Understanding MiFID 2 and Collective Investment Schemes

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Questions and Answers

What is a potential consequence of erroneous collateral valuation in securities lending operations?

Underestimation of asset value leading to firesale (correct)

Reduction in procyclicality of financial systems

Increased investor confidence in market stability

Enhanced protection against counterparty failures

Which regulatory rationale emphasizes the importance of protecting individual investors from mismanagement?

Facilitating increased access to shadow banking

Promoting long-term market-based savings

Ensuring financial stability as a public good

Investor protection addressing agency costs (correct)

What primary characteristic distinguishes Money Market Funds (MMFs) in terms of their funding structure?

They are exclusively available to institutional investors

They are designed to provide high volatility for returns

They are characterized by equity-like funding mechanisms

Their structure has deposit-like characteristics (correct)

Which of the following constitutes a key intervention tool to manage risk in financial products?

Implementation of leverage limits on issuers Signup and view all the answers

What potential issue arises from Fixed Income Exchange Traded Funds (ETFs), related to their operational characteristics?

They can obscure underlying counterparty risks Signup and view all the answers

What is a requirement for a public debt CNAV MMF regarding its investments?

It can only invest in money market instruments guaranteed by governments or supranational organisations. Signup and view all the answers

What is the maximum allowable investment percentage in eligible securitisations for MMFs?

15% of the MMF's assets, or 20% for STS securitisation. Signup and view all the answers

Which of the following statements regarding LVNAV MMFs is true?

They value assets and liabilities with mark-to-market unless maturity is below 75 days and the difference with MTM is not more than 10 basis points. Signup and view all the answers

What is the limitation on investment concentration for MMFs according to the regulation?

No more than 10% can be invested in money market instruments from a single entity. Signup and view all the answers

What type of financial instruments may MMFs invest in, apart from short-term assets?

Deposits not exceeding 12 months and shares in other MMFs. Signup and view all the answers

What does a defined investment policy primarily provide to governance?

Stewardship in governance Signup and view all the answers

Which of the following is a disadvantage of a defined investment policy?

Not suitable for high net worth investors. Signup and view all the answers

Which characteristic distinguishes open-ended funds from closed-ended funds?

Variable number of units based on market demand Signup and view all the answers

What is a known vulnerability associated with liquidity mismatches in asset management?

Run and contagion risks Signup and view all the answers

Which of the following correctly describes a characteristic of closed-ended funds?

Investors can sell their units only in open market transactions Signup and view all the answers

What is one reason why herding behavior can be problematic in fund management?

It can exacerbate market volatility and lead to poor investment outcomes. Signup and view all the answers

Why are investment funds considered a success for portfolio theory?

They allow for broader portfolio diversification and improved risk-adjusted returns. Signup and view all the answers

What term refers to the use of financial derivatives that can lead to a feedback loop in funds?

Leverage Signup and view all the answers

What is a major advantage of the ban on inducements under MiFID 2?

Asset diversification Signup and view all the answers

What is one key requirement imposed by MiFID 2 regarding inducements from third parties?

Only minor non-monetary benefits are permitted Signup and view all the answers

Which of the following is NOT a feature of Collective Investment Schemes (CISs)?

Unit holders have complete control over fund investments Signup and view all the answers

Which statement reflects a potential disadvantage of asset diversification under MiFID 2?

It limits the ability to achieve alpha returns Signup and view all the answers

How is the Net Asset Value (NAV) of an investment fund calculated?

Market Value of Assets minus Portfolio Liabilities divided by number of shares outstanding Signup and view all the answers

What is one characteristic that differentiates CISs from traditional investment vehicles?

CISs are designed for collective returns Signup and view all the answers

In the context of MiFID 2, what does 'unbundling' refer to?

Eliminating third-party inducements and benefits Signup and view all the answers

Which test is NOT required under MiFID 2 for appropriate client investment management?

Investment strategy test Signup and view all the answers

What is the primary purpose of the Key Investor Information Document (KIID)?

To summarize key characteristics of UCITS funds in an accessible manner. Signup and view all the answers

Which statement accurately describes the role of a depositary in the context of UCITS?

The depositary must prioritize the interests of unit-holders. Signup and view all the answers

What change was introduced following the Bernie Madoff Ponzi Scheme regarding depositary liability?

Depositaries are held liable for non-market risks to protect investors. Signup and view all the answers

What key information must the KIID include about ongoing charges?

Comparable data to facilitate easy shopping around. Signup and view all the answers

How is the KIID expected to communicate its information?

In a clear, concise, and non-technical manner. Signup and view all the answers

Which responsibility is NOT associated with a depository institution in the UCITS framework?

Engaging in the fund's investment strategy. Signup and view all the answers

What is one of the objectives of Regulation (EU) 2016/438 (CSDR) in relation to depositaries?

To address non-market risks related to depositaries' activities. Signup and view all the answers

What must the KIID avoid regarding its presentation of information?

Being misleading or unclear. Signup and view all the answers

Study Notes

MiFID 2

Banning inducements from third parties is a key requirement under MiFID 2.
Allowing only "minor non-monetary" benefits for research is part of this rule.
Asset segregation from other clients is crucial for investment firms.
Appropriateness and suitability tests for investment recommendations are mandatory under MiFID 2, Article 25.

