## FINANCIAL SECTOR ASSESSMENT PROGRAM — EUROPEAN SECURITIES AND MARKETS AUTHORITY — TECHNICAL NOTE — MARCH 2013 (content unit _cr1369)

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### Summary findings and assessments
- Within its resource envelope, ESMA performed well in its first two years, especially on the single rulebook and Credit Rating Agency (CRA) supervision: a significant number of technical standards, advice to the European Commission (EC), and opinions were developed.
- ESMA built expertise on CRAs and developed a risk framework to anchor its supervisory program.
- Results were more modest in other functions; prioritization reflected tight regulatory deadlines and the need to assume CRA supervision.
- Key institutional issues identified:
  - Need to step up supervisory convergence work.
  - Need for better access to granular and timely data for risk identification and crisis management.
  - Need for more expert resources to deliver expanded functions (e.g., EMIR, CRA3, MiFID2).
  - Governance review advised to strengthen ESMA’s independence vis-à-vis National Competent Authorities (NCAs).

### Supervisory convergence — observations and recommendations
- Observations:
  - Strategic directions and concrete actions set, but supervisory convergence remains underdeveloped.
  - Current tools: issuing opinions, conducting peer reviews, powers under Article 17 to investigate/remedy breaches.
  - Board of Supervisors (BoS) composition as a college of peers may hinder convergence.
- Recommendations:
  - Reengineer and strengthen peer reviews:
    - Make reviews more rigorous by relying more on onsite work.
    - Sharpen outcomes by linking reports to best practices and/or guidelines, with monitored implementation and follow-up.
  - If necessary, escalate to stronger actions (such as breach of law) after rigorous peer review.
  - Strengthen ESMA’s role in peer review groups and the review panel.
  - NCAs should ensure enforceability of ESMA’s opinions and guidelines in their jurisdictions.

### Risk identification and crisis management — observations and recommendations
- Observations:
  - ESMA contributes to risk assessment and financial stability via own analysis, participation in the Joint Committee, and cooperation with the ESRB.
  - ESMA’s role in crisis management is primarily coordination; direct intervention powers exist for short-selling.
  - Current voting requirements (BoS vote to provide data for particular studies) may hinder timeliness.
- Recommendations:
  - Ensure ESMA has access to data with necessary granularity and timeliness for in-depth analysis and stress testing for potentially systemic entities.
  - Keep risk identification as a recurrent BoS agenda item.
  - ESMA should coordinate simulation exercises and develop frameworks for identified scenarios.
  - Reduce procedural barriers that delay ESMA access to data for studies.

### Investor protection and product monitoring
- Observations:
  - Emphasis on product monitoring is warranted.
  - The consumer trends data project could enable qualitative improvement in investor protection.
  - Monitoring of financial innovation should be coordinated with financial stability work.
  - ESMA has power to issue warnings and (recently) product intervention powers; these should be used cautiously since ESMA is not a direct supervisor.
- Recommendations:
  - Ensure close cooperation between product monitoring and financial stability units.
  - Exercise product intervention powers cautiously and with clear coordination with NCAs.

### Resources, future workload, and staffing
- Observations:
  - Approved additional staff for 2013 will not be sufficient to cover expanded functions.
  - EMIR will assign additional functions to ESMA requiring critical resources.
  - Further expanded functions expected from CRA3 and MiFID2.
  - Austerity pressures should not undermine ESMA’s capacity.
- Recommendation:
  - Ensure adequate expert resources to meet current and upcoming responsibilities.

### Institutional mandate, powers, and governance — key facts and concerns
- Key facts:
  - ESMA created in 2011 under Regulation 1095/2010 of November 24, 2010.
  - ESMA is a legal body of the Union with legal personality (Article 5).
  - Mission (Article 1): enhance investor protection and reinforce stable and well functioning financial markets in the EU.
  - Tasks and powers (Article 8): regulatory work; supervisory convergence; financial stability and crisis management; investor protection; direct supervision (CRAs).
- Governance structure (Article 6):
  - Decision-making: Board of Supervisors (BoS) composed of heads of the 27 NCAs; observers from EC, ESRB, EBA, EIOPA; Norway, Iceland, Liechtenstein as permanent observers.
  - Other bodies: Management Board (MB); Chairperson; Executive Director (ED); Board of Appeals.
  - BoS is decision-making body; Chair prepares BoS work and participates without voting rights.
  - Decision rules:
    - Most decisions by majority of votes; each member has one vote.
    - Adoption of technical standards and guidelines requires a qualified majority; voting rights under qualified majority are weighted by population.
- Governance concerns:
  - Qualified majority requirement for technical standards may enable blocking minorities.
  - BoS composition as college of peers may negatively affect supervisory convergence and follow-up of divergent practices.
- Governance recommendations to analyze in ESAs review:
  - Enhance ESMA’s independence from NCAs while keeping high accountability to European authorities.
  - Consider adding more independent members to the board, moving to a fully full time board, or delegating more functions to the MB.
  - Strengthen rules for removal of the Chair and the ED by requiring removal only with due cause.
  - ESMA staff should continue to play a stronger role in the standing committees.
  - Explore more engagement with the Stakeholders Group in connection with the work plan.

