Views on improving the integrity of global capital markets
21 September 2020

Should the Financial System Be Worried — Again — About Investment Fund Leverage? A review of ESMA’s Recent Consultation on Article 25 of AIFMD

CFA Institute responded to the European Securities Markets Authority’s (ESMA) recent consultation on its proposed guidance to address the requirements of Article 25 of the Alternative Investment Fund Managers Directive (AIFMD), which closed on 1 September 2020.

The response can be found here:

Article 25 of Directive 2011/61/EU deals with the Use of information by competent authorities, supervisory cooperation, and limits to leverage, as it pertains to investment firms that manage leveraged Alternative Investment Funds (AIFs).

In a nutshell, the European Systemic Risk Board (ESRB) has mandated ESMA to provide technical guidance on the following two aspects for the purpose of Article 25:

  1. What metrics, indicators and process should be used to determine the potential systemic risk of any investment vehicle.
  2. How to set up limitations on the use of leverage by any fund or group of funds.

ESMA’s proposed guidelines, which were the subject of the consultation, largely draw on a body of work that has formed over a decade of cooperation between the International Organisation of Securities Commissions (IOSCO), the various national competent authorities (or national securities markets regulators) that are part of it and the Financial Stability Board (FSB). This work is broadly referred to as shadow banking or, more precisely, as the identification of non-bank non-insurance systemically important financial institutions (NBNI SIFIs).

This decade of work has been necessary (perhaps not yet sufficient) to delineate the structural differences in risk assessment that exist between banks and asset management firms. This debate, which started around the early 2010s, as the world was mending from the 2007–2009 Global Recession and the subprime crisis, usually has pitted prudential banking regulators against securities markets authorities on the dichotomy between the principal business of banks and the agency nature of the work performed by asset managers. In other words, is the total size of assets under management a sufficiently clear-cut measure to declare that an asset management firm could be systemic, just as a bank would be by looking at its balance sheet assets? We argued a resounding, “No.”. By its nature, asset management is simply a conduit for capital held by other agents and segregated in an investment vehicle. Without the presence of leverage or other transmission factors, the holders of fund shares act as a de facto buffer for any default of the fund.

In December 2019, IOSCO released its “Recommendations for a Framework Assessing Leverage in Investment Funds.”[1] This Final Report on the matter presents a two-step approach that ESMA also retained in its guidance. The particularity of this approach is to recognize that once potentially systemic entities have been identified through simple and direct measures of leverage, we also need to factor current market conditions and other risk transmission indicators into the equation before concluding that leverage (or the magnitude of risk taking) needs to be curtailed in any particular manner.

CFA Institute agrees with this approach.

We are old enough to remember the events that led to the audible default of Long Term Capital Management (LTCM) in 1998. At the time, it had marked the minds of market participants and regulators because of the sheer size of the positions it had amassed on derivatives markets and also because of the stature of its partners. Yet, subsequent reports concluded that LTCM’s failure was probably not of a systemic nature, whether considering its impact on trading counterparties or the market seizure that ensued. This seizure was rather the result of uncertainty as to the exact nature and size of LTCM’s position, which was in effect a problem of financial and regulatory reporting. With the benefit of hindsight, LTCM probably would not qualify as a NBNI SIFI.

Then the 2007–2009 crisis erupted, and we could all measure the effect of risk transmission channels through the system, starting with sub-prime mortgages, which were in turn compounded by structured finance. Ultimately, these toxic assets would be found one way or another in any sort of portfolio managed by professional investment management firms. The commotion caused by the realization that the whole system had been built over an asymmetric risk exposure between finance firms and the general public (or taxpayer) led authorities and regulators to roar in unison, “Never again.”

The FSB was created in this context in April 2009 as part of the G20 London Summit, after observing, in the face of the dire events that were unfolding, that the Financial Stability Forum established in 1999 was no longer fit for purpose. Regulators would need stronger teeth, more information from regulated firms and the capacity to intervene, if needed, to maintain the system’s financial stability.

This debate surrounding what information should be required, how it should be used and to what end, has been raging ever since.

ESMA’s consultation is another step toward industrializing the usage of the information that it now has access to through AIFMD reporting. The same is true in the United States with the SEC’s Form PF framework, although evident comparability issues are still at play.