Collective Investment Schemes (CIS)

CISs are investment vehicles that allow individuals to invest in portfolios of assets.
Investors receive "shares" or "units of investment funds" in the portfolio.
CISs are designed to generate returns and primarily focus on liquidity transformation.
The Net Asset Value (NAV) is the price of an investment fund share or unit, calculated by dividing the market value of assets minus portfolio liabilities by the number of shares outstanding.
Key features of CISs include:
- No general commercial or industrial purpose.
- Pooled capital raised for generating a pooled return for investors.
- No day-to-day discretion or control for unit holders.
- Operation under a defined investment policy determined by a document.
Pros of investing in CISs:
- Stewardship in governance.
- Capital allocation and asset diversification.
- Mitigation of behavioral weaknesses in investing.
- Lower costs compared to direct trading.
Cons of investing in CISs:
- Not suitable for high net worth investors due to potential indirect trading costs.
- Herding behavior and interconnection risks within investments.

Investment Funds

Investment funds are structured as corporate entities where investors acquire shares or units.
They are typically invested in financial assets but can also hold real assets like infrastructure or real estate.
Open-ended funds adjust the number of shares based on investor redemptions.
Closed-ended funds have a fixed number of shares, limiting redemptions and requiring sales to other investors.
The rise of investment funds is attributed to the portfolio theory's benefits, which include:
- Improved risk-adjusted returns through diversification.
- Broader portfolio and greater diversification opportunities.
- Research that adds value, especially in highly efficient markets, is expensive and is best spread across a wide portfolio.

Asset Management Vulnerabilities

Liquidity mismatch between fund investments and redemption terms (open-ended funds) is a major vulnerability in asset management.
- This mismatch can lead to "runs" and contagion risks.
Leverage used within funds, often synthetically through financial derivatives, amplifies this liquidity mismatch.
- This creates a feedback loop, further increasing risk.
Herding behavior in stressful market conditions is a significant concern.
- Retail fund managers may be susceptible to "spurious herding" due to changes in benchmark index composition.
Securities lending operations are another vulnerability:
- Fire sale of securities following counterparty failures can lead to sharp price declines.
- Erroneous collateral valuation can create additional risks.
- Re-hypothecation of encumbered assets can have cascading effects.

Regulatory Rationale for Intervention in Asset Management

Investor protection is a key driver for regulatory intervention, aiming to address agency costs between investors and managers, and prevent potential benefits extraction through trading practices or fraudulent activity.
Promoting long-term, market-based household savings is another rationale.
- This involves better hedging against market risk and promoting passive investing.
Financial stability is a public good, and certain CIS structures can operate as "shadow banks."
- Money Market Funds (MMFs) can have a funding structure similar to deposits, raising concerns about systemic risk and investor protection.
- Fixed income Exchange Traded Funds (ETFs) listed on exchanges offer maturity and liquidity transformation, but also expose investors to hidden counterparty risks.

Regulatory Strategies for Asset Management

Key intervention tools include:
- Rules on product structuring and governance, including eligible assets, issuer concentration, and leverage limits.
- Rules on risk management, such as liquidity and redemption management functions.
- Conduct of business rules addressing conflicts of interest.
- Rules on disclosure to investors, such as the Key Investor Information Document (KIID) and other transparency requirements.

Key Investor Information Document (KIID)

UCITS investment or management companies are required to publish a short document summarizing key fund characteristics like costs, past performance, and risk.
The KIID is a key investor protection tool designed to go beyond "caveat emptor" principles.
It is not approved by national competent authorities but provides no liability for the UCITS company.
It can be passported in English for easier international access.

Depository Liability

Depositories, usually central securities depositories (CSDs), perform crucial functions in UCITS funds.
They hold assets in custody, oversee compliance, act independently in the interest of unit-holders, and cannot be the management company of the fund themselves.
After the Bernie Madoff Ponzi Scheme, depository liability for non-market risks was introduced to ensure proper investment practices.
- This involves matching cash invested with underlying assets to limit misuse of fund structures.
Depository liability also encompasses safekeeping duties, including record-keeping of derivatives contracts, and oversight of cash accounts.
It extends to sub-custodian failures, highlighting cross-border regulatory issues.

Depository Liability in UCITS V and CSDR

Regulation (EU) 2016/438 (CSDR) addresses non-market risks related to depositories, including:
- Safekeeping of UCITS assets.
- Oversight duties.

Case Study: Run on Money Market Funds

Regulation 2017/1131 sets key requirements for Money Market Funds (MMFs):
- Strict investment policies focusing on short-term instruments.
- Limits on investments in specific assets, like securitisations and asset-backed commercial paper.
  - STS securitisations are allowed up to a limit of 20%.
- Public debt CNAV MMFs can only invest in specific instruments.
- Concentration limits: no more than 10% of investment in a single entity.

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Description

This quiz covers essential aspects of MiFID 2, including the prohibition of third-party inducements and mandatory suitability tests. It also explores Collective Investment Schemes, their structure, and features such as Net Asset Value. Test your knowledge on these important financial regulations and investment vehicles.