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ESMA reveals supervisory plans for 2016 – part 1

Earlier this month, the European Securities and Markets Authority (ESMA) released two key documents detailing its supervisory plans and priorities for 2016.  Whilst these publications primarily identify areas of focus for the current year, they also highlight the shortfalls in terms of promoting sound, efficient and consistent supervision across the European Union.

The first, published on 5 February, highlights the supervisory activities carried out by ESMA on Credit Rating Agencies (CRAs) and Trade Repositories (TRs) during 2015.  In addition, it outlines ESMA’s main priorities within these areas for 2016.  Following this, a second document was published on 11 February, which accompanies a previous publication – ESMA’s Annual Work Programme for 2016.  In particular, this document elaborates on the nature and focus of the work ESMA plans carry out in 2016 to promote supervisory convergence.

Part 1 of this article discusses ESMA’s first publication, which has been prepared in accordance with Article 21 of the CRA Regulation and Article 85 of EMIR.  Whilst the supervision of CRAs has been well established since 2011, a report by the European Court of Auditors (ECA) states that ESMA has not been “fully effective” in its role as the sole supervisor of CRAs.  Furthermore, in response to ESMA’s consultation on access, aggregation and comparison of trade repository data, DTCC Derivatives stated that “the absence of industry standards and lack of regulatory harmonisation has hampered the ability to effectively aggregate data and has contributed to diluted data quality”. 

To address these shortfalls, ESMA recently established a single Supervision Department in order to further develop its supervision of CRAs and TRs.  In particular, through the Supervision Department, ESMA intends to draw on the best practices identified from the supervision of both entity types to further enhance its supervisory effectiveness in the future.

Overview of ESMA’s 2016 plan

During 2015, a number of changes to both CRA and TR industries were observed by ESMA.  Both sectors witnessed new applicants for registration and authorised entities also sought to develop their current businesses.  In particular, CRAs pursued the provision of credit ratings on new asset classes and/or in new geographic areas and TRs offered trade reporting services for other instrument types.

In order to establish annual supervisory priorities, ESMA conducts a series of risk assessment exercises in accordance with its overall objectives of “promoting financial stability and orderly markets and enhancing investor protection”.  This approach relies on the analysis of information from a variety of sources and the application of multiple supervisory tools, such as “day-to-day supervision, cycle of engagement meetings with supervised entities, on-site inspections and dedicated investigations”.

This process identified high levels of governance and strategy risk, and operational risk in the CRA industry, and high levels of risk associated with TRs’ data and systems as the key supervisory priorities in 2015.  For 2016, it highlighted that ESMA should focus its supervisory activities on:

• CRA governance and strategy and the quality of credit ratings
• TR data quality and data access
• Fees charged and information security for all supervised entities.

2016 priorities for CRAs

In 2015, three new registrations brought the total number of CRA groups registered with ESMA up to 26.  However, as three of the largest CRA groups operating globally consist of 17 separate entities, the total number of separate CRAs registered with ESMA is now 40.

The risk-based assessments carried out identified that ESMA should focus its supervisory activities on “ensuring that CRAs’ compete and develop their businesses in compliance with the CRA Regulation”.  In particular, for 2016, ESMA’s supervisory areas of priority for CRAs include:

1. Governance and strategy
2. The quality of credit ratings and credit rating activities

A detailed plan highlighting the work to be undertaken within the above supervisory areas of priority are noted below.  In addition to work in these areas ESMA plans to continue its investigations into the conduct of specific CRAs – work which had initially begun in 2015 – and will also continue developing internal IT tools and external systems, including the fees reporting component of the Ratings Data Reporting tool (RADAR).

1. Governance and strategy

In 2016, under this first supervisory priority area ESMA will:

• Examine the impact that CRAs’ governance, shareholder structures and business decisions have had on their operations and internal controls. This is to ensure that CRAs’ business interests do not impair the independence of credit rating activities
• Monitor the impact that organisational changes may have had on the effectiveness of CRAs’ compliance, internal audit and internal review functions
• Examine the role of internal control functions in CRAs more broadly, with particular regard to their responsibilities for monitoring and evaluating the capability and effectiveness of CRAs’ systems and the steps taken to address deficiencies identified
• Determine compliance against the requirement to ensure that the fees charged by CRAs cannot depend on the level of the credit rating issued by the CRA or on any other result or outcome of the work carried out.

