EUROPEAN COMMISSION Brussels, 25.11.2021 SWD(2021) 340 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT REPORT

Accompanying the Proposal for a Directive of the European Parliament and of the Council amending Directives 2011/61/EU and 2009/65/EC as regards delegation arrangements, liquidity risk management, supervisory reporting, provision of depositary and custody services and loan origination by alternative investment funds {COM(2021) 721 final} - {SEC(2021) 570 final} - {SWD(2021) 341 final}



TABLE OF CONTENTS 1. Introduction 2. Problem definition 2.1 Problems 2.2 Problem Drivers 2.3 Consequences 2.4 How will the problem evolve if not addressed? 3. Why should the EU act? 3.1 Legal basis 3.2 Subsidiarity: Necessity of EU action 3.3 Subsidiarity: Added value of EU action 4. Objectives: What is to be achieved? 4.1 General objectives 4.2 Specific objectives 5. What are the available policy options? 5.1 Options to implement operational requirements for the managers of loan originating AIFs ensuring that risks to financial stability are mitigated and investors are protected whilst levelling the playing field for those funds in the internal market 5.1.1 Option 1 and Option 2 discarded early in the process 5.1.2 Description of Option 3 5.1.3 The impacts of the retained Option 3

5.1.4 Comparison of the Option 5.1.5 Costs 5.1.6 Preferred Option 5.2 Options to increase competition for depositary services provided to AIFs in those markets where there are a limited number of depositary service providers 5.2.1 Description of Options 5.2.2 The impacts of the Options 5.2.3 Comparison of the Options 5.2.4 Costs 5.2.5 Preferred Option 5.3 Options to improve effectiveness of the AIFMD and UCITS rules on delegation to ensure the necessary level of investor protection across the Union 5.3.1 Description of Options 5.3.2 The impacts of the Options 5.3.3 Comparison of the Options 5.3.4 Costs 5.3.5 Preferred Option 6. Preferred combination of options 6.1 General impacts Consistency with other Union laws 6.2 Cost implications 6.3 Impact on SMEs

6.4 REFIT (simplification and improved efficiency) 7. How will actual impacts be monitored and evaluated? Annex 1: Procedural information Annex 2: Stakeholder consultation Annex 3: Who is affected and how? Annex 4: Analytical methods Annex 5: Risks of loan-originating funds Annex 6: Technical improvements to the AIFMD that are not impact assessed 1.1 Options to improve the availability of LMTs for open-ended AIFs and UCITS across the EU 1.2 The impacts of the Options 1.3 Comparison of the Options 1.4 Costs 1.5 Preferred Option 2.1 Options to improve supervisory reporting by providing supervisors with more granular data for market monitoring while removing the reporting duplications for AIFs and UCITS managers 2.2 The impacts of the Options 2.3 Comparison of the Options 2.4 Costs 2.5 Preferred Option 3.1 Options to ensure the equal treatment of custodians upholding investor protection regardless of the type of entity that safe keeps AIFs’ or UCITS assets 3.2 The impacts of the Options

3.3 Comparison of the options 3.4 Costs 3.5 Preferred Option Annex 7. The main features of a selection of national loan originating frameworks Annex 8. Mapping of liquidity management instruments available for AIFMs in national frameworks Annex 9. Evaluation of the AIFMD 1.Introduction 2.Background to the intervention Baseline and points of comparison 3.Method 3.1Short description of methodology 3.2Limitations and robustness of findings 4.Analysis and answers to the evaluation questions 4.1Effectiveness 4.1.1 Specific objective: All AIFM are subject to appropriate authorisation and registration requirements 4.1.2 Specific objective: Proper monitoring of macro-prudential risks 4.1.3 Specific objective: Proper monitoring and limitation of microprudential risks …………………………………………………………………………... 4.1.4 Specific objective: Common approach to protect investors in AIFM managed funds 4.1.5 Specific objective: Develop the single market in AIFs 4.2Efficiency

4.2.1 Specific objective: All AIFM are subject to appropriate authorisation and registration requirements 4.2.2 Specific objective: Proper monitoring of macro-prudential risks 4.2.3 Specific objective: Proper monitoring and limitation of microprudential risks …………………………………………………………………………... 4.2.4 Specific objective: Common approach to protect professional investors in AIFM managed funds 4.2.5 Specific objective: Develop the single market in AIF 4.3.Relevance 4.3.1 Specific objective: All AIFM are subject to appropriate authorisation and registration requirements 4.3.2 Specific objective: Proper monitoring of macro-prudential risks 4.3.3 Specific objective: Proper monitoring and limitation of microprudential risks……………… 4.3.4 Specific objective: Common approach to protect professional investors in AIFM managed funds 4.3.5 Specific objective: Develop the single market in AIF 4.4.Coherence 4.4.1 Specific objective: All AIFM are subject to appropriate authorisation and registration requirements 4.4.2 Specific objective: Proper monitoring of macro-prudential risks 4.4.3 Specific objective: Proper monitoring and limitation of microprudential risks……………… 4.4.4 Specific objective: Common approach to protect professional investors in AIFM managed funds 4.4.5 Specific objective: Develop the single market in AIF 4.5EU added value 4.5.1 Specific objective: All AIFM are subject to appropriate authorisation and registration requirements 4.5.2 Specific objective: Proper monitoring of macro-prudential risks

4.5.3 Specific objective: Proper monitoring and limitation of microprudential risks…….. 4.5.4 Specific objective: Common approach to protect professional investors in AIFM managed funds 5.Conclusions GLOSSARY Assets under management (AuM): is the total market value of the investments that a fund manager manages on behalf the fund.

Collective Investment Undertaking (CIU): is a legal structure to pool capital and hold collective investments. It usually has no economic life on its own; the key decisions in relation to the management and marketing of a CIU are taken by a fund manager of the CIU. CIU span a wide range of legal structures, including closed and open-end funds and partnerships. Alternative Investment Fund (AIF): is a CIU defined by the EU law as raising capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors and does not require authorisation pursuant to Article 5 of Directive 2009/65/EC (UCITS Directive). Alternative Investment Fund Manager (AIFM): is responsible for the management of AIFs. Typical tasks include, for example, picking investments, managing risks of the composed collective investment portfolio, monitoring third entities to which AIFM delegated certain functions and providing investor disclosures. Alternative Investment Fund Managers Directive (AIFMD): was voted into EU law in 2011 and entered into application in July 2013. This Directive governs authorisation and supervision of AIFMs in the EU and lays down organisation and operation requirements for AIFMs. Alternative Investment Fund Managers Regulation (AIFMR): it supplements the AIFMD, including detailed supervisory reporting requirements by AIFs. Alternative Investment Management Association (AIMA): is the global representative of the alternative investment industry. Capital Market Union (CMU): is a plan of the European Commission to create a single market for capital. The aim is to get money – investments and savings – flowing across the EU so that it can benefit consumers, investors and companies, regardless of where they are located. Competent authority: means the national authorities of a Member State, which are empowered by law or regulation to supervise AIFMs and/or AIFs. Central securities depositories (CSDs): as a part of the post-trade infrastructures CSDs operate securities settlement systems, participate in controlling the integrity of an issue hindering the undue creation or reduction of issued securities and are involved in securing collateral for monetary policy operations as well as in securing collateral between credit institutions. CSD also hold securities of their participants. Central Securities Depositories Regulation (CSDR): is an EU Regulation No 909/2014 of 23 July 2014 governing activities of CSDs and improving securities settlement in the Union. Custodian: an entity that safe-keeps investment funds’ assets, which are financial instruments, often a credit institution, an investment bank or a central securities depository. Depositary: an entity, often a credit institution, which besides safe-keeping investment funds’ assets, has other oversight duties such as monitoring cash flows and compliance with fund rules. European Long-term Investment Funds (ELTIF): is an EU regulated CIU, which allows professional and retail investors to invest into companies and projects that need long-term capital. European Funds and Asset Managers Association (EFAMA): is a pan-European organisation that represents the European investment management industry towards European policymakers. Environmental, social, and corporate governance (ESG): this refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business. European Securities and Markets Authority (ESMA): ESMA is an independent EU Authority that contributes to safeguarding the stability of the European Union's financial system by enhancing the protection of investors and promoting stable and orderly financial markets. It achieves this by assessing risks to investors, markets and financial stability, completing a single rulebook for EU financial markets and promoting supervisory convergence. Gross notional exposure (GNE): is the sum of all the absolute value of all fund’s positions, a leverage –related measure to be reported under the AIFMR. Home competent authority: refers to the competent authority of the Member State where an AIFM is domiciled or authorised/registered. Host competent authority: refers to the competent authority of the Member State where an AIF is marketed and which is other than the Member State where the AIFM or AIF is domiciled or authorised/registered. Key Information Document (KID): refers to the document under the PRIIP Regulation, containing the key information necessary for retail investors to make an informed investment decision and compare different investment products.