### Securities markets — market structure and statistics (numeric precision preserved)
- EU financial system is mostly bank-based; equity and bond markets are well developed in certain countries.
- Market and industry aggregates:
  - As of 2012Q2 there were 6,654 issuers admitted to trading in regulated markets (RMs) or multilateral trading facilities (MTFs) in Europe.
  - Market capitalization of EU RMs amounted to US$11,076 billion.
  - The collective investment schemes (CIS) industry had assets under management of US$11,172 billion as of March 2012, of which US$7,965 billion were AUM by undertakings for collective investment in transferable securities (UCITs).
  - As of January 2012, AUM by hedge funds amounted to US$550.94 million.
- Trading venues and fragmentation:
  - As of 2012 Q2 there were 92 RMs and 138 MTFs licensed to provide services in EU.
  - Roughly 35 percent of the total volumes were transacted in MTFs.
- Transparency and trading composition:
  - Dark pools represent around two percent of all trading in Europe.
  - If OTC trading is included, around 45 percent of trading in the European Economic Area (EEA) is not subject to pre-trade transparency.
- High Frequency Trading (HFT) indicators (ESMA surveys, 2010 Q4):
  - HFT firms account for between 40 and 70 percent of total index trading volumes on individual trading platforms.
  - In the futures market HFT firms accounted for between 10 and 60 percent of total equity index futures trading volumes on individual trading platforms.
  - For one trading platform HFT firms accounted for up to 95 percent of all orders sent and 97 percent of all orders cancelled.

### ESMA functions and tools
- Regulatory work: development of technical standards, guidelines, advice to the EC to achieve a single rulebook.
- Supervisory convergence: issuing opinions; conducting peer reviews; powers under Article 17 to investigate breaches by NCAs; sectoral and cross-sectoral training; empowered to develop new practical instruments to foster convergence.
- Financial stability and crisis management: own analysis; contribution to the Joint Committee; cooperation with the ESRB; coordination role in crisis management, with direct powers in short-selling.
- Investor protection: issuing guidelines; power to issue warnings when financial activity poses a threat to investors.
- Supervision: direct supervisory role currently limited to CRAs (registration and supervision since July 2011).

### Governance and decision-making bodies — details and statistics
- BoS meetings and representation:
  - The BoS has met regularly; in 2011 it met seven times.
  - NCAs generally sent their head to BoS meetings; otherwise a high-level alternate was sent.
- Management Board (MB) and appointments:
  - MB composed of six members selected from the BoS by its members; Chair is a member and chairs the MB; ED prepares MB work.
  - Chair and ED appointed by the BoS after open selection; required to act independently; appointed for five year terms with possibility of reappointment for one more term.
  - The EP may object to Chair designation before duties begin; Chair may only be removed by the EP following a BoS decision; ESMA Regulation does not require “due cause” for early removal of Chair or ED.
- Standing committees and staffing:
  - There are 11 standing committees (SCs); ad-hoc task forces constituted as needed.
  - NCAs lead SCs; ESMA staff act as rapporteurs and are becoming more active.
  - ESMA chairs the Technical Committee (for CRAs) and the IT Committee; these are the only Committees chaired by ESMA.
- Stakeholder engagement and appeals:
  - Appeal Board for the three ESAs composed of two experts from each sector; decisions can be appealed to the European Court of Justice.
  - Securities and Markets Stakeholder Group: 30 members appointed for two and a half years following an open call; active and periodic meetings with BoS.
- Transparency and accountability:
  - High level of transparency: minutes of BoS meetings, annual work program, budget, annual report, reports of standing committees, and proposals for technical standards/guidelines published.
  - EP and Council can summon ESMA and require opinions; annual joint hearing at the EP for the three ESAs and ad-hoc technical hearings.

### Funding and budget issues — structure and process (numeric precision preserved)
- Funding sources (Article 62):
  - Subsidy from the EC (entered in the general budget of the EU (Commission section)).
  - Contribution from the NCAs.
  - Fee levied on registered firms under direct supervision (currently only CRAs; with EMIR, trade repositories would also contribute).
- Funding mix differs from other ESAs (other ESAs: 60 percent EU and 40 percent NCAs).
- For 2013, ESMA’s budget will amount to €28.3 million, with contributions roughly:
  - EC contribution: 46 percent
  - NCAs' contribution: 30 percent
  - CRAs' contribution: 20 percent
  - Trade repositories' contribution: 4 percent
- Budget process:
  - ED develops budget proposal, MB reviews, BoS approves, submitted to EC in EC template with three line items (staff, administrative and projects).
  - EC can change ESMA’s proposal; EP and Council can change EC proposal.
  - In practice EC made only minor changes to ESMA’s proposal in the first two years.
- Oversight and accountability:
  - Monthly reporting to the ED; quarterly reports on budget execution to the MB.
  - ESMA developing performance indicators for 2013.
  - Accounts audited annually by the European Court of Auditors (ECA): twice a year the ECA sends a team of three inspectors who spend roughly two weeks reviewing ESMA’s use of resources.
  - ESMA has an Internal Control Officer; internal audit by the EC annually focusing on efficiency.
- Conclusions and recommendations — funding:
  - Review funding structure and budget process.
  - Risks: potential conflicts of interest vis-à-vis NCAs; NCAs' contributions could become a heavy burden for smaller jurisdictions, with a risk of non-payment.
  - Funding alternatives to explore: industry fees (part already funded this way), fully EU-funded or increasing EU share.
  - Review EC’s role in ESA budget approval; consider ESMA presenting/justifying its budget directly to the EP and Council.

### Organizational structure, human resources, and capacity (numeric precision preserved)
- Current organization:
  - Three divisions: Markets, Investment and Reporting, and Operations.
  - Three units: Credit Rating Agencies Unit, Economic Research and Financial Stability Unit, and Legal Cooperation and Convergence.
- Human resources growth and composition:
  - ESMA started with 35 staff (from CESR).
  - As of November 2012, it had 85 professionals on post, 16 percent less than the 101 included in budget plans end 2012.
  - Recruitment average lead time is six months until a person arrives.
- Staff mix and contractual terms:
  - Mix of 75 percent staff and 25 percent secondees from NCAs and contractors.
  - Staff hired under a three year contract, renewable for another three years, then eligible for an “indefinite” position.
  - Salaries follow EC scales; salary differences across Europe affect hiring.
- Staffing table (figures preserved):
  - 2012 Current: Staff 68; Secondees 9; Contractual 8; Total 85
  - 2012 Planned: Staff 75; Secondees 16; Contractual 10; Total 101
  - 2013 Planned: Staff 121; Secondees 25; Contractual 14; Total 160
- Training and IT:
  - Eleven seminars organized in 2011.
  - In 2011, two training sessions targeted ESMA staff; nine sessions are planned for 2012.
  - IT projects: data depository for CRA supervision; CRA3 requires expansion for “live” information; MiFID2 may require further IT developments; registers of issuers and investment firms under development.