2. Quality of credit ratings and credit rating activities

Under this second supervisory priority area, ESMA will:

• Regularly monitor competition between CRAs and performance of credit rating indicators
• Examine the quality and accuracy of credit ratings issued by CRAs
• Continue building on the validation of methodologies: investigate how methodologies for particular asset classes have been developed, validated and applied
• Consider whether IT and analytical resources for CRAs are sufficient to confirm stability and consistency in the performance of its credit rating activities.

2016 priorities for TRs

The supervision of TRs by ESMA started in 2013, along with the requirement for TRs to register with ESMA in accordance with EMIR.  Trade reporting to TRs began the following February.

There are currently six registered TRs within the EU and a further two applications being reviewed.  By the end of 2015, almost 27 billion reports had been received by TRs, with an average of 330 million trade reports being submitted each week.

The risk-based assessment was also undertaken on TRs, and the findings highlighted that the main areas for supervision in 2016 relate to:

1. Data quality
2. Data availability and access to TRs
3. Financial risks
4. Information security risk.

1. Data quality

As the Level 2 data validations were only introduced late in 2015, this suggests that one of ESMA’s key areas of focus will be on further improving TR data quality throughout 2016.

In November 2015, ESMA submitted amended technical standards on reporting to the European Commission.  Once these new standards have been approved, ESMA can then begin to assess whether TRs are ready for the implementation of the amendments, including the introduction of new fields and values.

Although reporting under these amended technical standards is not expected to start until 2017, TRs and reporting entities will be required to prepare for the changes well in advance.  In light of this, ESMA will need to supervise the progress and compliance of TRs according to agreed timeframes.

2. Data availability and access to TRs

In 2016, ESMA plans to continue focusing on data availability and access to TRs.  In particular:

• The remedial action plans of inspected TRs are expected to be finalised and monitored
• ESMA will also pay consideration to the activities of other TRs regarding data availability and access to data.

3. Financial risks

The monitoring of the financial health of TRs began in 2015, in order to assess whether TRs would be able to comply with the equity requirements.  In particular, a TR is required to “hold sufficient equity to cover general business losses and to provide services…to help ensure it has sufficient financial resources to cover the operational costs of a wind-down or reorganisation of the critical operations and services for a period of at least six months”.  In light of this obligation, in 2016, ESMA will:

• Continue monitoring three major factors: liquidity, leverage and profitability of TRs, which are measured using specifically selected financial ratios
• Focus on the cost-relatedness of fees charged by TRs.

4. Information security

In 2016, ESMA will:

• Complete an analysis of the thematic TR cyber resilience review, which was launched in 2015
• Finalise and monitor the implementation of the remedial action plans arising from the onsite inspections that were performed in 2015 and 2014.

Common areas of focus across industries

Based on the supervisory priorities for 2016 listed above, there are 2 common areas of focus for both CRAs and TRs:

1. Information security
2. Fees charged by supervised entities.

1. Information security

The risk-based assessment exercises carried out by ESMA have identified that some of the greatest risks faced by all supervised CRAs and TRs are related to IT systems and processes.

To address this, the Supervision Department will ensure that supervised CRAs and TRs have effective systems in place for secure exchange of information within operating environments and that entities are resilient to cyber-attacks.

2. Fees charged by supervised entities

Both the CRA regulation and EMIR require entities within both industries to ensure that fees charged are non-discriminatory and based on actual costs.

ESMA states that combining its work within this area will allow them to “develop a consistent overall strategy for ensuring that it conducts its supervision in a way which maximises investor protection, financial stability and orderly markets”. 

ESMA has its work cut out and, although its documentation and internal monitoring tools have been described as a “rather rudimentary” means of supervision, ECA report that it’s not always possible to trace the supervisory work performed or the conclusions derived from it.

So far, ESMA has laid down good foundations for its supervision approach to CRAs and TRS, but its work is far from complete.  As both industries continue to evolve, ESMA will have to adapt to enhance its practices.

Stay tuned for part 2, where we discuss ESMA’s first Supervisory Convergence Work Programme.  To keep up to date with the latest regulatory developments, make sure you subscribe to our alerts.