Liquidity Management Tools (LMTs): refers to the tools asset managers can use to manage liquidity risks in open-ended investment funds. Loan originating fund (LOF): refers to an AIF that - provides credit by acting as the sole or primary lender, participates in loans through purchases on the secondary market and/or participates in loan restructuring for indebted borrowers. Directive on Markets in Financial Instruments (MiFID): is a Directive, which is a cornerstone of the EU regulation of financial markets conceived in 2004 with an effect from 2007. It governs the provision of investment services in financial instruments by banks and investment firms and the operation of traditional stock exchanges and alternative trading venues. MiFID II: in 2011, the European Commission issued a MiFID amending proposal, which led to the adoption of MiFID II. This new law entered into force in January 2018. Regulation on Markets in Financial Instruments (MiFIR): is the Regulation on markets in financial instruments complements MiFID II. It was voted into law on 15 May 2014. Money markets funds (MMFs): are open-ended investment funds that provide short-term finance to financial institutions, corporations and governments. They provide a high degree of liquidity, diversification and stability of value of the principal invested, combined with a market-based yield. In the Union activities of MMFs are governed by Regulation of 14 June 2017. Net Asset Value (NAV): value of a fund's total assets, minus its liabilities. The NAV per share is used to determine prices available to investors for redemptions and subscriptions. Open-ended fund: is a CIU, which can issue and redeem shares at any time. Investors can buy or sell shares directly from the fund. Undertakings for Collective Investment in Transferable Securities (UCITS): is an open-ended, standardised CIU, which predominantly invests in transferable securities and available to retail investors. A UCITS and its manager must be established in the EU. UCITS Directive (UCITSD): is the main European framework covering retail collective investment schemes. The first UCITS Directive was adopted in 1985, and since then the framework has continuously evolved. The last amendment took place in 2014 with the UCITS V Directive, where the depositary regime was clarified and strengthened. The UCITS Directive is seen as the benchmark for retail investment funds, as the Directive imposes a strict investment portfolio diversification and restricts eligible assets to transferable securities in order to ensure that retail investors can easily redeem their investment.



1. Introduction The Alternative Investment Funds Manager Directive (AIFMD) was first adopted in 2011 to establish a regulatory framework covering the activities of the Alternative Investments Fund (AIF) sector. It was designed as part of the policy response to the global financial crisis that exposed weaknesses and vulnerabilities in certain fund activities that could amplify risks to the broader financial system and to investors following the consensus among G20 Leaders that all sectors of the financial industry should be better regulated and supervised. In support of the G20 objectives the International Organization of Securities Commissions (IOSCO) issued high-level principles for hedge funds regulation to guide the development of international standards in this area. Following the European Council’s endorsement of Europe’s international commitments, and in the light of the European Parliament report, the European Commission (hereinafter - ‘Commission’) issued a legislative proposal for a regulatory framework governing Alternative Investment Fund Managers (AIFMs). The AIFMD was adopted on 8 June 2011. Following its transposition into national legal systems, the AIFMD entered into application on 22 July 2013. As a post-crisis regulatory initiative, the AIFMD seeks to achieve a coherent supervisory approach to the risks that the activities of AIFs may generate or transmit to the financial system, to provide high-levels of investor protections while also facilitating EU AIF market integration. AIFMs are required to effectively manage risks and ensure adequate transparency regarding the activities of their managed AIFs and in return, are able to manage and market AIFs to professional investors across the Union with a single authorisation from their home supervisor. The Evaluation annexed to this impact assessment (Annex 9) concludes that the AIFMD has largely met its objectives. The investment fund sector has roughly tripled in size since 2008, from EUR 5.5 trillion assets to more than 15 trillion assets (figure 1), and its assets as a percentage of total financial sector assets have also grown significantly. It has interconnections with the broader the financial sector (e.g. by providing wholesale funding to banks), making it important to manage potential systemic risks appropriately. At the same time, it is important to ensure that the AIFMD does not impose unnecessary costs on fund managers in the context of globally competitive financial markets and where such costs can affect fund fees and investor returns. The fund sector has an important role to play in the pandemic recovery as a channel for financing of the real economy, supporting economic growth, innovation and employment. The AIFMD contains rules on conflicts of interest, disclosure and transparency requirements to protect investors, which is beneficial for building confidence in EU financial markets and supporting the flow of capital to investments in the economy. Rules governing valuation, which is necessary for establishing each investor’s share in a given AIF and for monitoring the AIF’s performance, have increased discipline and structure in the asset valuation process. The AIFMD homogenizing depositary liability and functions, such as the safekeeping of AIF assets and fund oversight, and requiring that each fund appoints a depositary further enhanced investor protection. It is a requirement that for EU AIFs the depositary must be located in the same Member State as the fund, which has led to a fragmented landscape of depositary services in Europe. Nevertheless, the depositary regime can be credited with supporting the orderly functioning of the investment funds market and its integrity. The AIFMD introduced tools for improved macro-prudential monitoring and supervision of financial stability risks. AIFMs are required to report on the main AIF exposures, their liquidity profile and leverage. While the granularity of the reported data could be improved, this information has supported effective macro-prudential supervision and can help identify and mitigate potential financial stability risks. For example, the European Securities and Markets Authority (ESMA) aggregates supervisory reporting data and publishes Annual Statistical Reports on EU AIFs, which provide market participants, investors as well as supervisors and policy makers with information on market developments. Supervisory reporting is of outmost value in times of market stress. The onset of the COVID-19 pandemic resulted in a real life stress-test with markets experiencing significant turmoil and liquidity constraints during 2020. This led central banks to intervene to stabilise markets and provide market liquidity. Certain fund types, such as property funds, experienced difficulties given the illiquid nature of their underlying assets combined with open-ended fund structures where particular issues arose with obtaining accurate asset valuations. Funds investing in high-yield (HY) and emerging markets (EM) bonds, which are also less liquid assets, similarly faced significant liquidity pressure following increased redemption requests. The figures and trends reported as of 13 of May 2021 indicate that the European investment fund sector has, in general, weathered the COVID-19 storm quite well. The total net asset value (NAV) of funds that activated a liquidity management tool (LMT) for EU and EEA AIFs was €5.57bn. Regarding AIFs, suspensions of redemptions reported by NCAs amounted to €2.34bn unchanged from the previous iterations. There were only 56 AIFs out of 30,357 EU AIFsliquidated or entering into liquidation during the COVID-19 crisis. Besides managing liquidity risks, which may have an impact on the entire financial system, AIFMs are also mainstreaming sustainability into their risk management processes. The EU is determined to address climate/sustainability risks and is finalising the adoption of a range of measures applicable to financial intermediaries. The Sustainable Finance Disclosure Regulation (SFDR), which covers asset managers like AIFMs, seeks to increase awareness of adverse sustainability impacts and reliability of financial products claiming to pursue sustainable investing. AIFMs are set to play an important role in creating a more ESG-embedded investment culture by taking into account longer-term developments linked to ESG when assessing potential investments. The effectiveness of the ESG-related measures will be assessed in the future, whereas this Staff Working Document tackles the issues brought up by the backwards-looking analysis of the functioning of the AIFMD.

The AIFMD contains a review clause that mandated the Commission to start assessing the scope and functioning of this legal framework by July 2016, and to present a report to the European Parliament and Council. Drawing on the extensive preparatory work involving an external contactor conducting a general survey and producing an evidence-based study on the effectiveness of the AIFMD, the Commission submitted a report to the EU co-legislators assessing the application and the scope of the AIFMD (AIFMD Report) on the 10 June 2020. The AIFMD Report assessed the impact of the AIFMD on investors, AIFs, AIFMs in the Union and in third countries, establishing the degree to which the objectives pursued by the AIFMD have been achieved. An accompanying Staff Working Document provides more detail of the assessment provided in the AIFMD Report. Finally, an Evaluation of the AIFMD was completed as documented in Annex 9 of this impact assessment. The AIFMD Report, Evaluation and stakeholder feedback highlighted specific areas where targeted improvements could be made to the AIFMD regulatory framework and identified regulatory gaps that could be addressed. These are (i) fragmented market for loan-originating AIFs, which also raise potential risks to financial stability; (ii) fragmented market for depositary services; (iii) diverging interpretation of delegation regimes under AIFMD and UCITS; (iv) constrained liquidity risk management by the managers of open-ended investment funds; (v) inadequate data reporting for market monitoring and (vi) unequal treatment of custodians of AIFs’ assets. The sections below describe the problems that these regulatory gaps create offering a range of policy options that were assessed to determine the best way forward. Section 2 explains the market and regulatory developments that have led to the issues that have emerged since the Directive entered into force and discusses the problem drivers and the consequences for financial stability, the efficiency of the investment fund market and overall investor protection. Section 3 explains why it is necessary for the European Union to address these issues directly instead of the individual Member States. The proposed policy responses respect the principles of proportionality and subsidiarity. Section 4 lists the general specific objectives of this review. Section 5 assesses the available policy options caused by (i) fragmented regulation for AIFMs managing loan-originating AIFs, (ii) limited supply of depositary services in smaller markets and (iii) differing interpretation of delegation rules. The options related to (iv) the lack of harmonised availability of liquidity management tools in all Member States, (v) inadequate data reporting for market monitoring and (vi) the unequal treatment of custodians of investment funds’ assets are considered in Annex 6 as these policy elements are supported by technical recommendations provided by the ESRB and/or ESMA. Section 6 assesses the impact and cost implications of the preferred combination of options. Section 7 specifies how the impact of the preferred options will be monitored and evaluated after their adoption. Certain policy options are also relevant for the UCITS legal framework and this is explained further in those sections covering issues relating to (i) diverging interpretation of delegation regimes under UCITSD, (ii) lack of availability of liquidity management tools by UCITS, (iii) inadequate data reporting for market monitoring and (iv) the unequal treatment of custodians of UCITS’ assets. UCITSD legal framework does not contain the level of detail governing delegation arrangements existing in AIFMR. As open-ended funds, UCITS suffer from liquidity pressures in market stress situation like open-ended AIFs, therefore, the measures considered for improving liquidity management of AIFs are relevant also for UCITS. Finally, whilst supervisory reporting data by AIFMs could benefit from the revision, whereas UCITS are not even required to make periodic reports on their trades on the basis of a template that would be harmonised at the Union level. Finally, it seems that the recital in the UCITS Directive that was aimed at insuring that CSDs are considered depositaries’ delegates is not being followed in all cases for the lack of its normative force, therefore, proposals to this effect contemplated in the AIFMD review should be extended to the UCITS legal framework too. 2. Problem definition 2.1 Problems Based on the Evaluation of the AIFMD (Annex 9) and stakeholder feedback (Annex 2) to the public consultation, it is concluded that the AIFMD has generally functioned well and largely achieved its objectives in terms of establishing an effective supervisory regime for AIFMs, ensuring high levels of investor protection and facilitating the creation of the EU AIF market. However, the AIFMD could benefit from targeted improvements to those elements of the framework that have not been sufficiently addressed at the inception of the Directive and to take account of new developments in the market since its entry into force. As set out in the Problem Tree (Graph 1), three main problems have been identified:

1)Difficulties in monitoring and managing financial stability risks The AIFMD intended to improve the supervisory oversight and transparency of AIF activities in order to manage the risks they may pose to financial system and to identify potential new risks to the EU and its economy over time. Where the market data submitted to the supervisory authorities has gaps or lacks the requisite detail, their ability to perform this key role may be impaired. This reduces the effectiveness of the AIFMD and may lead to overlooking the build-up and spill over of risks to the broader financial system. Market developments and innovation may have led to the creation of new products that did not exist at the time of the inception of the AIFMD. As concluded in the Evaluation, the regulatory fragmentation in the loan-originating sector poses difficulties in identifying and reacting effectively to the potential market wide effects that may emanate from activities of such funds. 2)Inefficiencies in managing investment funds Inefficiencies in the regulatory framework can lead to unnecessary additional costs for industry and supervisory authorities. Increased operating costs for the fund managers harm investor returns and high management fees impedes further development of the AIF sector. Persistent under-development of certain sectors and service providers in the AIF market can also lead to level-playing field concerns within the internal market. The Evaluation of the AIFMD shown that there is room for increasing efficiency gains in managing investment funds, in particular levelling the playing field for loan-originating fund managers, streamlining supervisory reporting requirements and diluting market depositary concentration in smaller markets. 3)Inadequate protection of fund investors A core objective of the AIFMD is a high level of investor protection. The evaluation concluded that divergent interpretations of the legal requirements for fund managers delegating their functions to third parties or different national supervisory practices can create gaps that reduce the overall level of investor protection and trust in the market. Insufficient clarity of the applicable legal requirements leads to less legal certainty, increases divergence in supervisory outcomes ultimately failing to ensure the necessary level of investor protection across the Union. Graph 1 – Problem Tree 2.2 Problem Drivers 2.2.1 Incomplete or inefficient regulation a) Differing national requirements for Loan Originating Funds (LOFs) Since the adoption of the AIFMD in 2011, the market has seen significant growth and innovation in order to generate investor returns. One key trend is the provision of credit by investment funds. This is possible in several ways: loan origination, loan participation and loan restructuring. By carrying out loan origination, an investment fund provides credit while acting as the sole or primary lender. Loan participation typically involves funds that have gained exposure to loans through the secondary market, for example, buying loans from credit institutions. Examples of loan restructuring or 'opportunity' financing include where a fund invests in reaction to the restructuring of existing debt by a corporate issuer.

While the market for direct lending outside the banking sector in Europe is growing, a harmonised framework for loan-originating funds is missing. Graph 2. European Direct Lending Market Growth. Source: Deloitte Alternative Lending Deal Tracker, Autumn 2020. This has led to a fragmented regulatory landscape of national regimes, which may affect the ability to address potential micro- and macroprudential/financial stability risks and lead to different levels of investor protection across the EU. While the AIFMD contains general rules on liquidity management, use of leverage and valuation for managing risks at fund level, these are not specific enough to fully capture the specificities of managing direct lending portfolios and to address the potential micro and macro risks. This increases potential risks to broader financial stability. The differing national legal frameworks imposing varying leverage caps and other limits on risk enhancing techniques as well as insufficient market wide data does not allow sufficient monitoring and containment of potential financial stability risk arising from loan originating funds. As set out in the Evaluation, AIFs can originate loans without being subject to any specific EU level restrictions because the AIFMD does not contain provisions related to this activity. In the absence of harmonised EU rules for loan-originating AIFs, a number of Member States have chosen to establish their own national frameworks to regulate loan-originating funds leading to divergent approaches, market fragmentation and the concentration of funds in some Member States. It is important the note that loan origination is a highly specialised activity requiring specific processes, procedures and expertise to ensure that the newly created loans are of sufficient credit quality. Entities in this space must be able to evaluate the credit worthiness of borrowers, assess the potential impact of macro and micro economic changes on the performance of their loan portfolios, actively manage impaired or non-performing loans and comply with applicable prudential and consumer protection regulations. The accompanying mapping exercise in Annex 7 indicates that loan origination is either partly, or fully allowed in the majority of Member States and that a number of Member States (France, Germany, Ireland, Spain, Malta and Italy) have established bespoke national regimes. For example, Ireland and France require that loan-originating AIFs are managed by authorized AIFMs. Italy, Germany and Malta permit sub-threshold AIFMs to manage loan-originating funds. In fact, 80% of NCAs declared that loan origination was allowed in their jurisdictions for all or part of the AIFs/AIFMs. However, only 33% of them had a specific framework for this activity. This fragmented regulatory landscape creates uncertainty for fund managers that have to comply with different rules depending on the Member State they are located in leading to increased compliance costs, an un-level playing field and, inhibiting the cross-border activity of these funds and their ability to scale up in size to realise greater economies of scale. For example, divergent leverage limits in different Member States or differing restrictions on loan originating activity lead to different levels of risk mitigation depending on the limits imposed at the national level. This also makes it difficult for supervisory authorities to monitor market developments and manage potential risks as there are no minimum harmonised set of rules against which to assess the fund’s activity or market performance at the EU level. Market data indicates that private credit funds generally do not use significant levels of leverage. However, as the industry becomes larger and increases its share of the loan market in comparison to traditional lenders, it could contribute to self-reinforcing macro-financial mechanisms and credit bubbles that may contribute to the creation of unsustainable debt levels in the non-financial private sector, which may have implications beyond loan-originating funds. This would include risks that could arise from excessive risk taking or the impact of economic cycles particularly where there is a lack of sufficient prudent underwriting standards, effective risk management processes that could expose the loan portfolios to the impact of directional risks such as changes in interest rates. However, macro-prudential authorities lack effective instruments to mitigate such risks, as their scope of intervention is mainly focused on the banking sector (e.g., through the counter-cyclical capital buffer, which is meant to address risks related to excessive credit growth). This asymmetry could further exacerbate regulatory arbitrage and the un-level playing field across the financial system.