### ESMA’s role in financial stability — direct supervision of CRAs (numeric precision preserved)
- CRA Unit:
  - Dedicated unit with 16 staff (15 officers and the head of unit) at time of report; expected to grow to 26 people by 2013.
  - With approval of CRA3, ESMA will receive funding to hire 15 more staff (not all assigned to the CRA Unit).
- Since July 2011 registration and supervisory responsibilities for CRAs transferred from NCAs to ESMA.
- Supervisory activities:
  - Registration and certification:
    - Since July 2011 the Unit has taken charge of assessment of new applications; one new CRA was registered upon application received directly by ESMA.
    - There are currently 18 registered CRAs and one certified CRA.
    - Five applications pending.
  - Perimeter:
    - ESMA contacted around 30 companies whose activities prima facie could fall under the CRA Regulation.
    - Guidance on scope of the CRA Regulation to be published in 2013.
  - On-going supervision:
    - Multidimensional approach: desk reviews and on-site inspections (horizontal/thematic and vertical/individual).
    - Conducted on-site inspections of three global CRAs; sent individual reports with required changes and monitored implementation; published a report summarizing main findings.
    - Based on inspection findings, ESMA conducting a review of banking rating methodologies and decided to conduct a vertical individual on-site inspection on internal controls of another CRA.
    - Per CRA Regulation, inspections on all CRAs must be conducted by 2014; conducting these inspections is in the Unit’s work plan.
  - Central repository (CEREP) and IT:
    - CEREP developed to make available information on past performance of ratings (six months lag) via ESMA’s webpage.
    - CRA3 will require such data to be available in real time.
    - SOCRAT tool will facilitate processing of ratings data to support supervisory activities and the Unit’s risk assessment framework.

### CRA Risk Assessment Framework and supervisory program (numeric precision preserved)
- Work program will be risk-based.
- Risk factors: environmental risk, operational risk, business model risk and governance risk.
- Unit developed criteria/alerts for each risk type to foster consistent risk views.
- Estimated resource allocation: roughly 70 percent of supervisory resources would be spent on the large CRAs.
- Approach: engagement with all CRAs, including small ones; each CRA assigned a relationship manager for continuous monitoring.
- Minimum engagement: periodic (annual) meetings with compliance officers.
- Once inspections on all CRAs are concluded, on an on-going basis the Unit will conduct two thematic reviews and two vertical reviews per year, in addition to registrations, handling complaints, etc.

### International coordination, enforcement, and oversight (numeric precision preserved)
- MoUs finalized with jurisdictions including United States, Canada, Australia, Hong Kong, Japan, Brazil, Singapore, Mexico and Argentina.
- ESMA involved in IOSCO consultation on establishing a global “college” for CRAs.
- Enforcement tools available (per CRA Regulation): withdraw license; (i) temporarily prohibit CRA from issuing ratings with effect in the EU, (ii) suspend use for regulatory purposes of ratings with effect in the EU, (iii) require CRA to bring infringement to an end, (iv) issue notices, (v) impose fines.
- EC established minimum and maximum fines assigned to infringement categories:
  - “Lowest” category: sanctions ranging from €10,000 to €50,000.
  - “Highest” category: sanctions ranging from 500,000 to 750,000.
- Overall maximum fine that could be imposed is €750,000 for a first time infringement.
- Sanctions can be appealed to the Appeal Board; Appeal Board decisions can be appealed to the European Court of Justice.
- Internal oversight and public accountability:
  - Medium term objectives prepared by staff and approved at BoS level; implementation monitored via reporting to the MB; public versions of work program, annual report, and reports following thematic reviews to be published.

### Risk identification and monitoring — capabilities, outputs, and data needs (numeric precision preserved)
- Responsibility: Economic Research and Stability Unit.
- Staffing: as of November 2012 the Unit had 6 staff; expected to grow to 11 staff by 2013.
- Standing Committee for Economics and Market Analysis (CEMA) exists.
- Risk identification based on indicators feeding two periodic reports requiring BoS approval; current analysis based on publicly available data.
- Periodic reports:
  - Quarterly risk dashboard: ESMA produced seven risk dashboards. Publication is market trends analysis divided in categories (risk overview, liquidity risk, market risk, contagion risk, and credit risk). Q2 2012 included an indicator of stress in securities markets.
  - Bi annual report of Trends, Risks and Vulnerabilities (first report produced).
- Complementary and on-going thematic work: structured/complex retail products; size of shadow banking; credit default swaps market; hedge fund contribution to systemic risk; high frequency trading in European equity markets; bank funding issues and securities financing transactions.
- Stress testing development: techniques for stress testing securities firms, focusing on trading venues, hedge funds and CCPs; informal ESMA data requests to NCAs met opposition.
- Data needs: intention to build a data warehouse incorporating public and incoming regulatory data; gaps exist where data not collected at NCA level and will need to be filled.
- Weekly Financial Monitor also exists.
- Recommendations:
  - Critical that ESMA has access to data with sufficient granularity for in-depth analysis and stress testing.
  - Article 35 provides ESMA power to request information from NCAs; only when information not made available in timely fashion and after certain steps can ESMA request it directly from market participants.
  - BoS should take a more active responsibility in risk identification and monitoring; risk identification should be a recurrent BoS agenda item.

