB) show that MMF shares/units held by euro area investors are very small relative to the deposits managed by euro area credit institutions (only 3.7% at end 2010).17 At the end of September 2011, MMF shares/units were held by euro area investors in the following way: households (EUR 196 billion), non‐financial corporations (EUR 169 billion), insurance corporations and pension funds (EUR 81 billion), and other sectors (EUR 162 billion). The ECB data also show that MMFs held less than 2% of all debt securities issued by euro area non‐financial sectors in mid 2010, and 7% of all debt securities issued by euro area credit institutions.18 Three conclusions can be drawn from these statistics:

• The share of European MMF assets in the so‐called “shadow banking system” is very limited in both absolute and relative terms (only 2.6% of the total assets of the shadow banking system reported by the FSB).

17 Source: ECB Statistical Data Warehouse. 18 Source: ECB Monthly Bulletin October 2010, p. 23.

Shadow banking assets

US$ 60 trillion(€ 45 trillion)

European MMFs € 1,171 bn (2.6%)

VNAV€707 bn (1.6%)

CNAV MMFs€464 bn (1.0%)

European MMFs Assets(end 2010)

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very strong competition from banks which led to significant net withdrawals. The process was mainly supply‐driven in the sense that many banks, particularly in Continental Europe, have actively encouraged their clients to reallocate their portfolios out of MMFs to deposits. The steepening of the yield curve, with money market yields moving to unprecedented lows, also had an impact on the attractiveness of MMFs as an investment vehicle. While the cumulative outflows created pressure on MMFs, they didn’t create a run on MMFs. In other words, investors have not reduced their investment in MMFs on the basis of news about withdrawals from MMFs and fears about the capacity of MMFs to withstand the pressure associated with the cumulative outflows. 5. The systemic risks posed by European MMFs should not be overestimated

The following comments can be made on the pattern of net inflows in MMFs in Europe in recent years:

• In 2007‐2008, euro area domiciled MMFs experienced net outflows only when the market for short‐term credit ceased to function following the Lehman bankruptcy in the third quarter of 2008. While MMFs were associated with systemic risk, it can hardly be argued that they were a cause of – or amplified – systemic risk, particularly in regard to the financial chaos of 2008.

• In 2010‐2011, investors reduced significantly their holdings of MMFs, mainly because of the competition from bank deposits and the low level of short‐term money market rates. There is no evidence, however, that investors redeemed preemptively from their funds to be on the side of caution. What is certain is that MMFs were able to cope with the withdrawals without being forced to sell securities at fire‐sale prices.

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General Government 6,840 436 6.4%

Non-financial corporations 868 102 11.8%

Financial Corporations other than MFIs 3,293 119 3.6%

Total 16,529 884 5.3%

2. Bond Funds are not significant from a systematic risk point of view In the euro area, the outstanding amount of securities other than shares issued by euro area issuers amounted to EUR 16,529 billion at end 2011. Out of this total, euro area bond funds held only EUR 884 billion, or 5.3%.

Source: ECB 3. Liquidity/maturity transformation is explicitly dealt with

• Duration exposure is part of the “bond package” and takes part of a high level of transparency

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• Liabilities matched by liquid assets as

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4. Leverage is highly constrained

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investment purposes • Exposure diversification rules are consistently applied (5/10/40 rule) • Any exposure (including derivatives) may not exceed 100% of the fund’s NAV

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Annex 4 EFAMA Reply to the Financial Stability Board’s Note on Potential financial stability issues

arising from recent trends in Exchange‐Traded Funds (ETFs) EFAMA is the representative association for the European investment management industry. It represents through its 26 member associations and 51 corporate members approximately EUR 13.5 trillion in assets under management, of which EUR 8 trillion was managed by approximately 53,000 funds at the end of 2010. Just under 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. EFAMA’s membership includes a very large proportion of the European investment management industry, as well as nearly the entire European ETF industry. ETFs are a growing segment of the industry, and EFAMA fully supports initiatives to increase the understanding of ETFs, among them this Note by the Financial Stability Board. First, we wish to highlight the key issues which we will address in detail in this reply:

1) ETFs in the European Union are already subject to one of the most respected and widely recognized frameworks for public investment funds – the UCITS (Undertakings for Collective Investment in Transferable Securities) Directive;

2) The areas of concern in the Note are not unique to ETFs; 3) A significant number of exchange‐traded investment products are not ETFs – appropriate

distinctions must be drawn and understanding among investors and the public must be improved;

4) The distinguishing features of ETFs are highly valued by investors; 5) The ETF segment is a very small percentage of the overall investment fund market.

We wish to highlight that EFAMA’s comments apply only to European ETFs/UCITS ETFs, not to ETFs from other jurisdictions. ETFs as UCITS The vast majority of retail funds in the European Union are structured as UCITS, and a large majority of European ETFs are UCITS as well. The UCITS Directive provides a robust regulatory framework for investment funds which has evolved over time and provides the necessary flexibility together with strong risk mitigation provisions. Further enhancements to risk management and transparency to investors have been introduced by UCITS IV23 in 2010, which will enter into force on 1 July 2011. The high quality and strength of the UCITS framework are recognized and appreciated not just in Europe, but also in Asia and Latin America.