According to the AIFMD, NCAs can impose leverage caps on an ad hoc basis, however, it is very difficult to time this supervisory action right to contain systemic risks associated with excessive credit growth and leverage across the entire financial system. In this respect, where Member States have established national regimes, they have imposed specific statutory limits on the use of leverage and derivatives by loan-originating AIFs to reduce the potential risks posed by these funds. The ESMA and ESRB recommendations related to loan originating funds are summarised in Annex 5 and contain further details on the potential systemic risks posed by these funds. Similar to lending banks, loan-originating funds can face a range of risk factors including maturity, liquidity transformation and leverage (see Part I of Annex 5 for a full list of risks). However, unlike banks where the systemic risks have been extensively studied following the global financial crisis, loan-originating funds are not as well understood, also due to the lack of specific disclosure requirements. Under the AIFMR supervisory reporting template, AIFMs have to fill in two data fields: ‘leveraged loans’ and ‘other’. As such, there is no useful breakdown of the originated loans debt classes or reporting of non-performing loans and loans subject to forebearance thus creating difficulties in monitoring the market for low credit quality loans and potential negative effects thereof on financial stability. Moreover, depending on the linkages with the banking and insurance sectors, there could be a channel for contagion. The fund industry may seek partnership with banks for a number of reasons, including the ability to adopt best practices for credit analysis, risk management, and the structuring and servicing of loans. Alternatively, banks may also find it beneficial to use funds’ balance sheets, including for risk sharing purposes and for financing new lending activities. This interplay can contribute to systemic risks but is not currently addressed in the AIFMD. The potential systemic risks posed by the growth of loan originating funds has been the subject of research by the ESRB, ESMA, IOSCO, FSB and EBA which have all highlighted concerns related to loan origination by funds: 1)Risk of runs – these funds are invested primarily in non-listed assets that are intrinsically illiquid which poses particular risks in open-ended fund structures which are more exposed to maturity and liquidity risks. 2)Flawed credit risk transfer – as described above, loan origination requires undertaking a thorough credit assessment of the borrower. Granting loans requires specific skills and experience as the process requires not only screening the loans but also their active administration particularly when recovering payments or managing delinquencies. A lack of proper loan risk management may lead to funds undervaluing risk or extending loans without sufficient due diligence. 3)Pro-cyclicality risk – the use of leverage is a risk magnifier. High leverage could imply potential contagion effects for financial institutions through debt financing particularly if the available capital was not sufficient to cover loan losses. If loan originating funds are a major source of credit to the real economy, falling asset prices could lead to their withdrawal from providing credit amplifying the impact of an economic downturn. 4)Inter-connectedness (cross-border and banking sector) – the cross border impact of lending (where may be possible) should be monitored as funds may invest in loans not originated in their country of domicile and sold across the EU with potential systemic implications on other Member States. A key area of risk is the potential interplay between the loan originating and banking sectors. In particular, banks could establish loan originating funds in a manner linked to their own balance sheet management (similar to how securitisation was used before the financial crisis) to reduce their regulatory requirements. Banks could also transfer non-performing loans from their balance sheet to loan originating funds transferring the credit risk to investors. 5)Integrity of the EU financial market – the lack of a harmonised EU framework could undermine broader market integrity if the sector continues to grow (as it is expected to do) in importance within national frameworks and potentially lead to regulatory arbitrage between the jurisdictions. This is the view of ESMA and the FSB which have recommended that minimum regulatory standards are established while allowing Member States to then adopt stricter measures if they wish. Concerns were also raised about the potential for regulatory competition through a ‘race to the bottom’ in order to attract entities to locate in that jurisdiction. The FBS states that ‘given the importance of contagion risks in global financial markets leaving the door open to regulatory competition of this type may be dangerous’. In general, fund industry representatives either have no opinion on whether there is a need for further measures tackling activities of AIFMs managing loan-originating funds, or deem the current AIFMD rules sufficient. Public authorities, as evidenced by differing national rules, believe that there is a need for more targeted measures to address micro and macro risks emanating from the activities of such funds. b) Fragmented rules on and availability of Liquidity Management Tools (LMTs) During times of market stress, large-scale liquidations or fire sales of assets by asset managers and institutional investors can lead to significant price decreases, which can then impact on investors including other financial institutions (banks and insurers) and translate into broader systemic risk and market instability. To manage their liquidity profile and risks effectively, AIFMs incorporate liquidity management tools (LMTs) into their portfolio management. These tools include gates, suspension of redemptions, swing pricing, and temporary borrowing that restrict the ability of investors to redeem their holdings and protect both the redeeming investor and those that are remaining invested in the fund. The effective and proper use of these tools can protect the value of investors’ money and reduce liquidity pressure on the fund and mitigate against broader systemic risk implications in situations of market-wide stress. At present, the AIFMD does not provide for a minimum harmonised set of LMTs available to AIFMs that would enable fund managers in every Member State to deal with (future) redemption pressures under stressed market conditions and better handle potential cross-border spill-overs of liquidity tensions. Only the suspension of redemptions by an NCA, a measure of last resort, is explicitly allowed under the AIFMD. In the absence of appropriate LMTs, asset sales by fund managers facing increased redemption requests in response to negative market developments can further exacerbate asset price falls, creating a self-reinforcing negative loop between fund redemptions and asset sales that can endanger broader financial stability. The ESRB has recommended the Commission to propose that EU legislation incorporates a common legal framework governing the inclusion of LMTs in the design of investment funds. By law, this recommendation is subject to a comply-or-explain principle. The lack of homogenised measures makes it difficult for some fund managers to manage liquidity risks effectively, which can spill over to and destabilise the financial system. The varying availability of LMTs in different Member States. National rules are filling in these regulatory gaps that are open at the Union level leading to market fragmentation and insufficient measures for supporting the stability of the financial system. Inefficient and incomplete data reporting further undermines the monitoring development in the markets and management of potential risks to financial stability.

Over the past years, investment funds have taken on more liquidity risks in a search-for-yield due to the prolonged low interest rate environment. In the EU, smaller funds and fixed-income funds have increased their average portfolio maturities making them more vulnerable to liquidity shocks (IMF GFSR October 2019). In its FSR of November 2020, the ECB concluded that investment funds are again increasing their liquidity risk-taking after the market turmoil of Spring 2020. Two thirds of open-ended AIFs offer daily redemptions, but at an aggregate level, the sector’s liquidity profile shows that they may not hold sufficient liquid assets to sell within that period to meet redemption requests. Liquidity stress events can expose investment funds to high and rapid redemption requests, as it happened in the 2008 crisis, in the 2011 and in the March 2020 turmoil. ESMA observes in a letter to EVP Dombrovskis in August 2020 on the AIFMD Review “the experience of market dislocation during the on-going COVID-19 crisis also demonstrates the need for all LMTs to be available in all jurisdictions in a consistent manner.” As this was not the case, AIFMs in some Member States were not able to use (certain) LMTs. The availability and implementation of LMTs for investment funds varies significantly across the Member States, despite similarities in fund characteristics. (see Table in the Annex 8 with the overview of LMTs across the EU). The November 2020 ESMA report reveals important weaknesses, which should be addressed: (i) some funds presented potential liquidity mismatches and weak liquidity risk management or valuation processes due to their liquidity set up, and (ii) despite the severity of the 2020 liquidity crisis, only a few funds have adjusted their liquidity set-up in light of the issues encountered. The report cautions against taking too much comfort from how funds managed to cope with market stress in spring 2020, as that took place ‘amid significant government and central bank interventions which provided support to the markets in which these funds invest and relatively short in time. In most Member States, fund managers are solely responsible for the activation of almost all liquidity management tools, and do usually not need regulatory authorisation to do so. Typically, LMTs and the circumstances under which they can be used must be listed in the constitutional and contractual documents of the investment fund, which are subject to authorisation in EU Member States. The availability of the tools is, in some cases, restricted to certain types of investment funds and/or to exceptional circumstances. However, fund managers are often not keen to activate LMTs due to competitive or reputational reasons. They may also not internalise that forced asset sales in response to large-scale redemptions may have negative implications for the stability of the financial system. The AIFMD provides a limited harmonised solution permitting NCAs to step in and suspend redemptions in the public interest. Nevertheless, NCAs usually do not have the power to activate LMTs other than suspension of redemptions. For example, redemption gates are a more nuanced tool, as they can still allow investors to redeem a part of their AIF shares and thus limit the extent to which liquidity shocks are spread across the financial system. However, only in a number of jurisdictions NCAs are granted the power to activate redemption gates. Currently, the AIFMD framework does also not explicitly include provision on ensuring consistency in application and coordination across borders if NCAs would use their powers, as also signalled by the ESRB. c) Differential regulatory treatment of custodians of AIF and UCITS assets The AIFMD was adopted prior to the CSDR and therefore does not fully take account of the different functions that CSDs can perform. It does not clearly distinguish the situations when CSDs are acting outside their primary function as market infrastructure (as Issuer CSD) and are competing with other custodians to provide custody for AIFs (as Investor CSD). An incomplete regulation of custodians of investment funds’ assets at the Union level is undermining investor protection, which depositaries are meant to guard. It is worth to mention that the ongoing CSDR review has no impact on this analysis, as it does not touch the custody activity of Investor CSDs. The AIFM needs to appoint a depositary and only certain entities can act as depositaries (credit institutions, under certain conditions investment firms and other institutions subject to prudential regulation). The depositary has extensive duties and tasks, including monitoring of cash flows, carrying out instructions from the AIFM if they do not conflict with fund rules or national law, and safekeeping of assets, which means either custody of financial instruments or verification of ownership for other assets. Custody is the only task a depositary can delegate. This implies in return that all the necessary checks, e.g. including checking that no financial instrument has been lost, still need to be undertaken by the depositary itself and that the information flow in the custody chain, and more precisely between the depositary and its delegate, needs to be complete, timely and smooth. Under the AIFMD, however, a Central Securities Depositary (CSD) is not considered to be part of the custody chain and thus it is not considered a delegate of the depositary. This legal situation does not guarantee a stable information flow between the custodian of an AIF’s asset and the depositary. Consequently, depositaries’ ability to fulfil their oversight duties effectively is impaired absent a stable flow of information on the portfolio movements. Moreover, CSDs, in contrast to custodians acting as delegates of the depositaries, are not subject to the asset segregation rules as laid down in the AIFMR. Instead, they follow the CSDR rules in this respect that in many jurisdictions are less detailed. It was attempted to solve a similar issue in the UCITS legal framework by inserting a recital in the UCITS V. The recital states that when CSD act as custodians they should be considered as delegates of the depositaries. Due to the lack of normative force, however, the recital seems to be often ignored in practice and hence the discussed issues persist where CSDs hold in custody UCITS assets. ESMA carried out extensive work on this matter and in its Opinion strongly recommends a legislative intervention to address the issue. Anecdotal evidence was provided by a number of depositaries on a confidential basis regarding delegation of custody to investor CSDs. This evidence shows that in several Member States investor CSDs hold a share of more than 8% of the financial instruments entrusted for custody to the depositary. This share can exceptionally exceed 30% of the financial instruments, which can be held in custody. In these cases, where depositaries are not ensured a stable information flow and therefore cannot discharged their duties properly, the investor protection is weaker. d) Overlapping or missing supervisory reporting data Timely, high quality reporting of relevant data is vital for supervisors to monitor developments in the markets and address potential risks to financial stability stemming from AIFM and AIF activities. The AIFMD lays down principles for supervisory reporting, which are further detailed in a Regulation supplementing the AIFMD - AIFMR. However, the AIFMD Report and AIFMD Evaluation concludes that the AIFMR template is not sufficiently granular for effective market monitoring. Moreover, the fitness check of supervisory reporting requirements existing across different EU financial laws revealed that there was a significant overlap between the AIFMR supervisory reporting obligations and reporting to the ECB for statistical purposes. A more detailed study is currently on-going to investigate a potential approach for an integrated reporting of respective supervisory and statistical data. This could potentially lead to reduced administrative burdens in the area of reporting by reducing duplicative, but different reporting obligations (for more details see evaluation in Annex 9 on the fitness check). The current inefficient and incomplete supervisory reporting obligations impede better monitoring of developments observed in the markets and addressing potential financial stability risks.