### Crisis management role, powers, and framework
- ESMA’s crisis management role focuses on coordination; direct powers only where sectoral legislation provides or European Council declares an emergency.
- Short-selling regulation grants ESMA and NCAs temporary intervention powers; NCAs' measures can include:
  - (i) increased transparency requirements;
  - (ii) prohibiting or restricting natural and legal persons from engaging in short sales on a trading venue, or otherwise limit transactions on a specific financial instrument in such trading venue for a maximum of three days in certain circumstances;
  - (iii) an outright prohibition on short-selling for a period of time;
  - (iv) imposition of conditions on a short sale or transactions that indirectly create short positions.
- If an NCA intervenes it must notify ESMA, which must issue an opinion within 24 hours; if ESMA considers the NCA's measure inadequate it can take any measures available to NCAs.
- As of review, ESMA had not used such direct powers; in November 2012 two NCAs issued bans on short-selling and ESMA issued an opinion but did not intervene directly.
- Legal action: United Kingdom brought suit against the European Parliament and the Council for granting such powers to ESMA; suit pending (C-70/12).
- ESMA developed a definition of “crisis” for securities markets and identified six types of events:
  - (i) EU wide trading suspension,
  - (ii) EU wide ban on short selling,
  - (iii) EU wide suspensions of redemptions of units in UCITs,
  - (iv) settlement fails on a pan-European basis,
  - (v) EU wide product intervention measures,
  - (vi) failure of clearing members and CCPs.
- Framework development ongoing; first output is a protocol for exchange of information in connection with CCPs covering identification of emergency situations, principles and mechanisms for exchange, and information to be exchanged.
- Recommendations:
  - Concern about use of direct powers on short-selling: short-term effects may slow downward spirals but medium-term restrictions affect liquidity and price formation.
  - If NCAs use such measures, aim for non-conflicting and preferably identical measures unless domestic differences warrant variation.
  - ESMA should coordinate simulation exercises and develop frameworks for each identified “crisis” type.

### Single Rulebook work and transparency (numeric precision preserved)
- Public consultations required when developing implementing technical standards and when providing technical advice to the EC; required to consult the Securities and Markets Stakeholders Group; technical standards must be endorsed by the EC.
- First two years’ output:
  - Forty technical standards developed, involving significant work for EMIR implementation.
  - Four technical standards developed for the new CRA supervisory regime.
  - Seven technical standards developed for the new short-selling and credit default swap regime.
  - Five pieces of advice provided to the EC on secondary legislation (prospectuses, UCITs, AIFs, short-selling).
  - Six sets of detailed guidance and recommendations in areas such as automated trading, AIF managers (AIFMs), exchange traded funds (ETFs), suitability of advice and the investment firm compliance function.
- ESMA delivered some technical standards under very tight deadlines; consultation processes at times squeezed, raising stakeholder concerns.
- Future workload includes MiFID2/MiFIR, MAD/MAR, CRA3, the Transparency Directive, and UCITs VI.
- Conclusion: EC’s authority to make changes to technical standards could be troublesome but process is transparent; EC interventions should be motivated by technical reasons.

### Supervisory convergence — tools, peer reviews, and reengineering (numeric precision preserved)
- Tools: guidelines and opinions, peer reviews and training, practical instruments and convergence tools.
- Review panel is main standing committee for supervisory convergence; conducts peer reviews and monitors implementation.
- Legal, Cooperation and Convergence Unit staffing: "two staff directly dedicated to convergence work and three more lawyers that support all of ESMA’s work, including the standing committees." The Unit is recruiting four more staff members in 2013 (including additional lawyers).
- Peer review methodology approved January 2012; peer review teams are experts from NCAs; methodology allows external experts.
- Peer review activity: since 2011 ESMA conducted four peer reviews; two finalized.
  - Examples: review of use of sanctions under MAD; prospectus approval review with best practices.
- Planned peer reviews for 2012 and 2013 include:
  - (i) review of the money market guidelines developed by ESMA,
  - (ii) review of MAD supervisory practices,
  - (iii) review of MiFID requirements for fair, clear and not misleading information.
- Mission recommendations:
  - Make reviews more rigorous (onsite work); sharpen outcomes by linking to best practices/guidelines and enforce follow-up; consider stronger role for ESMA in peer review groups and review panels; develop comprehensive strategy and annual peer review plan with input from standing committees.

### Investor protection — structure and initiatives (numeric precision preserved)
- Investment and Reporting Unit: "currently has 17 staff, but it covers a wide array of issues in addition to investor protection."
- Financial Innovation Standing Committee established to identify risks to investor protection and financial stability and produce a risk mitigation strategy; also an Investor Protection and Financial Intermediaries Standing Committee.
- Product monitoring:
  - Tool: market intelligence via regulator network, industry participants, and private vendor data.
  - Joint Committee project: determine critical information for authorities to make risk assessments and define data format.
- ESMA interventions and powers:
  - Current main tool: warnings. ESMA issued two warnings to the public: one on forex and the other on internet trading.
  - Intervention criterion: problem exists in multiple member states; otherwise NCAs handle domestic issues.
  - Expectation: MiFID 2 will give ESMA product intervention powers; some reforms seek to extend to product pre-approval.
- Product distribution and suitability: ESMA produced guidelines on process to assess client needs and suitability.
- Investor education: objective to coordinate programs; start with mapping work by NCAs and consider OECD work; then impact assessment.
- Recommendations:
  - Continue priority to product monitoring; consumer trends data project key to advance capabilities.
  - Exercise any product intervention powers cautiously and with clear, transparent protocol; evaluate pre-approval powers carefully due to risks of slowing innovation and moral hazard.

