Background
On 29 February 2024, the Central Bank of Ireland (Central Bank) published its first Regulatory & Supervisory Outlook (Report) in which it sets out the Central Bank's perspective on key trends and risks, as well as outlining its supervisory priorities for the next two years.
Key Risks and Areas of Focus for 2024/5
While the Report identifies key trends and risks applicable to the Irish financial sector more generally, it also provides a sector by sector view of trends and risks for each sector that it regulates, including the funds and securities markets sector. The Report also outlines the Central Bank's key supervisory activities for the next two years for each individual sector.
For the purposes of this briefing, we focus on the key risks relevant to the funds and securities markets sector, and more specifically in relation to Irish fund management companies (FMCs), the funds that they manage and outline certain suggested actions that should be taken to manage such risks.
Delegation and Outsourcing |
Suggested Action to be taken |
The Report reminds FMCs that the ultimate responsibility for any
activities delegated and outsourced rests with the regulated
FMC. |
Review and ensure compliance with the Central Bank's Outsourcing Guidance.2
|
Sustainable Finance |
Suggested Action to be taken |
In the Report, the Central Bank notes that in order to support
the transition to net zero, it is essential that investors are
fully informed on the stated sustainability credentials of
financial products and are in no way misled. As well as identifying the risks posed by
greenwashing3, the Report highlights the emergence of
the occurrence of "green bleaching" which the Central
Bank notes can occur when an FMC does not want to risk
non-compliance with the more onerous requirements of Article 9 of
the SFDR, and so instead opts to categorise the relevant fund as an
Article 8 fund, or, in certain cases, as an Article 6 fund. The
Report notes that such actions can result in inaccurate disclosures
being made. The Report notes that the Central Bank has identified that FMCs
are struggling to obtain adequate data on the sustainability of
their own investments, and when sustainability related data has
been provided to the Central Bank, it has generally been low in
quality. The Report notes that this may result in investors being
poorly informed and perhaps misled. In "Section 3 – Supervisory Priorities"
of the Report, the Central Bank also outlines that it expects FMCs
to improve their response to climate change, and to enhance their
role in the move to a Net Zero economy. |
Review existing disclosures for "sustainable" funds to
ensure that they comply with applicable requirements and to ensure
that investors are in no way misled. |
Leverage and Liquidity |
Suggested Action to be taken |
The Central Bank notes in the Report that "the way
investment funds manage their leverage, liquidity, pricing and fund
entry-exit mechanics has implications for the financial
system as a whole", highlighting the fact that, since
Ireland is one of the largest fund domiciles in the world, if
leveraged exposures are not managed appropriately, they can have
systemic consequences to the wider financial system. |
FMCs to ensure that they have an appropriate risk management
framework in place to identify, manage and mitigate the potential
risks arising from the use of leverage within a fund's
portfolio (including liquidity stresses which may result from
increased margin calls). |
Conflicts of Interest |
Suggested Action to be taken |
The Report highlights the risk that conflicts of interest can lead FMCs and their employees to prioritise their own interests over the interests of their clients or others. In particular, the Central Bank notes that transactions between related parties are common in fund structures in Ireland and they can provide scope for potential conflicts of interest. |
FMCs should ensure that conflicts of interest are carefully identified and managed in accordance with a documented conflicts of interest policy which is regularly reviewed and updated as necessary. All related party transactions should be effected in accordance with rules imposed by the Central Bank. |
Cyber Security |
Suggested Action to be taken |
The Central Bank notes in the Report that cyber-attacks are a
constant threat due to the extensive use of interconnected IT
systems in the securities markets sector which could result in a
successful cyber-attack having widespread effects across the
sector. |
Having regard to applicable Central Bank guidance and the Digital Operational Resilience Act (DORA),4 which will apply from January 2025, ensure that appropriate governance frameworks and tools are in place to identify, measure, manage, monitor and report ICT/cybersecurity risks so that the FMC is made more resilient to possible disruption from cyber and operational risks.5 |
Data Quality |
Suggested Action to be taken |
The Central Bank notes in the Report that "the quality
of fund and securities market-related data received by the Central
Bank, while improving, remains a concern." |
Ensure that accurate data is submitted to the Central Bank on a timely basis and have appropriate oversight of data reporting from board level down (including where data reporting is outsourced). |
Artificial Intelligence and Fintech |
Suggested Action to be taken |