The KPMG general survey and semi-structured interviews revealed that regardless of the reporting template included in Annex IV of the AIFMR, the reporting requirements differ among NCAs, with different interpretations or additional requirements. AIFMs that have reporting obligations to NCAs located in Member States in addition to their home office domicile, or if the AIFM invests in a target company located in a different specific observed the differences in filing procedures and translation costs were said to add to the administrative and cost burden. Most of the respondents, therefore, would support a rationalised template and a consistent application of the AIFMD reporting requirements. Considering the high costs of implementation of the reporting requirements, it is advised strongly to have a cross-sectoral view at regulatory reporting and to look for possible cost reductions and efficiencies for managers. AIFMR supplementing the AIFMD requires only the reporting of aggregated data, such as the 5 most important instruments in which the AIF trades, 10 principle exposures, 5 most important portfolio concentrations etc., at times may provide an incomplete picture of the funds activities for the supervisory authorities depending on the whole investment portfolio. In addition, ESMA, ESRB and industry stakeholders consider that addressing other current data gaps would improve macro-prudential monitoring. The examples of the missing information include collecting data on loan origination, details on initial margin and variation margin, and Value at Risk. The ESRB suggests that a mandatory Legal Entity Identifier (LEI) for AIFs could enhance financial stability monitoring by enabling matching various data sets reported under different Union laws (e.g. EMIR). A direct link to other data sets, especially transaction reports, is currently not possible in many cases as only the AIFMs hold LEI but not the individual funds they manage (i.e. often the same LEI used for multiple funds). Also, over 60% of AIFs are self-classified as ‘other’. The ESRB recommends improving the reported self-classification of funds and to report the use of certain instruments. IOSCO, for its part, promotes a global approach to leverage reporting by focusing on leverage by asset class. Insufficient data makes monitoring of market developments and identifying risk built-ups in the system difficult, which increases risks to financial stability. 2.2.2 Market Developments a) Growth in AIFMs managing Loan Originating Funds (LOFs): The tighter regulation and increased capital requirements imposed on traditional lending banks through Basel III have reduced the capacity for banks to issue loans to higher risk borrowers such as SMEs or to already highly indebted entities (leveraged loans). Graph 3. EU Bank’s Share of Leveraged Loan Market. Source: Standard and Poor’s LCD Q3 2020 Leveraged Lending Review. In comparison to traditional lenders such as banks, funds are not subject to the same type of capital requirements, as they do not hold customer deposits in order to serve as a base to extend credit, albeit their AIFMs are subject to rules on liquidity risk management. This feature enables these funds to continue lending even during times of extreme market stress while avoiding liquidity mismatches. According to the OECD, loan-originating funds constitute an important and widely-used source of funding for SMEs, which in Europe face more limited borrowing options and are typically reliant on banks. At the same time, institutional investors have looked to diversify their assets in the search for yield in the current low-interest rate environment. These factors have created a gap in the market that loan-originating funds have sought to fill (Graph 3 below). Market research indicates that the global private debt funds reached $887 billion with nearly $188 billion in capital raised during 2020. According to a report by Deloitte, private debt is now the third largest fund class behind only private equity and real estate funds.

While the pandemic led to reduced growth in 2020, 25 new direct lending funds still raised $23.4 billion in funding with the largest fund, the GSO European Senior Debt Fund II raising $6.1 billion. Given the low returns on government debt generally, it is expected that investors will continue to increase their allocation to this fund class. With particular regard to leveraged loans, ESMA statistical report on EU AIFs concludes that over the past few years EU AIFs’ exposures to leveraged loans and collateralised loan obligations (CLOs) have increased by 15% reaching € 108bn by the end of 2018 compared with €95bn in 2017. The growing attractiveness of this asset class is evidenced by the fact that “the increase in exposures comes from AIFs with no previous exposures to the leveraged loan market.” In a proper functioning and effectively supervised Capital Markets Union (CMU), loan-originating funds have the potential to provide an alternative source of financing to Europe’s corporates and SMEs allowing them to access a wider range of competitively priced funding options. This allows these funds to directly support job creation, economic growth, innovation and contribute to the recovery from the Covid-19 pandemic. Loan-originating funds can also serve as a backstop or shock absorber when liquidity is constrained by continuing to provide loan financing when more traditional lenders such as banks have pulled back from the market. At the same time, the lack of a proper incentive structure, in terms of governance and risk management, aiming at avoiding excessive risk-taking by loan originating funds, may lead to potential financial stability risks, especially if we consider the interconnectedness of the investment funds’ sector with the banking and insurance sector in the EU. As set out in the Evaluation, the divergent approaches across Member States can prevent funds from accessing certain national markets, limit cross border competition and the ability of the funds to scale up their portfolios. It can also present a challenge with regard to the level playing field in the internal market as funds in some jurisdictions may be subject to more stringent rules or total prohibitions on engaging in loan origination, which produces inefficiencies in the internal market. The syndicated loan market has a level of inherent discipline around credit assessment and monitoring because loans must be structured and priced accurately in order to satisfy potential lenders. In the absence of specific EU regulatory requirements, it is not certain that similar levels of discipline exist in direct debt financing or loan origination activity by AIFs and a number of risks can arise as a result. This is particularly important in the context of an observed deterioration of underwriting standards and lower credit quality of leveraged loans. Some national frameworks have imposed requirements on funds governing their credit assessment and granting processes or requiring stress testing of the portfolios to determine the resilience of the loan portfolio to general economic shocks such as interest rate changes. However, there are no common set of rules applicable to all AIFMs managing loan originating funds to establish a minimum level of good practice in the EU and to support the growth in sources of alternative financing in the Union. It is important to note that loan-originating funds generally do not have access to public backstops or central bank liquidity. If a fund encounters difficulties due to poor lending practices or a failure to properly manage its risk exposures and bad debts, this may negatively affect investors in the fund and its borrowers, particularly in the event of a fund’s failure. Generally, this is a positive feature as a failure would be limited to the fund and its investors. However, in certain circumstances, it could translate into broader systemic risk depending on the fund’s overall size, its interconnectedness with the broader financial system and the degree of concentration of its loan book in certain sectors of the real economy. For funds engaged in loan origination, it is important that they have staff with the relevant skills and expertise in loan origination to ensure a robust and effective credit assessment and granting process to prevent the accumulation of or concentration in excessively risky loans or bad debts that may impair the fund’s performance. In terms of best practices among loan originators to effectively manage their risks, research suggests a highly involved selection process requiring specialist skills to identify projects, undertake due diligence, negotiate loan terms, extending credit and monitoring the loans once they are on the books. Different national requirements in this respect undermine a development of expertise and an efficient loan-originating fund market in Europe. b) Limited supply of depositary services in smaller markets One of the main pillars of the AIFMD framework protecting investors is a depositary regime. AIFMs are required to appoint a single depositary for each AIF they manage to safe-keep AIF assets, monitor cash flows and ensure the AIF’s compliance with the relevant regulations and fund rules. AIFMD requires the depositaries to have their registered office or a branch in the same country as an EU AIF under their care. As established by the Evaluation, the regime is deemed to be robust and is functioning well. However, there is an outstanding problem of a limited supply of depositary services in smaller markets. Originally, during a transitional period that lasted until July 2017, the competent authorities of the home Member State of an AIF could allow the appointment of a depositary established in another Member State. Several competent authorities made use of this possibility in order to avoid a market concentration, which could pose risks to the financial stability in the concerned Member States. However, after that date, this avenue for AIFMs or AIFs reliant on depositary service providers established in other Member States was closed. The ending of the transitional period caused difficulties for certain AIFs/AIFMs in smaller markets where there is still a sufficient lack of supply of depositary services. A few Member States have an extremely concentrated depositary market. For example, in one Member State two depositaries hold over 40% of the financial instruments and four depositaries hold 70% of the financial instruments. In another Member State only three depositaries offer their services.