CFA Institute has a history of working on systemic risk in financial services in general and asset management in particular. Please see the following link for our various positions on the topic:

CFA Institute also sponsors the CFA Institute Systemic Risk Council (, a private sector, non-partisan body of former government officials and financial and legal experts committed to addressing regulatory and structural issues relating to global systemic risk.

A balance is needed between the industry and regulators. Risk mitigation cannot be pursued as an absolute objective as it would stifle innovation, entrepreneurship, and sound risk taking by private actors. Conversely, it is no longer acceptable for financial services firms to engage in risky activities in an asymmetric fashion hoping that authorities and tax payers ultimately will be responsible for the stabilization of the system. Somehow a rebalancing needs to take place and it is probably fair to assume that regulators have a role to play in this regard. Through the data they now have access to and the appropriate means they may put in place to analyze this data, regulators should become better informed on the level of risk in the system.

We recognize that leverage (financial and synthetic) is the one important channel through which risk can migrate from fund shareholders to the wider economy, via other counterparties, banks and central clearing counterparties (CCPs).[2] Therefore, it is important to monitor the build-up of risk in the system through leverage and to appropriately control the vehicles and firms that wield this leverage through the funds they manage.

ESMA’s two-step approach bears the following logic:

  1. Identify the potentially systemic investment funds by using simple and widely available measures of leverage and gross notional exposure (financial and synthetic).
  2. Use further risk measures and transmission indicators to assess the severity of risk of any particular fund or group of funds (e.g., liquidity, turnover, credit risk).

The ultimate question ESMA and ESRB will need to answer is the specific parameters that will dictate when and how to force a deleveraging in particular circumstances.

In our answer to the consultation, we note the following:

  • Because of the inherently global nature of the alternative investments industry, international regulatory cooperation continues to play an important role in data sharing, which is not helped by the fact that a large part of hedge funds activity is domiciled offshore. Data are still difficult to compare or merge at an international level and regulatory oversight is not always properly coordinated.
  • We caution, however, against a blanketed approach to leverage restriction, as has been considered in the consultation. We recommend targeted actions depending on the market situation and also after a thorough assessment of any given firm’s risk management systems and processes. This means the need to combine quantitative and qualitative approach as part of the analysis.

The work performed by ESRB and ESMA in the EU along with their international peers on NBNI SIFIs and shadow banking is an important part of regulators’ responsibility to ensure that an increasing globalization of exchanges and financial services does not unduly affect the stability of local economies. Ideally, the level of risk in the system and related control mechanisms should be such that the system at large would be resilient and strong enough to tolerate the failure of specific parts in an orderly manner, without unmanageable spillover effects. This is what we believe a balanced risk management framework should aim to achieve.

In the current context characterized by low or negative interest rates as a policy maintained by central banks, combined with a Covid-induced economic crisis whose structural effects on systemic risk are still largely unknown, it makes sense to keep an eye on alternative investments and the transmission channels to the wider economy.

[1] See IOSCO, “Recommendations for a Framework Assessing Leverage in Investment Funds,” FR18/2019 (December 2019),

[2] See the work done by the SRC on the risk posed by CCPs, “Statement by the Systemic Risk Council Addressed to the Chairman, Financial Stability Board, Bank for International Settlements on CCP Resolution” (31 July 2020),

Photo Credit @ Getty Images / boonchai wedmakawand

About the Author(s)
Olivier Fines, CFA

Olivier Fines, CFA, is head of Advocacy and Capital Markets Policy Research for EMEA at CFA Institute. With teams based in London and Brussels, he leads the effort in researching and commenting on the major trends that affect the investment management industry as well as changes to the profession and policy and regulatory developments. The positions taken on these issues and the research pieces that are published are meant to promote the fundamental principles upheld by CFA Institute, that of investor protection, professional ethics, and market integrity. Fines joined CFA Institute in March 2019 after a 15-year career in investment management spanning research, portfolio management, product management, and regulatory compliance work at firms based in Paris and London. Prior to joining CFA Institute, he was head of Risk and Compliance at Rothschild & Co in London for the private equity and private debt division.

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