23 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:302:0032:0096:EN:PDF


Summary of relevant UCITS regulation All UCITS (including UCITS ETFs) are regulated and are subject to the same requirements and constraints. This robust product regulation is at the heart of the high level of investor protection UCITS provide. Key elements of the framework include: a fiduciary duty for the management company to act in the best interest of the fund and of investors; that the assets of the fund are held separately from the management company’s balance sheet; that there is an independent depositary that oversees the activity of the manager and safeguards the assets; and that the manager is subject to detailed requirements relating to the management of conflicts of interest. The universe and strategies of UCITS are evolving due to investor demand for risk reduction and return enhancement. This is true for all UCITS (including UCITS ETFs) and is a global trend. In relation to UCITS, however, all strategies must fit within the detailed UCITS requirements and constraints. The key UCITS investment limits and requirements relevant to the FSB’s stated concerns are: • There are strict limits in relation to the global exposure of a UCITS; cover for investment in

derivatives, and counterparty risk. There is a limit on absolute Value at Risk (VaR): a 99% confidence limit of 20%.

• Relative VaR: with the same confidence levels VaR has to be less than 2 times that of the benchmark.

• Benchmark Indices: where a UCITS aims to track a particular index, that index must be sufficiently diversified, an adequate benchmark for the market to which it refers and published in an appropriate manner.

• Liquidity: investor right to redeem and NAV publication at least twice a month. In practice, most UCITS are priced daily and UCITS ETFs provide investors with the ability to buy or sell shares at intra‐day prices in the market.

• Collateral: there are strict requirements regarding liquidity and issuer credit quality in respect of collateral received for transactions in OTC derivatives. In addition, the collateral must be capable of being valued on at least a daily basis.

• Disclosure requirements: annual and semi‐annual report, simplified prospectus (to be replaced by the key investor information document, the KIID, under UCITS IV) and a prospectus for the fund need to be published. In particular, the specificities and characteristics of the investment strategy of the UCITS and the relevant risks involved must be adequately explained. In practice, UCITS ETFs provide much more frequent disclosures relating to portfolio holdings, collateral compositions and counterparty exposures.

All these limits and restrictions are minimum requirements. In practice, UCITS managers (including UCITS ETF managers) operate against self‐imposed tighter limits. Also, the UCITS requirements impose detailed responsibilities on management companies in relation to risk management and risk measurement, in terms of both their organisation and procedures and in the way that funds are monitored. Management Companies are required to employ an appropriate liquidity risk management process in order to ensure that each UCITS they manage is able to meet redemptions. Senior management is responsible for approving and reviewing the risk management policy and arrangements, and the processes and techniques for implementing the risk


management policy. UCITS management companies must establish a permanent risk management function, which must be functionally and hierarchically independent from other departments within the management company, and which is responsible for implementing the risk management policy and procedures. Managers are required to measure and manage at any time the risks to which the fund is or might be exposed, and must ensure compliance with the UCITS limits concerning global exposure and counterparty risk. It should therefore be emphasised that risk management in UCITS is already state‐of‐the‐art, and will be enhanced even further by the entry into force of the UCITS IV Directive on 1 July 2011. These new rules include many, even more detailed provisions on internal control mechanisms for the UCITS management company, including conflicts of interest management. The rules cover the risk management, compliance and internal audit functions, risk management policies, risk measurement, counterparty risk and issuer concentration risk calculation, as well as procedures to value OTC derivatives. In addition, UCITS ETFs are subject to listing rules, to European‐wide requirements relating to their prospectuses, and to national rules on securities lending. Furthermore, market makers in shares of UCITS ETFs are subject to European‐wide rules on transaction reporting. Concerns not unique to ETFs and effectively mitigated by the UCITS framework We note the concerns raised by the FSB regarding potential conflicts of interest, synthetic exposure, securities lending and the use of collateral. We wish to stress that, whilst these types of issues and risks are common across the financial services industry, they are managed and mitigated to a large degree within the highly regulated framework of UCITS. UCITS ETFs must comply with the same stringent requirements applicable to all UCITS. Some of the structures mentioned in the Note would not be possible under the UCITS Directive, and in other examples raised the UCITS rules deal with the concerns expressed. For example, the same legal entity cannot be the ETF provider and the derivative counterparty. Conflicts of interest rules (to be strengthened under UCITS IV) apply to the choice of counterparties, and the risk management process must be submitted to regulators for approval. Counterparty risk rules limit to 10% of AUM the exposure to any individual counterparty for OTC derivative transactions in case the counterparty is a credit institution with its registered office in a Member State of the European Union or is subject to equivalent prudential rules (5% in other cases)24, and collateral for transactions in OTC derivatives is subject to strict liquidity and issuer credit quality criteria25, thus mitigating collateral risk to a substantial degree. Further detailed collateral regulation can be found in national regulation implementing the UCITS Directive.