Table 1: AIF Net Assets compared to number of depositaries for a selection of Member States Member State AIF Net Assets at end 2020 Number of depositaries Germany 2.1 € trillions 35 France 1.2 € trillions 18 Netherlands 1.0 € trillions 27 Luxembourg 0.8 € trillions 49 Ireland 0.8 € trillions 22 Malta 11,115 millions € 7 Cyprus 4,463 millions € 3



Sources: AIF Net Assets: EFAMA quarterly statistics March 2021; Number of depositaries: national competent authorities and asset management associations Respondents to the public consultation observe, that such market structures have cost implications for fund managers and investors and can cause limitations to the provision of more cost-efficient packaged services that could for example, also include fund administration (NAV calculation, unit/shares issuing service). Therefore, AIFMs have to internalise these services, which can be highly inefficient and expensive for some AIFMs (that have to create and maintain dedicated teams regardless of their size) and consequently for the investors.Indicatively, AIFMs operating in the Baltic markets usually bear 20 -70 bp on the basis of the assets under management (and depending on the types of assets, where they are issued and if they are held outside the EU). EU only assets attract 5-10 bp. This is much higher than what the AIFMs/AIFs bear in competitive markets (1-2 basis points for larger AIFMs and up to 10 basis points for smaller AIFMs and AIFMs specialising in Private Equity and Venture Capital) . This anecdotal evidence dates from 2009; contractual information is confidential and therefore in general not accessible. Given that the number of depositaries has remained stable or decreased, there are no grounds to believe that the costs for depositary services lowered. Inefficiencies in certain Member States persist and cause decreased competition in the internal market for AIFs. Moreover, a failure of a depositary holding a large share of the AuMs would have significant repercussions on the AIF sector and investors. 2.2.3 Inconsistent application of rules in Member States Delegation The AIFMD and UCITS rules permitting fund managers to delegate their core or non-core functions to third parties are designed to ensure that it is possible to control the delegate effectively and to ensure a proper execution of the delegation mandate thus serving investor interests. However, differing interpretation and application of the AIFMD and UCITSD rules on delegation by NCAs is leading to potential investor protection concerns depending on where the fund manager is domiciled. The delegating fund manager may not be subject to the same level of substance requirements in every Member State. A lack of clear legal requirements in the Union law leads instead to national regulatory guidelines, which impose divergent substance requirements for AIF and UCITS managers. For example, there are differing national guidance on the number and classification of employees, conducting officers or senior/board members an AIF or UCITS manager in the Union should have so that it can be deemed sufficiently staffed to ensure the effective monitoring of activities of the entity receiving the delegation of portfolio or risk management. Depending on the Member States of their establishment, AIF and UCITS managers are subject to different regulatory standards when they use delegation, which results in different levels of investor protection. Pursuant to the AIFMD and UCITSD, managers of AIFs and UCITS are allowed to delegate core functions (portfolio or risk management) and non-core functions (fund administration, marketing or record keeping) to third parties while retaining the liability and obligation to control the delegate. The AIFM must properly supervise the delegate and be able to withdraw delegation immediately, while being liable at all times towards the managed AIF and investors, who remain covered by the investor protection measures provided for in the Union laws. Before delegation arrangements become effective, AIFMs must notify NCAs so they can assess whether the delegation structure is objectively necessary. The acceptable justifications most commonly include optimisation of business functions and costs, seeking expertise of the delegate in specific markets or accessing global trading capabilities. Often delegation serves a useful purpose by connecting European investors with investment opportunities and expertise in third country markets to meet their investment needs and properly diversify their investment portfolios. However, AIFMs can no longer be considered as a fund manager under the Directive, if through an improper use of delegation, they become letterbox entities. An entity is no longer considered to be an AIFM where it does not ensure a permanent supervision of the delegate, or where it does not retain the prescribed standard of decision making. The AIFMR states that performance of investment management functions by a delegate should not exceed by a substantial margin such functions performed by the AIFM itself. When the AIFMD and AIFMR delegation rules are not respected, the AIFM may no longer be considered as a manager of the AIF concerned and the AIFM licence can be taken away. However, the ‘substantial margin’ criterion is too vague leading to its divergent application and enforcement by different NCAs. The relevant rules in UCITSD are even less detailed or prescriptive than the AIFMD. The UCITS regulatory framework mirrors some of the principle rules laid down in the AIFMD by outlawing the formation of letter-box entities and requires UCITS managers to monitor effectively the activities of the delegates. The Commission is only invited in a recital to examine the possibilities for further harmonising delegation arrangements applicable to UCITS at Union level but no such specific requirements have been adopted yet. In effect, the same issue persists in this market. ESMA has issued guidelines advising NCAs to apply the AIFMR approach to UCITS funds but there are persistent disagreements among the NCAs, some of which argue that the UCITS regime is less prescriptive and therefore more permissive. This results in different supervisory outcomes across Member States producing a varying protection for European investors. An absolute majority of industry representatives believe that the current AIFMD and UCITS rules on delegation are sufficient and warn against tampering with the valuable tool, which benefits European investors and European fund industry. They agree, however, that proliferation of letter-box entities should be prevented and would welcome clarifications around substance requirements. At least a third of the European NCAs, on the other hand, have advocated for greater clarification of the Union rules to prevent regulatory arbitrage and to ensure the necessary levels of investor protection.

2.3 Consequences 2.3.1 Impaired identification, monitoring and management of potential threats to financial stability The AIFMD does not contain specific rules that would address the potential micro and macro risks, which increases potential risks to the broader financial stability. The differing national legal frameworks imposing varying leverage caps and other limits on risk enhancing techniques as well as insufficient market wide data does not allow for a sufficient market-wide monitoring. This regulatory situation impairs the identification, monitoring and management of potential threats to financial stability arising from loan originating funds. The lack of a harmonised set of LMTs across the Union means that managers in different Member States may be limited in their ability to respond to periods of market stress and liquidity shortages thus possibly engaging in forced asset sales that can further amplify systemic shocks across the financial system. Timely, high quality reporting of relevant data is vital for supervisors to monitor developments in the markets and address potential risks to financial stability stemming from AIFM and AIF activities. The reporting of data is of particular importance for supervisors and policy maker in the times of stressed markets. Where there are gaps in the supervisory reporting, these will limit the effectiveness of the supervisory oversight and the ability to identify and intervene to address emerging risks. Given that protecting financial stability is one of the core objectives of the AIFMD, it is important to ensure that supervisors have access to sufficiently detailed fund level data and that the framework remains up to date to account for developments in the market such as the use of liquidity management tools and new investment products with specific risk profiles. 2.3.2 Inefficiencies in the internal market Overlapping reporting requirements lead to inefficiencies for fund managers, investors and supervisors. This duplicative administrative burden increases costs for managers, reducing fund returns for investors and impairing the competitiveness of EU AIFMs. Lack of competition among service providers, particularly in smaller markets can lead to increased costs for managers and less efficient fund structures due to a lack of local service providers and insufficient competition. The internal market efficiency is undermined where fund managers are subject to differing national requirements, in particular where those restrict economic rights by reserving them for domestic market participants. 2.3.3 Reduced protection for AIF investors undermining trust in the market The different national rules applied to AIFMs managing LOFs can lead to divergent levels of investor protection due to different fund level requirements for disclosure of supervisory data, different risk management requirements and the lack of harmonised rules for the granting of credit. Different interpretations and implementation of the rules on delegation can pose risks to investors, particularly where there is a lack of effective oversight of the delegate. Different regulatory treatments of the custodians of AIFs assets can impair supervisory monitoring and pose a risk to investor protection where depositaries are not provided with all the data necessary to perform their oversight role of the funds activity. 2.4 How will the problem evolve if not addressed? This section contemplates how the defined problems would evolve should the European Commission propose to do nothing to address them. The considerations below are “baseline scenarios” – ‘Option 0’ – followed by the possible policy options for each problem discussed in Section 7. 2.4.1 Difficulties in monitoring and managing financial stability risks