Artificial Intelligence (AI) The Central Bank warns in the Report that the use of AI by
market participants, if not governed correctly, may result in
certain risks being created or amplified. |
FMCs should ensure that, if they are using AI for any of their
functions, that they have an appropriate AI policy in place. |
Market Integrity |
Suggested Action to be taken |
Algorithmic Trading The Report notes that algorithmic trading now accounts for the
majority of trading on many Irish and European marks and that the
use of poorly controlled algorithms increases the risk of
manipulation or disorderly market conditions. In the Report, the Central Bank has identified inadequate market
surveillance frameworks as a key driver of risk. The Central Bank acknowledges in the Report that, while it is welcome that social media is a key source of information for many investors, it can also lead to the risk of the swift spread of false, misleading and often unverifiable information. |
Where relevant, FMCs, should ensure that they have clear
governance frameworks around algorithmic trading in place, having
regard to the Central Bank's expectations outlined in its May 2021 Dear Chair Letter. |
Assessments of Resilience |
Suggested Action to be taken |
The Central Bank in the Report warns that there are key
exposures from external environments which may pose significant
risks to FMCs, including: The Report notes the rapid transition to higher interest rates,
which can be caused by high levels of inflation, can give rise to
significant risks, especially to highly leveraged funds and FMCs
managing portfolios of assets sensitive to interest rate
changes. The Report also notes that the failure of international firms may have an impact of Irish FMCs as it may result in a build up of concentration risk as there becomes a greater reliance on certain firms to carry out certain tasks. |
FMCs should ensure that they are financially resilient and mitigate key exposures from external environments. FMCs may assess their resilience to external factors by completing, among other tests, (i) severe but plausible stress testing and (ii) performance analysis. |
Supervisory Priorities for 2024/2025
In the Report, the Central Bank also outlines its supervisory priorities for the Irish financial sector for the next two years. In listing its priorities, the Central Bank also outlines its expectations for FMCs in the funds and securities markets sector, which include:
- Taking greater responsibility for the governance and risk management of their firms;
- Ensuring that they are resilient and well-prepared for shocks arising from uncertainty in the areas of financial and geopolitical risk;
- Addressing deficiencies identified in their governance, risk management and control frameworks to ensure they are effective, both in the current environment and in the future;
- Demonstrating how their digital and business plans support and deliver transformation that is fully aligned with the FMC's business strategy and minimises any significant risk to financial stability; and
- As outlined in the "Sustainable Finance" section of the above table, improving their response to climate change and enhancing their role in the move to a Net Zero economy.
Please refer to "Section 3 – Supervisory Priorities" on pages 29-33 of the Report for further detail on the above listed expectations of the Central Bank.
Next Steps
As a next step, we would encourage all FMC to scrutinise the risks and supervisory expectations outlined by the Central Bank in the Report and review same against their current business activities, practice, procedures and systems. Where required, FMCs should consider putting an action plan in place to address any identified gaps in their existing arrangements when assessed against the Central Bank's supervisory expectations outlined in the Report.
Should you require any assistance in carrying out a review of your existing framework and governance arrangements or have any queries in respect of the issues raised in this briefing, please get in touch with your usual contact in our Asset Management and Investment Funds Department.
Footnotes
1. In the Report, the Central Bank cites ESMA's description of White Label FMCs as those fund management companies that "provide a platform to business partners by setting up funds at the initiative of said partners and typically delegating investment management functions to them or appointing them as investment advisors
2. Our detailed analysis of the implications of the Cross-Industry Guidance on Outsourcing for FMCs is available here
3. Described by the Central Bank as the "principle of overstating green or ESG credentials".
4. See our latest briefing on DORA here.
5. Regard should be had to the Central Bank's expectation, as outlined in its Cross Industry Guidance in respect of Information Technology and Cybersecurity Risks, for boards and senior management to understand and recognise their responsibility relating to IT, cybersecurity governance and risk management and to maintain oversight of these responsibilities as a priority. In addition, FMCs should be mindful of the Cross Industry Guidance on Operational Resilience Cross Industry Guidance in respect of Information Technology and Cybersecurity Risks and the Outsourcing Guidance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.