24 Art. 52 of the UCITS Directive. 25 CESR Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (http://www.esma.europa.eu/popup2.php?id=7000)


Synthetic ETFs – The counterparty risk limits and collateral rules in the UCITS framework ensure that at all times the exposure of the Fund to a single counterparty is managed to a very low level. The rules ensure that UCITS are at all times fully supported by own assets or collateral (unlike, for example, bank issued structured products). Securities lending is a technique commonly used in the fund industry and is not specific to ETFs. Efficient portfolio management techniques like securities lending or repurchase transactions are taken into consideration in the determination of the global exposure and counterparty risk for UCITS. Detailed rules regarding collateral for securities lending are found in national implementing regulation. EFAMA would welcome a dialogue on collateral rules with respect to collateral provided both for synthetic ETFs and for securities lending exposure, if deemed appropriate for market clarity and to reduce the risk of jurisdictional arbitrage. We entirely agree with the need for transparency to investors regarding investment strategies, synthetic or physical replication, and collateral/fund assets composition. As mentioned above, there are extensive disclosure requirements in the UCITS Directive, and UCITS ETF providers already provide on a voluntary basis a higher level of transparency on fund assets and swap exposure via their websites. Enhanced transparency has been driven in particular by institutional client requirements. ETFs and other Exchange‐Traded Products In order to address the concerns raised in the Note, we encourage the FSB not to limit the discussion exclusively to ETFs, as most issues are not unique to them. Furthermore, the concerns have already been addressed in some jurisdictions. We encourage the FSB as well as other regulators to carry out a comprehensive analysis of all Exchange‐Traded Products (ETPs) and to make appropriate distinctions among them and their regulatory frameworks (both by product and by jurisdiction). It is very important that a level playing field be maintained (or established, as the case may be) among financial products, and that regulatory arbitrage among ETFs, ETNs, ETCs and other product structures be avoided. Regrettably, ETFs are often confused in the public domain and in the press with other ETPs, and more investor education is required to correct some of the misperceptions. EFAMA members strongly believe that investors should understand that only ETFs have certain features, and that in Europe they are operating within the UCITS framework, which provides the highest level of investor protection.


ETFs: valuable features for investors An ETF is – first and foremost – a conventional investment fund. To be regarded as an “exchange traded” fund it must (i) permit and respect secondary market transactions in fund units (i.e., allow investors to buy and sell from each other and not just with the fund) and (ii) provide a high degree of transparency regarding its assets and performance in order to allow for accurate intra‐day pricing. As a consequence of these additional attributes, an ETF can be cleared, settled and held in custody like any other equity security. ETF investors are attracted by the many advantages arising from these additional features, among them intra‐day liquidity through exchange trading, multiple listings, availability of intra‐day NAV, tight spreads, commitment by multiple market makers, low investment costs. ETFs: fast growing, but a very small part of the overall investment fund market. EFAMA largely agrees with the FSB analysis of ETF trends and growth factors. ETFs in Europe have indeed enjoyed fast growth, and statistics show that they regularly attract approximately 6% of European equity traded volumes (in spite of incomplete trade reporting due to the exclusion of off‐exchange volumes). Rapid growth has also been underpinned by strong innovation, but the ETF “phenomenon” is still very small in comparison to the overall fund market and its impact on secondary markets and their stability should be put into perspective: only 2.6% of all European funds are ETFs (3.5% of UCITS funds), and high growth rates are due to a low starting base. In particular, new ETF types such as leveraged, inverse and leveraged‐inverse ETFs are a tiny proportion of the ETF universe, as highlighted by the FSB Note. Liquidity issues Lastly, EFAMA wishes to offer some comments on a number of concerns articulated by the FSB relating to the liquidity of the product and the liquidity of banks and asset managers involved in exchange‐traded products. As noted above, all UCITS managers are required to employ an appropriate liquidity risk management process in order to ensure that the UCITS is able to meet redemptions. This overarching requirement is supported by a number of prescriptive rules as regards eligible assets and markets, diversification of fund investments, a tight counterparty exposure limit as described above, and quality of collateral. The NAV pricing mechanism for UCITS reflects market prices of the underlying assets in a transparent way. Furthermore, for UCITS ETFs, intra‐day NAVs are regularly provided to the market, enabling all investors to track the value of their investment. Investors in UCITS ETFs may, depending on the jurisdiction and on fund rules, receive redemption proceeds in the form of the fund’s underlying assets rather than cash. For UCITS ETFs, there are already national requirements as regards the handling of potential fund suspensions, and IOSCO has recently issued draft principles for CIS suspensions.


As regards potential liquidity issues for the parties involved in the ETF market, we would first note that the assets of a UCITS ETF are held segregated from the balance sheets of the UCITS manager, portfolio manager or counterparty. Instead, they are held by the depositary under custody arrangements. We therefore do not understand the reference in the Note to “the liquidity of the large asset managers”. Contrary to banks, asset managers do not issue balance sheet products. EFAMA looks forward to a constructive dialogue regarding ETFs with the FSB and other regulatory bodies, and we remain at your disposal for any clarification you may require. 13 May 2012

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