### Cross-sectoral arrangements — Joint Committee (JC) and cooperation with ESRB
- JC role: forum for cooperation among ESAs; chairs of three ESAs sit on it; EDs, EC and ESRB representatives and chairs of JC subcommittees participate as observers.
- Secretariat and leadership: no permanent secretariat; each ESA provides one staff rapporteur; chairperson rotates annually.
- Subcommittees (four currently) conduct bulk of technical work. Highlights:
  - Risk SC: produces Report on Risks and Vulnerabilities in the EU System twice a year; shared with ESRB and EFC.
  - Consumer Protection and Financial Innovation SC: focuses on product oversight and Packaged Retail Investment Products (PRIPs); harmonization of consumer trends data and product oversight principles.
  - Financial Conglomerates SC: response to EC call on review of financial conglomerates directive.
  - Anti-Money Laundering SC: assessed application of Third AMLD, resulting in two reports and a cooperation protocol for AML supervision of agents and branches of payment institutions.
- Cooperation with ESRB:
  - ESMA’s Chair: permanent member of ESRB General board and member of the Steering Committee; General board meets "at least four times a year."
  - ESMA Head of Economic Research Unit: permanent member of ESRB Advisory Technical Committee; Committee meets "at least four times a year."
  - ESMA economists participate in ESRB research and expert groups; each group meets "at least four times a year."
  - ESMA sends quarterly data on number of shares and trading venues in the EEA to the ESRB; provides ad-hoc contributions and joint projects (CDS markets, systemic risks).
- Recommendations:
  - Continue committing resources to cross-sectoral work; establish a single JC website to add transparency.
  - Close coordination with ESRB to avoid overlap in cross-sectoral risk assessment.

### Looking ahead — supervisory roles, CCPs, centralization
- Need framework for ECB cooperation with ESMA in context of proposed banking union and ECB’s new supervisory role; define scope when prudential supervision moves to ECB.
- EMIR and CCPs: ESMA must build expertise in new EMIR-assigned functions; will benefit from other ESAs' college-of-supervisors experience.
- Short-term stance: assigning additional direct supervisory functions beyond EMIR is not desirable short term; ESMA needs stability and delivery in current mandate areas.
- Medium-term exploration of further centralization of supervisory functions in ESMA may consider:
  - Facilitating cooperation for third country regimes (mutual reliance, equivalence determinations, MoUs).
  - Direct supervisory activities where domestic presence not critical: (i) issuers’ information (prospectus approval and review of periodic/ongoing issuer information), (ii) market surveillance.
  - Direct supervisory responsibilities for firms with pan-European reach or unclear home regulator: (i) CCPs (EMIR provides some role), (ii) trading venues, and potentially (iii) auditors.

### Table of Recommendations — selected high-priority actions (verbatim)
- "Review governance arrangements of ESMA with a view to make it more independent from NCAs." — Authority: EA — Importance: High — Time: Short to medium term
- "Review budget funding structure." — Authority: EA — Importance: High — Time: Medium Term
- "Review role of the EC in ESMA’s budget proposal." — Authority: EA — Importance: High — Time: Medium Term
- "Provide more resources to ESMA." — Authority: EA — Importance: High — Time: Short Term
- "Finalize implementation of a risk based supervisory approach for CRAs that ensures an appropriate level of engagement for all CRAs." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Review the enforcement framework for CRAs." — Authority: EA — Importance: Medium — Time: Medium
- "Implement projects to enhance financial stability role, including improving risk reports and developing stress testing and data warehousing." — Authority: ESMA — Importance: High — Time: Short-to Medium Term
- "Ensure that ESMA has easy access to complete data with sufficient granularity." — Authority: BoS of ESMA — Importance: High — Time: Ongoing
- "Finalize development of frameworks for crisis scenarios, including simulation exercises." — Authority: ESMA — Importance: High — Time: Short-to Medium Term
- "Ensure that ESMA has sufficient time to conduct public consultation on technical standards and advice to the EC." — Authority: EA — Importance: High — Time: Ongoing
- "Reengineer the peer reviews, by making them more rigorous and follow up in their outcomes in a systematic manner." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Clarify the enforceability of opinions and guidelines issued by ESMA in each relevant jurisdiction." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Continue to provide priority to product monitoring, including via the development of a framework for data collection on consumer trends." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Continue to commit resources to the JC." — Authority: ESAs — Importance: High — Time: On-going
- "Review whether further centralization of functions in ESMA is desirable." — Authority: EC — Importance: Medium — Time: Medium

*Source: ESMA Technical Note (Financial Sector Assessment Program — European Union), March 2013 (excerpt provided in content unit _cr1369).*

### 2013. The views expressed in this document are those of the staff team and do not necessarily reflect

### FINANCIAL SECTOR ASSESSMENT PROGRAM — EUROPEAN SECURITIES AND MARKETS AUTHORITY — TECHNICAL NOTE — MARCH 2013

### Summary findings and assessments
- Within its resource envelope, ESMA has performed well during its first two years, especially on the single rulebook and Credit Rating Agency (CRA) supervision. A significant number of technical standards, advice to the European Commission (EC), and opinions were developed.
- ESMA has built expertise in connection with CRAs and has worked on the development of a risk framework to anchor its supervisory program.
- Results are more modest in other functions; prioritization reflected tight regulatory deadlines and the need to assume CRA supervision.
- Key institutional issues identified:
  - Need to step up supervisory convergence work.
  - Need for better access to granular and timely data for risk identification and crisis management.
  - Need for more expert resources to deliver expanded functions (e.g., EMIR, CRA3, MiFID2).
  - Governance review advised to strengthen ESMA’s independence vis-à-vis National Competent Authorities (NCAs).

