Each month, FactSet's Regulatory team offers a rundown of the most important developments in compliance and regulatory news. Read on to see which stories dominated the conversation last month.
FSB Releases New SFT Haircut Framework
On November 12, 2019, the Financial Stability Board (FSB) published a revised version of its regulatory framework on haircuts for non-centrally cleared securities financing transactions (SFTs) to combat the financial stability risks associated with SFTs that crystallized during the financial crisis.
The framework includes qualitative standards to be used when calculating haircuts on SFT collateral, quantitative haircut floors for non-centrally cleared SFTs in non-government securities when SFTs are used to provide financing for non-bank entities, together with a host of detailed requirements on implementation.
As with the other EU shadow banking regulations (e.g., the Money Market Funds Regulation and the Securities Financing Transaction Regulation (SFTR)), these types of FSB regulatory frameworks typically make their way on to the EU statute book in due course, with SFT haircuts having been on the EU’s agenda for some time as an extension of the broader suite of SFTR rules.
BCBS Consults on Proposed Revisions to Basel III’s CVA Risk Framework
On November 28, the Basel Committee on Banking Supervision (BCBS) published a consultative document, proposing a series of “targeted adjustments” to Basel III’s credit value adjustment (CVA) risk framework. The primary goal of the adjustments is to align the CVA risk framework with the January 2019 market risk framework and capital requirements for bank exposures to central counterparties. BCBS is soliciting comments on the proposals through February 25, 2020.
SEC Extends MiFID II Research Unbundling No-Action Letter for Broker-Dealers Through July 2023
In October 2017, the SEC issued a trio of no-action letters to address questions and conflicts that arose for U.S. financial firms due to the extra-territorial effects of EU rules under MiFID II. One of the no-action letters, set to expire on July 3, 2020, was specifically addressed to broker-dealers who provide research services to investment managers subject (whether directly or contractually) to MiFID II research payment rules.
In brief, under U.S. rules, broker-dealers who receive “soft dollar” payments for research services are excluded from the definition of an investment adviser under the Investment Advisers Act of 1940 (the Advisers Act). MiFID II, by contrast, requires “hard dollar” payments from clients receiving research services with the consequence that broker-dealers providing research services in exchange for hard dollar payments would no longer be excluded from the definition of an investment adviser. The no-action letter effectively enables broker-dealers to receive hard dollar payments under specified circumstances without registering as investment advisers.
On November 4, the SEC announced the extension of that letter through July 3, 2023, while it continues to monitor changes in the market for research brought about by MiFID II.
SEC Proposes Updates to Decades-Old Advertising and Solicitation Rules Under the Advisers Act
The SEC has proposed modernization of investment adviser advertising and solicitation rules in response to changing technologies, shifting investor profiles, and developing market practices. In broad terms, the proposed advertising rule will replace the current rule with principles-based provisions, update the definition of “advertisement,” and will permit the use of testimonials, third-party ratings, and tailored presentations of performance. The proposed changes to the cash solicitation rule will expand the rule to cover other forms of compensation that includes an exception for de minimis payments, tailor required disclosures by solicitors, and remove the requirement to obtain a signed acknowledgment of receipt of solicitors’ disclosures.
SEC (Re) Proposes Rule 18f-4 on Funds’ Use of Derivatives, Sales Practices, and Changes to Forms N-PORT, N-LIQUID, and N-CEN
When the SEC first proposed rule 18f-4 in December 2015, comprehensively updating the regulation of funds’ use of derivatives and other Section 18 transactions, it attracted a raft of public comments—some supportive, others critical. On November 25, 2019, the SEC re-proposed rule 18f-4 with certain alterations and is soliciting public comment on numerous aspects of the proposal.
Rule 18f-4 would be accompanied by coordinated changes to Forms N-PORT, N-LIQUID (to be re-titled Form N-RN) and N-CEN, as well as other sales practices rule changes related to leveraged/inverse funds (new rule 15l-2 under the Exchange Act and new rule 211(h)-1 under the Advisers Act), and an amendment to rule 6c-11 to enable leveraged/inverse ETFs to operate without obtaining an exemption order.
Key elements of proposed rule 18f-4 include: (i) the requirement to implement a derivatives risk management program with board oversight; (ii) VaR-based limits on fund leverage risk with back-testing, stress testing, and reporting requirements; and (iii) exceptions for limited derivatives users.
