The Supervision of Conduct in the Funds Market - Colm Kincaid, Director of Securities and Markets Supervision

Remarks delivered to the Asset Management and Investment Funds Group Seminar hosted by A&L Goodbody

Introduction

Good evening, it is a great pleasure to be here and I would like to thank A&L Goodbody for the opportunity to speak to you. I want to use the next few minutes to share with you some perspectives on how our market is evolving and the Central Bank’s development of its approach to conduct supervision and innovation in securities markets. I will also make a few points about corporate governance in funds, including in a Brexit context.

Market developments

The funds industry in Ireland has seen significant growth in recent years and with it the scale and complexity of our work at the Central Bank has also grown. For example, in the first half of this year alone the Central Bank of Ireland granted 568 fund authorisations and we aim to be ever more effective in the performance of this gatekeeping activity and raising standards of disclosure.

As a prominent jurisdiction for the securities sector, we also have to work hard to make a meaningful contribution to the development of the regulatory framework at an EU and international level. This is most evident perhaps in our work in the field of Exchange Traded Funds (ETFs), where Ireland has been to the fore of both the growth of the industry and thought leadership on how to regulate it. Last month saw the publication of our Feedback Statement¹ in response to our ETF Discussion paper of May 2017². This Feedback Statement was the culmination of an extensive and rich exercise of engagement both domestically and internationally, and we are grateful for the level and quality of responses we received. These responses will inform the Central Bank’s approach in the ongoing debates on ETFs and funds generally in European and international policy forums, as well as our overall risk outlook on this sector and our supervision of it.

As well as increasing in scale, the securities industry here in Ireland, as elsewhere, has increased in complexity, and the scale and complexity of financial regulation has grown to match the challenges and risks presented by this. As we continue to embed the extensive detailed requirements of MiFID II / MiFIR, we are also working on the implementation of the Money Market Fund Regulation and commencing work on the implementation of the Prospectus Regulation. In tandem with this expanded regulatory mandate, we have adopted a more assertive and intrusive model of supervision backed by robust enforcement. Since the financial crisis, we have also seen the establishment of the European Supervisory Authorities, where in a securities context (for example) we work alongside our EMSA and NCA colleagues to achieve ever greater convergence in how securities markets, products and activities are supervised.

Financial Conduct Regulation

A key development in how the Central Bank of Ireland discharges its mandate took place last year with the establishment within the Central Bank of a new pillar dedicated to financial conduct regulation. The Directorate which I was appointed to in January, the Securities and Markets Directorate, forms part of that pillar.

Of course, financial conduct regulation has always been a part of the Central Bank’s functions and practices. However, by pulling the various aspects of conduct regulation together into one pillar, the Central Bank started a process of developing a more cohesive, consistent, risk-based approach to conduct supervision across all of the sectors we supervise, including funds. You will for example have seen the announcement in September of the results of our review of performance fees in UCITS. On foot of this review, all fund management companies of UCITS which charge performance fees have been required to review their existing methodologies and report back to the Central Bank by 30 November. We will continue our supervisory engagement on this topic with the relevant UCITS and fund service providers until we are satisfied that the issues we have identified regarding performance fees have been resolved, as well as advancing the work on our proposal to migrate our guidance into binding regulations. Together with ESMA and fellow NCAs, we are also now looking more closely into “closet indexing” or “index hugging”.

Wholesale Market Conduct Supervision

Whether it be funds or other securities market activity, the efficient functioning of wholesale financial markets is critical to both global and national economies and misconduct in these markets can undermine their effective operation to serve investors and the wider economy³.  As the nature, scale and complexity of our overall securities market continues to grow therefore, we are also working hard on the development of our approach to conduct supervision of securities markets more generally, outside of direct protection of consumers – what we are terming ‘wholesale market conduct supervision’. The advent of Brexit has accelerated our work under this heading, as we see larger and more complex wholesale securities market businesses look to establish in Ireland. But our approach will apply equally to incumbent firms, and in funds we see a securities sector where Ireland is already of course a prominent jurisdiction in an EU and international context.

The details of our approach to wholesale market conduct supervision will be informed by our principles for a proper and effectively regulated securities market, namely one that:

• Provides a high level of protection for investors and market participants.
• Is transparent as to the features of products and their market price.
• Is well governed (and comprises firms that are well governed).
• Is trusted, by both those using the market to raise funds and those seeking to invest.
• Is resilient enough to continue to operate its core functions in stressed conditions and to innovate appropriately as markets evolve.

Corporate Governance

Turning to corporate governance, here too I believe conduct regulation provides a topical and useful language for directors and others within regulated firms to frame the level of challenge that I know from experience to be necessary if you are to ensure that the right standards of behaviour are set and met. Both conduct regulation and corporate governance standards are also about incentives. Experience tells us that if a structure or practice incentivises a particular behaviour then that is the behaviour that will prevail. Experience also tells us that the culture and incentives that drive any commercial enterprise begin at how it is constructed in the first place and the culture of its governing board.