a) Potential risks emanating from AIFs originating loans The retreat of the banking sector and growth of non-bank lending is one of the biggest and most significant trends in the European economy and financial system during the last decade. In the EU, the non-bank financial sector has already reached the same size as the banking sector in terms of financial assets – a trend that is expected to continue. In Eurozone non-bank credit, where the ultimate lender is a non-bank financial institution rather than a bank irrespective of the mode of financing, makes up around one-third of total credit from financial institutions. ESMA and NCAs have observed the continued expansion of private equity funds, which are active in extending loans. It is estimated that European focused AuM makes up 30% of the total or approximately €266 billion up from 25%. It is also predicted that the global private debt market will nearly double in size to $1.4 trillion by 2025. Further progress towards the CMU will strengthen the role of market-based finance in Europe and lead to a more diversified financial system. Without common EU standards the potential risks generated by loan-originating funds are likely to increase and concentrate in some parts of the internal market making it difficult to control and address them at the EU level. In addition, this market segment will remain fragmented by a patchwork of national rules (see Annex 7 mapping national regimes across the Union) impeding its coherent development without being subject to the appropriate safeguards and restrictions, for example, regarding the use of leverage or limiting inter-connectedness with the other components of the financial system. This may limit the ability of supervisory authorities to effectively monitor and manage potential risks from this sector, particularly as it continues to grow in size. b) Constrained management of liquidity risk under stressed market conditions In the absence of appropriate liquidity management tools, asset sales by fund managers facing increased redemption requests in response to negative market developments can further exacerbate asset price falls creating a negative loop between fund redemptions and asset sales and endangering systemic financial stability. If the necessary LMT tools remain unavailable in certain parts of the Union to fund managers or to NCAs for their activation this will limit the availability of an effective and coordinated response mechanism to the market stress and liquidity shortages. Failing to tackle the perceived reputational cost and competitive pressure whereby fund managers refrain using certain LMTs tools even if they are more effective, would continue having detrimental effects on financial stability and on investor interests. Failing to activate the relevant liquidity tools where it is warranted the fund managers are likely to fail in protecting the value of investors’ money. c) Inadequate supervisory data reporting Failing to harness potential synergies between the ECB statistical reporting and the AIFMR supervisory reporting will lead to AIFMs bearing a double burden of mandatory reporting to different authorities regarding the same activities. Securities markets supervisory efforts to monitor markets closely will continue to be impeded by insufficient granularity of the reported data under the AIFMR because many of the submitted values are aggregated (e.g. 5 main exposure, 5 main counterparties, etc.). The existing data gaps will continue impeding supervisors’ understanding of market developments and accumulating risks. This reduces their ability to respond to emerging risks in a timely and effective manner. This is particularly relevant during times of market stress or crisis with unforeseen market shocks where the immediate need to react is impaired by an incomplete understanding of the market situation. 2.4.2 Inefficiencies in managing investment funds a) Market inefficiencies linked to uneven playing field for loan-originating AIFs The loan originating funds sector is expected to become an ever more important source of financing to the real economy. This is supported by market data and research as explained in section 3.2. In the absence of harmonised EU rules, the sector will continue to rely on fragmented national frameworks to operate in Europe, which will impair funds ability to scale up in size, realise cost savings through economies of scale or access new markets where they are currently prevented from carrying out loan origination. Fund managers would continue to incur higher compliance costs due to differing requirements between Member States leading to uncertainty and limiting their ability to operate on a cross border basis. This would also impair the development of the CMU and the development of alternative sources of finance for the real economy. Harmonising the requirements for loan originating funds will improve their ability to operate across the Union, lower compliance costs and level the playing field between the different jurisdictions. b) Market inefficiencies linked to limited supply of depositary services in smaller markets The current status quo whereby EU AIFs must appoint a depositary in the same Member State or that the depositary has established a branch in the Member state where the fund is established would perpetuate the situation in smaller markets of a limited supply of depositary services. This means that the number of depositaries active in these markets would remain low. For depositaries to run a profitable operation, they need scale, which is not possible in smaller markets. This implies a potential lack of sufficiently robust depositaries; e.g. some depositaries have a low investment grade. A lack of sufficiently robust depositaries, as well as the predominance of depositaries offering limited services (e.g. no fund administration), poses in particular a problem for AIFs with a high(er) number of AuM and might also concern AIFs with certain underlyings (e.g. private equity or yet exotic derivatives). Market concentration in smaller markets would also perpetuate insufficient competition and therefore inefficient functioning of the AIF market. In these highly concentrated depositary markets funds often do not have access to packaged services. As a result, the investment funds market in such Member States is likely to remain underdeveloped, the investment choice for the investors would continue to be restricted. Having such barriers is at odds with the rationale and spirit of the internal market and prevents managers from accessing the most cost efficient service propositions. 2.4.3 Inadequate protection of investors a) Investor protection issues where the fund manager delegates its functions to third parties

Failing to take measures at the Union level, NCAs would continue enforcing AIFMD and UCITSD rules of delegation with divergent interpretations and implementation at national level. This leads to divergent supervisory outcomes to the detriment of ensuring a uniform level of investor protection in the Union. Entities willing to exploit accommodative national guidance may seek to establish in the Member States where the standards are perceived as being lower leading to possible regulatory arbitrage. At the same time, the current rules on delegation are important to European fund managers as a cost saving measure and means to access foreign market expertise and knowledge allowing investors safely diversify their investment portfolios. The purpose of clarifying and specifying existing rules on delegation is to seek better alignment of supervisory practices across the EU in order to ensure the protection of investors. b) Investor protection issues with CSDs as custodians of funds’ assets Not putting CSDs on an equal footing with other custodians when they provide competing services will perpetuate an unjustified advantage for the CSDs and impede depositaries in carrying out their duties in accordance with the AIFMD and UCITSD. c) Diverging protection of investors in loan originating funds In addition to new and growing risks to the financial stability and limiting the development of the internal market for loan originating AIFs, differing national rules can lead to divergent levels of investor protection as AIFMs of such funds will be managing micro risks and will be providing investor disclosure information according to the nationally designed regulatory standards. NCAs may not have access to the full set of information they need to ensure effective oversight of these funds and the monitoring of potential risks. As these funds grow in size these issues will amplify further. 3. Why should the EU act? 3.1 Legal basis The Treaty on the Functioning of the European Union (TFEU) confers upon the European institutions the competence to lay down appropriate provisions that have as their object the establishment and functioning of the internal market (Article 114 TFEU). For the policy options chosen and the specific design of the rules, the appropriate legal base could be Article 53(1) TFEU on the taking-up and pursuing of activities by self-employed persons, which is used to regulate financial intermediaries, their investment services and activities. Divergent national approaches to the issues discussed in the preceding sections can make the cross-border provision of services difficult and impede the development of internal market for such AIFs. Insufficient supply of depositary services and different national regulatory standards for loan-originating AIFs undermine level playing field for AIFs. Moreover, the patchwork of national rules on loan-originating AIFs make it more difficult for supervisors to monitor risk to the financial stability and to preserve market integrity. The proposed improvements to the AIFMD seek to promote sound processes for loan origination by AIFs and to further market integration in this segment. Facilitating access to cross-border provision of depositary services aim to facilitate a further integration of EU AIF market ensuring high level of investor protection. It is sought to achieve a coherent approach to delegation activities by European investment funds. Unilateral actions of Member States cannot fill in the AIFMD gaps to achieve these objectives individually. Therefore, the Union may adopt measures in accordance with the principle of subsidiarity as set out in Article 5 of the Treaty on European Union. 3.2 Subsidiarity: Necessity of EU action The AIFMD has been adopted in full respect of the principle of subsidiarity pursuing the objective to remove market fragmentation and address the risks to the financial stability that are inherently transnational. The Directive was a choice of instrument for finding an appropriate balance between EU-level and national action. The proposed improvements to the AIFMD, which aim at completing this regulatory edifice with additional regulatory amendments and clarifications, aims to preserve the balance between harmonising key risk control measures and preserving Member State flexibility to continue regulating sub-threshold AIFMs that operate in a purely domestic environment or the distribution of certain types of AIF to retail investors. Action at EU level must respect the principle of proportionality. Any amendments proposed will respect the principle of proportionality, as set out in Article 5 of the Treaty on European Union, and would not go beyond what is necessary in order to achieve the objectives of completing a Single Market for AIFs and contributing to the process of building the CMU, while ensuring a coherent approach to macro-prudential oversight of the EU AIF market. The chosen options do not go beyond what is necessary to achieve the set objectives and are restrained in their level of interventionism. Where appropriate, new requirements imposed on AIFMs managing loan-originating AIFs are designed as general principles and more specific regulatory requirements would not unnecessarily disrupt existing business models (e.g., leverage cap which would be appropriate to limit the risks to the financial stability and would not interfere with the current prudent market practice). As regards investor protection, the proposed additional disclosure requirements are in line with the best market practice, which should be extended to all investors in the Union to ensure the same level of investor protection. The proposals to enable cross-border access to the depositary services strikes the right balance between the AIF and investor needs and averting risks that may materialise without appropriate Union regulation of the depositary services. The clarification proposed to the delegation regimes preserve the valuable features of these activities at the same time ensuring that there are requisite human resources provided to supervise the delegate and retain the core functions by an AIF or UCITS manager. 3.3 Subsidiarity: Added value of EU action Harmonising requirements for the AIFMs managing loan originating AIFs should address risks generated by such funds to the financial system and at the same time facilitate internal market creation, which is currently fragmented by the differing national rules. Investors must be afforded the same level of protection regardless where the loan-originating fund or its manager is established in the Union.

The now expired transitional provision in Article 61(5) AIFMD, which allowed the necessary cross-border supply of depositary services, has already proven to add EU value, especially for smaller Member States. Therefore, finding a European solution to reopen the abruptly closed channels of such service flows is an imperative for the functioning of the internal market. Attempts to ensure supervisory convergence regarding the delegation regime under the AIFMD and UCITSD have been exhausted. A legislative intervention is now required to clarify what the binding requirements are for the fund managers based in the Union that outsource their activities to third parties while still being considered as the managers of those investment funds. These market wide effects can be achieved only by taking measures at the EU level. 4. Objectives: What is to be achieved? 4.1 General objectives The general objective of the proposed improvements to the AIFMD is the same as of the original proposal for this Directive - to have a complete and consistent framework for the supervision and prudential oversight of AIFMs. Notably, the AIFMD pursues the objectives of ensuring financial stability, high protection of investors and an integrated AIF market. Managing micro-prudential risks is intrinsically linked to the macro-prudential risks, in particular where the AIF is large and interconnected with other financial intermediaries and thus able to generate and spread fund-level risk across the whole financial system. 4.2 Specific objectives The proposed improvements would pursue the following specific objectives to: ·implement operational requirements for the managers of loan originating AIFs to ensuring that risks to financial stability are mitigated and investors are protected whilst levelling the playing field for those funds in the internal market; ·increase competition for depositary services provided to AIFs in those markets where there are a limited number of depositary service providers; ·improve effectiveness of the AIFMD and UCITS rules on delegation to ensure the necessary level of investor protection across the Union; ·improve supervisory reporting by providing supervisors with more granular data for market monitoring while removing the reporting duplications for AIFs and UCITS managers; ·improve the availability of LMTs for open-ended AIFs and UCITS across the EU; ·ensure the equal treatment of custodians upholding investor protection regardless of the type of entity that safe keeps AIFs’ or UCITS assets. 5. What are the available policy options? This section discusses the proposed policy choices for achieving three specific objectives: (i) implement operational requirements for the managers of loan originating AIFs to ensuring that risks to financial stability are mitigated and investors are protected whilst levelling the playing field for those funds in the internal market, (ii) to increase competition for depositary services provided to AIFs in those markets where there are a limited number of depositary service providers and (iii) to improve effectiveness of the AIFMD and UCITS rules on delegation to ensure the necessary level of investor protection across the Union. Annex 6 contains technical proposals for achieving the remaining three specific objectives: (iv) to improve supervisory reporting by providing supervisors with more granular data for market monitoring while removing the reporting duplications for AIFs and UCITS managers; (v) to improve the availability of LMTs for open-ended AIFs and UCITS across the EU and (vi) to ensure the equal treatment of custodians upholding investor protection regardless of the type of entity that safe keeps AIFs’ or UCITS assets. Given that the broad policy direction is clear with the technical proposals already provided by ESMA and/or ESRB, the debate in Annex 6 centres on the possibilities for the best technical execution.

