Investment funds, securities lending, and European capital markets

Speech by Gerry Cross, Director of Policy & Risk from the Central Bank of Ireland delivered to ISLA’s Securities Lending Roundtable 

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

Addressing ISLA’s concerns over ESMA rules

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

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

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

Central Bank approach to collateral requirements for investment funds

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

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

The speech also discussed the EU capital markets union, Brexit, and changes to the supervisory architecture.

Read the full speech

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