### Supervisory convergence — observations and recommendations
- Observations:
  - ESMA has set strategic directions and developed concrete actions but supervisory convergence remains underdeveloped.
  - Current tools include issuing opinions, conducting peer reviews, and, as a last resort, powers to investigate and remedy breaches of Union laws (Article 17).
  - The Board of Supervisors (BoS) composition as a college of peers may hinder performance, particularly in convergence.
- Recommendations:
  - Reengineer and strengthen peer reviews to:
    - Make reviews more rigorous by relying more on onsite work.
    - Sharpen outcomes by linking reports to best practices and/or guidelines, with monitored implementation and follow-up.
  - If necessary, escalate to stronger actions (such as breach of law) after rigorous peer review.
  - Strengthen ESMA’s role in peer review groups and the review panel.
  - NCAs should ensure enforceability of ESMA’s opinions and guidelines in their jurisdictions.

### Risk identification and crisis management — observations and recommendations
- Observations:
  - ESMA’s obligations include contributing to risk assessment and financial stability via own analysis, participation in the Joint Committee, and cooperation with the ESRB.
  - ESMA’s role in crisis management is primarily coordination, except for short-selling where it has direct intervention powers.
  - Current voting requirements (BoS vote to provide data for particular studies) may hinder timeliness in ESMA’s work.
- Recommendations:
  - Ensure ESMA has access to data with necessary granularity and timeliness to conduct in-depth analysis and stress testing for potentially systemic entities.
  - Keep risk identification as a recurrent BoS agenda item, not only in crises.
  - ESMA should coordinate simulation exercises and develop frameworks for identified scenarios.
  - Reduce procedural barriers that delay ESMA access to data for studies.

### Investor protection and product monitoring
- Observations:
  - Emphasis on product monitoring is warranted.
  - The consumer trends data project could enable a qualitative improvement in investor protection.
  - Monitoring of financial innovation should be coordinated with financial stability work.
  - ESMA has power to issue warnings and (recently) product intervention powers; these should be used cautiously since ESMA is not a direct supervisor.
- Recommendations:
  - Ensure close cooperation between product monitoring and financial stability units.
  - Exercise product intervention powers cautiously and with clear coordination with NCAs.

### Resources, future workload, and staffing
- Observations:
  - Approved additional staff for 2013 will not be sufficient to cover expanded functions.
  - EMIR will assign additional functions to ESMA requiring critical resources.
  - Further expanded functions expected from initiatives such as CRA3 and MiFID2.
  - Austerity pressures should not undermine ESMA’s capacity.
- Recommendation:
  - Ensure adequate expert resources to meet current and upcoming responsibilities.

### Institutional mandate, powers, and governance
- Key facts:
  - ESMA was created in 2011.
  - Regulation establishing ESMA: Regulation 1095/2010 of November 24, 2010.
  - ESMA is a legal body of the Union with legal personality (Article 5).
  - ESMA’s mission (Article 1) is to enhance investor protection and reinforce stable and well functioning financial markets in the EU.
  - Tasks and powers (Article 8) grouped as: regulatory work; supervisory convergence; financial stability and crisis management; investor protection; direct supervision (CRAs).
- Governance structure (Article 6):
  - Decision-making: Board of Supervisors (BoS) composed of the heads of the 27 NCAs, with observers from EC, ESRB, EBA, EIOPA; Norway, Iceland, and Liechtenstein as permanent observers.
  - Other bodies: Management Board; Chairperson; Executive Director; Board of Appeals.
  - BoS is the decision-making body; Chair prepares BoS work and participates without voting rights.
  - Decision rules:
    - Most decisions by majority of votes; each member has one vote.
    - Adoption of technical standards and guidelines requires a qualified majority; voting rights under the qualified majority process are weighted by population.
- Governance concerns and impacts:
  - Requirement for a qualified majority for technical standards and guidelines may enable blocking minorities, potentially stalling work or forcing compromises.
  - Stakeholders indicate, however, that in practice the qualified majority has not prevented agreement on legally required technical standards.
  - The BoS composition as a college of peers may negatively affect ESMA’s performance in supervisory convergence and the identification and follow-up of divergent practices.

### Securities markets — market structure and statistics (preserve numeric precision)
- EU financial system is mostly bank-based; equity and bond markets are well developed in certain countries.
- Market and industry aggregates:
  - As of 2012Q2 there were 6,654 issuers admitted to trading in regulated markets (RMs) or multilateral trading facilities (MTFs) in Europe.
  - Market capitalization of EU RMs amounted to US$11,076 billion.
  - The collective investment schemes (CIS) industry had assets under management of US$11,172 billion as of March 2012, of which US$7,965 billion were AUM by undertakings for collective investment in transferable securities (UCITs).
  - As of January 2012, AUM by hedge funds amounted to US$550.94 million.
- Trading venues and fragmentation:
  - As of 2012 Q2 there were 92 RMs and 138 MTFs licensed to provide services in EU.
  - Roughly 35 percent of the total volumes were transacted in MTFs.
- Transparency and trading composition:
  - Dark pools represent around two percent of all trading in Europe.
  - If over the counter (OTC) trading is included, around 45 percent of trading in the European Economic Area (EEA) is not subject to pre-trade transparency.
- High Frequency Trading (HFT) indicators (from ESMA surveys to selected trading platforms, 2010 Q4):
  - HFT firms account for between 40 and 70 percent of total index trading volumes on individual trading platforms.
  - In the futures market HFT firms accounted for between 10 and 60 percent of total equity index futures trading volumes on individual trading platforms.
  - For one trading platform HFT firms accounted for up to 95 percent of all orders sent and 97 percent of all orders cancelled.