5.1 Options to implement operational requirements for the managers of loan originating AIFs ensuring that risks to financial stability are mitigated and investors are protected whilst levelling the playing field for those funds in the internal market Establishing a harmonised framework for managers of loan-originating funds would support overall stability of the financial system, while facilitating the development of an efficient loan origination sector across the EU with effective supervisory oversight and ensuring investor protection. Based on the analysis of national frameworks, there are certain common requirements imposed by certain Member States that could be adapted as a basis to develop similar requirements at EU level. 5.1.1 Option 1 and Option 2 discarded early in the process Option 1 prohibiting AIFs from originating loans or participating in the credit market as direct lenders was considered early in the process and discarded as disproportionate and in conflict with the overall goals of the CMU to create new sources of finance for the real economy in Europe. On a positive side, Option 1 would also remove the concerns that private credit markets are competing with the banking sector while subject to different rules leading to possible regulatory arbitrage opportunities. This approach would lead to a clear separation of function between financial intermediaries and the requirements attached to a particular licence, as it is not possible to subject close-ended loan-originating funds to capital requirements similar to those applicable to the credit institutions. The banking model creates liquidity mismatches on the banks’ balance sheets because long-term, illiquid loans are provided mainly from the demand deposits, which can be redeemed daily. The closed-ended structure of loan originating funds mitigates maturity transformation as such funds are not vulnerable to redemption demands and can hold originated loans to maturity. On a negative side, however, Option 1 would produce significant negative effects on the real economy. Loan originating funds provide a valuable source of alternative financing to Europe's corporates and SMEs, particularly to those that find it difficult to access more traditional sources of finance. Option 1 would reduce availability and access to finance with associated increased costs for the businesses. Therefore, this approach would also conflict with the objectives of CMU to develop alternative sources of financing for the real economy. Moreover, a total prohibition for AIFs to originate loans would severely restrict economic freedom of AIFMs/AIFs and have an immediate impact on existing loan originating fund managers precluding them from engaging in new lending. Conversely, Option 1 would result in a more limited product offering and therefore have a negative impact on the investment choice for investors that are in search for a yield in low interest environment. A total prohibition would have mixed effects on financial stability. On one hand, it would address the problem to financial stability by eliminating interlinkages with other parts of the financial system thus cutting the channels of potential contagion. On the other hand, loan-originating funds can provide an additional liquidity buffer or shock absorber in times of market stress. Prohibiting AIFs’ taking up such a role would leave the financial markets more vulnerable. Finally, pursuing this option would place European funds at a disadvantage in comparison to other international markets such as the US. Therefore, it was discarded at an early stage and not considered further. Option 2 as a partial harmonisation of only certain measures modelled on the common elements of existing national frameworks was also considered at an early stage. This approach was discarded as it would not sufficiently address the potential risks to financial stability that the loan-originating fund sector may pose. Increasingly interconnected European financial markets require a sufficiently harmonised approach on a number of aspects, at a minimum those presented under Option 3 in the section below. A partial harmonisation would suffer from significant drawbacks in terms of monitoring financial stability risks, particularly as the sector continues to grow in size and becomes a more important source of finance for the real economy. To prevent the emergence of new risks, it is important that the proposed EU rules establish a minimum number of safeguards regarding the funds activities and risk profiles. Based on the recommendations made by the ESAs and the potential risks highlighted in their research on loan-originating funds, a lighter framework would not fulfil the objective of supporting the continued development of this sector in a safe and sustainable way and would not fully address the issues raised by the ESA’s in their feedback to the pubic consultation and other research that has been conducted. While industry feedback is more mixed, there is general support for the overall objectives of the proposal – to improve the supervisory oversight of loan funds and protect against potential systemic risks. This element was acknowledged in subsequent follow-up consultations with industry stakeholders. 5.1.2 Description of Option 3 Policy option Description Option 3: Harmonise requirements for AIFMs managing loan-originating AIFs a)Establish common EU rules allowing AIFs to originate loans but requiring AIFMs to develop robust credit assessment procedures, valuation methodologies and specific risk management frameworks to ensure sound credit origination b)Impose concentration limits, limit the funds inter-connectedness with the broader financial system and in particular credit institutions, and impose the closed-ended nature on these funds. c)Require retention of an economic interest when a loan is originated and sold by an AIF on the secondary market. Option 3 proposes a set of comprehensive measures to address risks of loan originating AIFs as set out by the ESAs, including counterparty and credit risk and mitigating the potential risks of this alternative financing channel, level the playing field for AIFMs managing loan-originating funds and increase transparency around the activities of such funds. Whilst the AIFMD already contains requirements related to a fund managers risk management processes and reporting but these only cover standard fund risks such as liquidity, counterparty or broadly refer to ‘other relevant risks’. By establishing a harmonised set of EU rules based on the guidance of the ESAs and the potential risks highlighted in their research, loan originating funds would be able to originate credit in all Member States allowing them to scale up their funds and realise additional economies of scale and cost savings. This would increase the aggregate level of non-bank financing available in Europe leading to greater competition effects and association reductions in the cost of non-bank financing for borrowers such as SMEs. Fund managers would have greater certainty about the regulatory requirements applicable to their loan origination activity which compares to the present fragmented landscape where there are different requirements in each Member State increasing compliance costs for managers and restricting cross-border investments.

This is also in line with the objectives of the CMU and the development of the Single Market to establish common rules across the Union and support supervisory convergence. This proposal would add requirements for managers to manage credit risks effectively specific to their loan originating activities. Such credit risk specific requirements could include: a) Organisational requirements It would require the implementation of specific organizational requirements and policies to improve the robustness of the process of originating loans and the management of loan portfolios by AIFMs. Under this option, AIFMs would be required to ensure that the granting of credit is based on sound and well-defined criteria and that the process for approving, amending, renewing and re-financing credits is clearly established (including the risk management process to reassess and monitor the risk on an ongoing basis). AIFMs would be required to establish and regularly update procedures, policies and processes for the assessment, pricing and granting of credit as well as for credit monitoring. AIFMs would be required to use internal methodologies to assess the credit risk of exposures to individual obligors, securities or securitization positions and credit risk at the portfolio level under the supervision of their NCAs (authorisation process and ongoing monitoring). b) Stress-testing Level 2 measures regarding stress testing would be specified to require AIFMs to identify possible events or changes in economic conditions that could impact the AIF’s credit exposures and improve the fund’s resilience to market shocks. AIFMs would be also required to take into account the principal market risk factors for such funds, including interest rates, FX and credit spreads in order to identify and address outsized concentrations in specific directional risks. The potential liquidity risks caused by maturity transformation of loan funds and the illiquid nature of their loan portfolios should be better captured in reporting with appropriate risk management and stress-testing put in place. c) Risk retention requirement To avoid moral hazard, AIFs that directly engage in loan origination should be required to retain a degree of economic interest in the loans they originate if they subsequently sell those loans on to another party. However, AIFs that only purchase loans on the secondary market and subsequently sell those purchased loans would not be required to retain a portion of the risk as they did not originate the loans. d) Limit inter-connectedness with the broader financial system Furthermore, as recommended by ESMA and to ensure the independence of the funds activities and limit inter-connectedness with the broader financial system, in particular traditional credit institutions, AIFs should not be permitted to lend to: a)the AIFM, management company, general partner, depositary, or to delegates or group companies; b)other financial institutions. Data from Lipper (2011) and the ECB show that in 2013, 18 out of the 25 largest asset managers in the EU are run by banks. Commission services calculations based on ECB data on investment funds (Q1 2021) and the Orbis database show that, as of Q1 2021, at least 43.7% of all investment funds in EU27 having a management company are managed by companies that are part of banking/insurance groups. Given that since the late 1990s banks have been diversifying into non-interest earning activities such as asset management (the trend is global, but particularly pronounced in Europe), such structural ties serve as potential channels of contagion. The failure of a large loan-originating fund could pose a systemic risk to the extent that it is interconnected with other components of the financial system and in particular, credit institutions or fiduciary investors either through the loan portfolio itself, or the provision of backstop credit facilities. To contain the potential for such contagion, AIFs should be limited to originating loans to financial intermediaries by respecting a concentration limit of, for example 20% for a a single borrower, which is another financial institution. e) Impose a closed-ended fund structure To prevent excessive liquidity transformation risk, loan originating funds should be closed-ended. This would avoid the impact of redemption pressures particularly under stressed market conditions. f) Investor disclosures

AIFMs would be required to provide investors periodically with the specific inf