Five years ago, we began a body of work specifically to look at the effectiveness of fund management governance. This body of work, which became known as “CP86”, was driven by concerns to ensure that our framework for protecting investors remained fit for purpose, including as the funds industry grows in nature, scale and complexity. While it was not formulated with a market development as significant as Brexit in mind, it has certainly positioned us well in the current context by providing an explicit framework for existing firms and new entrants. It has also provided us with a framework to develop our own thinking on the practical application of our governance requirements as we look at new business models and engage with firms on their application of CP86, which came into full effect on 1 July 2018. We expect firms and applicants for authorisation to demonstrate to our satisfaction that they meet these requirements in the context of their specific business model and risk profile. 

In particular, CP86 makes clear that running a fund management company requires that adequate resources are dedicated and organised to ensure investors’ best interests are protected. This includes ongoing management but also dealing with extraordinary risks such as the impact of Brexit. Questions for funds and their management companies include: What have you done to plan for the possibility that come 29th March you can no longer receive certain services from the UK? If you envisage migrating those services to a new provider, have you a plan in place with that provider for this to take place? Have you taken steps to execute that plan, or if not when will you take those steps? The expectation at the level of both the Central Bank and investors will be that firms have dedicated the necessary time and planning to these issues.

When considering what good corporate governance looks like, firms also need to factor in the need for diversity. The importance the Central Bank places on diversity and inclusion, and our work to create a diverse and inclusive culture within our own organisation has been highlighted recently⁴. As I have said in previous remarks⁵, diversity of gender, experience and background has an important role to play in ensuring good governance and sound decision-making within management bodies. It acts as an essential safeguard against the emergence of groupthink and harmful industry practices. We expect firms to take steps to ensure they are sufficiently diverse and inclusive and to improve on their current position.

For instance, analysis of over 3,600 fitness and probity related applications to the Central Bank received in 2017 shows that while the asset management sector saw a modest increase in the proportion of female applicants in 2017, the percentage of female applicants remained low (at just 23%). Indeed, fund applications showed a decrease in the proportion of female applicants (from 20% for 2012-2016 to 19% for 2017)⁶.

Innovation

Finally, the pace of technological development in the financial services sector continues to intensify, not least in securities markets. Our engagement with firms through the Central Bank’s Innovation Hub is one of the methods we use to gain early awareness of new technologies and enhance our understanding of potential risks and mitigants. We are also working to maximise the benefits of technology to improve how we do our job, and earlier this year we hosted an international conference on RegTech to help foster a greater level of discussion on this topic. Recently conducted analysis has revealed that spending on RegTech platforms will exceed US$115 billion by 2023, up from an estimated US$18 billion in 2018 and reports that regulatory pressures are increasingly driving businesses towards RegTech solutions rather than more traditional compliance approaches.⁷

Indeed, I have made the point previously that we are now regulating not just the conduct of individuals, but also the conduct of machines acting across fractions of a second. An example of the increasing use of data and technology by the Central Bank to supervise securities markets is the work we have undertaken in relation to algorithmic high frequency trading. Over the course of the year we have sharpened our focus on this activity, which now accounts for a significant amount of securities market activity (over half of trading volume in certain cases). Our computer-based analysis of the several millions of transaction reports we receive each day has increased our visibility on the level of algorithmic trading being carried out in the Irish market, as well as the interconnectivity of trading on the market. Through this investigative work, we have identified that algorithmic trading is being used more extensively in the Irish market than previously reported. We continue to engage with the firms concerned in order to bottom out our queries on reported levels of algorithmic trading. We are also liaising with our colleagues in other NCAs and ESMA on the definition of algorithmic trading in the relevant EU reporting requirements. This is just one example of the extent to which regulated firms need to understand and manage how they use and rely on technology.

Concluding remarks

To conclude, it is a busy time at the Central Bank of Ireland and I am sure it is a busy time for you too. As we tackle the challenges of today and look to the future, it is worth bearing in mind that we are still emerging from a profound financial crisis the lessons of which must not just be learned but also embedded permanently into our approach to financial services and financial services regulation. These lessons include the importance of high standards of conduct and market transparency, the need to avoid being captured by group think and the need to understand and mitigate the risks of innovation while also fostering its benefits. The lessons also include how quickly hard-won trust in a financial service can be lost and the need to demonstrate on an ongoing basis to users of that service, and those who represent those users, that their best interests are being protected. It is essential that we apply these lessons if we are to achieve a trusted financial system supporting the wider economy, where firms and individuals adhere to a culture of fairness and high standards.

I wish to thank Stephanie Kearns for her assistance with this speech.

-------------------------------------------------------------------------------------------

¹ Central Bank of Ireland: Feedback Statement on Exchange Traded Funds Published, 14 September 2018.

² Central Bank of Ireland: Discussion Paper 6 - Exchange Traded Funds, 15 May 2017.

³ IOSCO Task Force Report on Wholesale Market Conduct (PDF 476.04KB) (FR07/2017), June 2017. 

⁴ The Irish Times: Creating a culture of inclusion; harnessing difference in the public interest, 9 October 2018.

⁵ Kincaid, Colm: 'A Properly and Effectively Supervised Private Equity Market', Central Bank of Ireland, 10 September 2018. 

⁶ Central Bank of Ireland: Demographic analysis – Applications for Pre-Approval Controlled Functions (PCF) roles in regulated firms – 2017 (PDF 1.01MB), 7 March 2018.

⁷ FS Tech: ‘RegTech spending to exceed $115bn by 2023’, 19 September 2018.