### ESMA functions and tools
- Regulatory work:
  - Development of technical standards, guidelines, and provision of advice to the EC on secondary legislation to achieve a single rulebook.
- Supervisory convergence:
  - Issuing opinions; conducting peer reviews; powers under Article 17 to investigate breaches by NCAs; development of sectoral and cross-sectoral training; empowered to develop new practical instruments to foster convergence.
- Financial stability and crisis management:
  - Own analysis; contribution to the Joint Committee; cooperation with the ESRB; coordination role in crisis management, with direct powers in short-selling.
- Investor protection:
  - Issuing guidelines; power to issue warnings when financial activity poses a threat to investors.
- Supervision:
  - Direct supervisory role currently limited to CRAs (registration and supervision since July 2011).

*Source: ESMA Technical Note (Financial Sector Assessment Program — European Union), March 2013.*

### 17.      The BoS has met regularly. In 2011, it met seven times. As indicated by the BoS

### _cr1369 - 17.      The BoS has met regularly. In 2011, it met seven times. As indicated by the BoS

### Governance and decision-making bodies
- The BoS has met regularly; in 2011, it met seven times.
- In the majority of cases the NCAs sent their head to BoS meetings; when not possible a high-level alternate was sent.
- ESMA has a Management Board (MB) composed of six members selected from the BoS by its members.
  - ESMA’s Chair is a member and chairs the MB.
  - The Executive Director (ED) prepares the work of the MB.
  - The EC representative is a non-voting participant but votes on budget matters.
  - The MB focuses on management aspects such as development of the annual work program, the budget and resources.
- Appointment and tenure:
  - The Chair and the ED are appointed by the BoS following an open selection procedure based on merits, skill, knowledge, experience relevant to financial sector regulation and supervision, and managerial experience.
  - Both are required to act independently and are prohibited from taking instructions from any European body or domestic authority.
  - Both are appointed for five year terms with the possibility of reappointment for one more term.
  - Before the Chair takes up duties, the European Parliament (EP) may object to the designation.
  - The Chair may only be removed by the EP following a decision of the BoS.
  - The ED is appointed by the BoS after confirmation of the EP and may be removed by decision of the BoS.
  - ESMA Regulation does not require the existence of “due cause” for the early removal of the Chair or the ED.

### Standing committees, task forces, and staff roles
- There are currently 11 standing committees (SCs); ad-hoc task forces are also constituted from time to time.
- NCAs lead the work of the SCs (chair them and in some cases “hold the pen”); ESMA staff act as rapporteurs.
- Stakeholders reported that ESMA staff is becoming more active in discussions over time.
  - When consensus is not reached, reports more often now explicitly state ESMA’s position in addition to highlighting different alternatives.
  - At BoS meetings, the Chair presents the position of the institution.
- ESMA chairs the Technical Committee (for CRAs) and the IT Committee; these are the only Committees currently chaired by ESMA.

### Stakeholder engagement and appeal mechanisms
- There is one Appeal Board for the three ESAs composed of two experts from each sector (and their alternates).
  - Decisions of the Appeal Board can be appealed to the European Court of Justice.
- A Securities and Markets Stakeholder Group is established to facilitate consultation.
  - It has 30 members appointed by ESMA for a period of two and a half years following an open call for candidates.
  - The Group is active, has its own work program, and holds periodic meetings with the BoS with a pre-set agenda.
  - ESMA officials indicated the Group is vocal and expected to be a source of valuable information for supervisory convergence.

### Transparency and accountability
- ESMA operates under a high level of transparency.
  - A significant amount of information is available on ESMA’s website, including minutes of BoS meetings, ESMA’s annual work program, its budget and its annual report, reports of standing committees, and proposals for technical standards and guidelines.
- Mechanisms of accountability to the EP and the Council of the EU:
  - By regulation, the EP and Council can summon ESMA at any time and can require opinions.
  - Accountability is operationalized via an annual joint hearing at the EP for the three ESAs and ad-hoc technical hearings with the EP and Council.

### Conclusions and recommendations — governance
- Governance arrangements should be evaluated in the upcoming review by the EC.
- Observations and concerns:
  - ESMA represents a significant evolution from CESR legally and operationally.
  - Stakeholders indicated the Chair’s presence ensures ESMA’s positions are heard, but decisions are still dominated by “domestic” views.
  - The governance structure could be particularly troublesome for supervisory convergence.
  - Weak follow up of peer review conclusions may be partly explained by the current composition of the BoS.
- Recommended actions to be analyzed in the ESAs review:
  - Enhance ESMA’s independence from the NCAs while keeping high accountability to European authorities.
  - Consider alternatives such as adding more independent members to the board, moving to a fully full time board, or delegating more functions to the MB.
  - Strengthen rules for removal of the Chair and the ED by requiring removal only with due cause.
  - ESMA staff should continue to play a stronger role in the standing committees.
- From a transparency perspective:
  - Explore more engagement with the Stakeholders Group in connection with the work plan; engage early to get their views on priorities.