A comprehensive new rule may be welcomed by the fund industry to the extent that it eases Section 18 compliance, which currently occurs within a patchwork quilt of no-action letters and SEC guidance, but certain aspects of the proposal are likely to garner substantial commentary from the industry given the derivatives rule’s potential to impose new compliance costs and curtail certain investment products.
ESG Disclosure & Climate Benchmark Regulations Published In Official Journal Imminently
On December 9, 2019, Regulation 2019/2088 "on sustainability-related disclosures in the financial services sector" (the Disclosure Regulation) and Regulation 2019/2089 "amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks, and sustainability-related disclosures for benchmarks" (Climate Benchmark Regulation) were published in the EU’s Official Journal.
The Disclosure Regulation requires financial services firms to undertake sustainability risks and adverse impact disclosures at entity and product level, in financial promotions, in pre-contractual documents for UCITS, AIFs, pension funds and other products and services, and periodic reports.
The Disclosure Regulation enters into force 12 months after publication in the Official Journal. However, the promotional disclosures and pre-contractual and periodic report disclosures will enter into force following the adoption by the European Commission of regulatory technical standards (RTS) prepared by the European Supervisory Authorities who have 12 months following entry into force of the Disclosure Regulation to submit the standards.
The Climate Benchmark Regulation imposes ESG disclosure requirements for all benchmark administrators (except in relation to interest rate and FX benchmarks) from April 20, 2020. The regulation also introduces two new benchmark types: the EU Paris-Aligned Benchmark (PAB) and the more modest EU Climate Transition Benchmark (CTB). To attract the CTB or PAB label, strict composition conditions need to be met, including a requirement that other ESG objectives are not significantly compromised. Provision is made for the development of minimum technical standards by way of delegated legislation. There is also a requirement for significant benchmark EU administrators to "endeavor" to provide EU CTBs.
The Climate Benchmark Regulation also contains rules requiring the transition away from benchmarks that are not compliant with the regulation’s requirements, which includes third country benchmarks, together with additional transitional measures including the extension of mandatory administration and contributions to critical benchmarks for five years.
Benchmark administrators which provide a CTB or PAB Benchmark must comply with the Climate Benchmark Regulation by April 30, 2020. The regulation contains further, staggered dates for related compositional requirements, disclosure requirements, and the introduction of delegated regulation.
Finally, among other reviews and reports mandated by the Regulation, the Commission is instructed to submit to the European Parliament and Council recommendations as to the feasibility of an "ESG benchmark" by December 31, 2022.
ESMA Prepares Market For Brexit and The MIFID II Review
On November 19, 2019, Steven Maijoor, ESMA’s Chair, delivered the Key Note Speech at Euro Finance Week in Frankfurt on the topic of "Banking and the MiFID II Review."
Maijoor commenced his speech by noting a serendipitous confluence of three phenomena: the increase in business relocations from the UK to the Continent in anticipation of Brexit, the imminent German Presidency of the European Council, and the upcoming review of MiFID II. Historically the UK had led the regulatory reform agenda. However, with the confluence of these three factors, Maijoor emphasized that the time was ripe for Germany and others to shape the regulatory agenda.
Maijoor then reeled off a series of MiFID II’s achievements such as product governance, client reporting, and disclosure rules. As such, tea-leaf readers might see these as areas unlikely to be subject to the red pen in upcoming changes. However, for research unbundling, the conclusion was that "the jury was still out," leaving the door open for potential changes to these rules.
As expected, the MiFID II transparency regime figured prominently as an area targeted for review with bond markets identified as in need of attention, together with a broader focus on the "equity and non-equity transparency regime, the double volume cap, and the derivatives trading obligation and the systematic internalizer regime"; with Maijoor further commenting that "In parallel, we are working on a report assessing the quoting behavior of Systematic Internalizers (SIs) in non-equity instruments. We intend to consult on these reports towards the beginning of next year and aim at submitting the reports to the Commission in July 2020."
Within the context of transparency, the cost of market data was confirmed as a topic for review together with the development of an equities Consolidated Tape. Maijoor also confirmed that costs and charges would be on the agenda, with the PRIIPs KID part of this broader disclosure review.
EU Co-ordinated 2020 Review into UCITS Liquidity Announced Following FCA Letter on Liquidity
On November 22, 2019, Steven Maijoor, ESMA’s Chair, delivered a Keynote Address at the EFAMA Investment Management Forum in Brussels, on liquidity and supervisory convergence in the asset management sector. Following the redemption suspension and eventual liquidation of the Woodford Equity Income fund and concerns over H2O Asset Management’s Allegro Fund’s illiquid bond exposures, Maijoor stated that ESMA had decided to analyze liquidity management in UCITS to assess whether there might be a broader non-compliant mismatch between redemption policies and liquidity profiles within the UCITS management sector. Specifically, ESMA has decided to implement common supervisory action on UCITS liquidity management under which "EU NCAs will agree to simultaneously conduct supervisory activity in 2020 on the basis of a common methodology to be developed together within ESMA."
The announcement comes less than three weeks after the FCA published a letter to the Chairs of UK Authorized Fund Managers emphasizing the importance of effective liquidity management and good practice.
New STS Securitization RTS on Homogeneity of Underlying Exposures Enters Into Force
On November 6, 2019, Commission Delegated Regulation (EU) 2019/1851, establishing regulatory technical standards in relation to the homogeneity of underlying exposures in securitizations, was published in the EU Official Journal. The Regulation is part of a suite of ongoing delegated legislation the Commission is working on in relation to securitizations. In a welcome development, unlike other legislative texts in the securitizations stable, the new regulation is short, to the point, and intuitive. It enters into force on November 26, 2019.
New EU Covered Bond Regime to Be Published in Official Journal Imminently
In furtherance of the EU’s Capital Markets Union initiative, on November 27, 2019, the Presidents of the European Council and Parliament signed a Regulation and a Directive establishing a harmonized covered bond regime within the Union. Both texts will be published in the EU Official Journal imminently.
The Directive establishes a formal definition of covered bonds and specifies those institutions eligible to issue them together with harmonized features such as dual recourse, bankruptcy remoteness, eligible assets, quality and compositional requirements, investor protection measures, quarterly investor disclosures, and liquidity requirements including a cover pool liquidity buffer. The Directive also contains supervision and sanctions requirements and voluntary labeling requirements in relation to a "European Covered Bond" and "European Covered Bond (Premium)."
In turn, the Regulation modifies the Capital Requirements Regulation (CRR), providing risk-weighted capital relief for covered bonds that meet specified requirements such as over-collateralization.
Both the Directive and Regulation apply 30 months after entry into force, anticipated to be around mid-2023. Member States have 18 months after entry into force to enact the Directive’s measures.
UCITS KIID Exemption Extended Following ESA’s Publication of Consultation Paper on PRIIPS KID
The Joint Committee of the European Supervisory Authorities (ESAs) have published a Consultation Paper, dated October 16, 2019, proposing amendments to the calculation and presentation of transaction costs and the performance scenario methodology underlying the PRIIPS Key Information Document (KID), together with proposals for changes to the KID’s format and in relation to the treatment of corporate bonds.
The consultation remains open until January 13, 2020. The ESAs will then submit their proposals to the Commission by the end of Q1 2020. If accepted, the amendments are expected to enter into force by Q4 2021, corresponding to the end of the UCITS exemption period for publishing a KIID, as specified in Delegated Regulation 2019/1866, which was published in the Official Journal on November 8, 2019 and applied from November 28, 2019.
Meanwhile, the deadline for the European Commission’s broader review into the PRIIPS Regulation is the end of December 2019.
PRA Imposes Largest Ever Fine of £44M for Governance & Controls Failings
On November 26, 2019, the UK Prudential Regulatory Authority (PRA) announced that it had imposed its largest ever fine on a number of Citigroup entities collectively, for systems and controls and governance failings in relation to PRA regulatory reporting.
Specifically, the entities’ reporting frameworks were found to be designed, implemented, and operating inadequately leading to incomplete and inaccurate regulatory returns. Further, the PRA found that inadequate human resources were deployed and that multiple aspects of the entities’ reporting control frameworks were inaccurate, the interpretation of reporting requirements was insufficiently robust, and the oversight and governance in relation to regulatory reporting fell significantly below the standards expected of such a systemically important institution.
Despite the reporting failures, the entities remained compliant with liquidity and capital requirements at all times. Nevertheless, the PRA determined that the widespread nature and duration of the failings were sufficiently serious to pose a significant risk, given the systemically important nature of the institution, and as such warranted a significant regulatory penalty for non-compliance.