### Funding and budget issues — structure and process
- Funding sources (pursuant to Article 62 of ESMA Regulation):
  - A subsidy from the EC (entered in the general budget of the EU (Commission section)).
  - A contribution from the NCAs.
  - A fee levied on registered firms under its direct supervision (currently only CRAs; with EMIR, trade repositories would also contribute).
- Funding mix differs from other ESAs (where 60 percent comes from the EU and 40 percent from the NCAs).
- For 2013, ESMA’s budget will amount to €28.3 million, with contributions roughly:
  - EC contribution: 46 percent
  - NCAs' contribution: 30 percent
  - CRAs' contribution: 20 percent
  - Trade repositories' contribution: 4 percent
- The contribution of the largest NCAs does not represent a significant proportion of ESMA’s budget.
- Budget development and approval process:
  - The ED develops the budget proposal (in close collaboration with divisions and units), submits to the MB, which submits to the BoS.
  - The BoS-approved proposal must be submitted to the EC in an EC template with three line items (staff, administrative and projects) and a justification.
  - The EC can make changes to ESMA’s proposal; the EP and Council can make changes to the EC proposal.
  - In practice during ESMA’s first two years the EC made only minor changes to ESMA’s proposal; this differs from other ESAs where the EC proposed cuts.
- Oversight and accountability:
  - Monthly reporting to the ED and quarterly reports on budget execution to the MB.
  - ESMA is developing performance indicators for 2013.
  - ESMA’s accounts and use of resources are audited annually by the European Court of Auditors (ECA).
    - Twice a year the ECA sends a team of three inspectors who spend roughly two weeks reviewing ESMA’s use of resources.
  - ESMA has an Internal Control Officer and an internal audit is carried out by the EC annually focusing on efficiency.

### Conclusions and recommendations — funding and budget
- Review the funding structure and the budget process.
- Risks and considerations:
  - Current funding structure could create conflicts of interest vis-à-vis NCAs (possible bias against ESMA growth).
  - As ESMA grows, NCAs' contributions could become a heavy burden for smaller jurisdictions, with a risk of non-payment.
- Funding model alternatives to explore:
  - Industry fees (part of ESMA’s budget is already funded this way), though expanding this may face resistance due to double charging concerns.
  - Fully EU-funded or increasing the EU share of funding.
- Review the EC’s role in ESA budget approval:
  - In times of austerity the EC could be pressured to reduce ESA budgets using mechanistic reductions across the board.
  - Explore whether ESMA should present and justify its budget directly to the EP and Council.

### Organizational structure, human resources, and capacity
- Current organization:
  - Three divisions: Markets, Investment and Reporting, and Operations.
  - Three units: Credit Rating Agencies Unit, Economic Research and Financial Stability Unit, and Legal Cooperation and Convergence.
  - ESMA is bound by EU public agency administrative rules for recruitment and procurement.
- Human resources growth and composition:
  - ESMA started with 35 staff (from CESR).
  - As of November 2012, it had 85 professionals on post, 16 percent less than the 101 included in the budget plans end 2012.
  - Recruitment average lead time is six months until a person arrives.
  - All key positions (heads of division or unit) were subject to an open selection process.
  - Rapid institutional growth is a managerial challenge as staff must familiarize with procedures and functions.
- Staff mix and contractual terms:
  - A mix of 75 percent staff and 25 percent secondees from NCAs and contractors.
  - Staff hired under a three year contract, renewable for another three years, then eligible for an “indefinite” position.
  - Salaries follow EC scales; differences in salaries across Europe make hiring experts from “the north” more challenging.
- Staffing table (preserve figures as presented):
  - 2012 Current: Staff 68; Secondees 9; Contractual 8; Total 85
  - 2012 Planned: Staff 75; Secondees 16; Contractual 10; Total 101
  - 2013 Planned: Staff 121; Secondees 25; Contractual 14; Total 160
- Training and IT:
  - ESMA provides training on securities market issues and cross-sectoral issues together with EBA and EIOPA.
    - Eleven seminars were organized in 2011.
    - In 2011, two training sessions targeted ESMA staff; nine sessions are planned for 2012.
    - ESMA staff has access to EC training programs.
  - Several IT projects are key:
    - A data depository was developed to assist CRA supervision.
    - CRA3 requires expansion so “live” information must be stored and made publicly available.
    - MiFID2 might require further IT developments.
    - IT needs connected to risk identification function.
    - Ongoing IT initiatives include registers of issuers (notifications of prospectus approval) and investment firms (consolidation of registered firm information from EU member states).

### Conclusions and recommendations — organizational capacity
- ESMA is building a strong institution with adequate expertise; ESMA staff is becoming more active in standing committees and can act as a counterbalance to “domestic” positions of NCAs.
  - Ideally ESMA staff should chair standing committees to foster EU-wide interests in work plans and reports.
  - Critical that ESMA keeps a high ratio of expert staff versus secondees.
- Resource needs:
  - ESMA needs more resources to carry out all functions effectively.
  - The 2013 budget envelope would not be sufficient to implement initiatives critical for ESMA to take a more active role beyond the single rulebook and CRA supervision.
  - Pipeline initiatives such as EMIR, CRA3 and MiFID2 will create new or expanded responsibilities.
- Recruitment policy monitoring:
  - The six year term policy leading to an indefinite position may work to ESMA’s advantage now, but may not be conducive to long-term organizational stability; recruitment policies should be monitored.

### ESMA’s role in financial stability — direct supervision of CRAs
- CRA Unit:
  - Dedicated unit for supervision of CRAs with 16 staff (15 officers and the head of unit) at the time of the report.
  - Unit expected to grow to 26 people by 2013.
  - With approval of CRA3, ESMA will receive funding to hire 15 more staff (not all assigned to the CRA Unit).
- Since July 2011 registration and supervisory responsibilities for CRAs transferred from NCAs to this unit.
- CRA supervision structures:
  - A Technical Committee chaired by the ED, composed of NCAs and observers from the EC, EBA and EIOPA provides advice on policy and international cooperation.
- Supervisory activities conducted by the CRA Unit:
  - Registration and certification:
    - Since July 2011 the Unit has taken charge of assessment of new applications; one new CRA was registered upon application received directly by ESMA.
    - There are currently 18 registered CRAs and one certified CRA.
    - Five applications pending.
  - Perimeter:
    - ESMA contacted around 30 companies whose activities prima facie could fall under the CRA Regulation and requested explanations.
    - ESMA is preparing guidance on the scope of the CRA Regulation to be published in 2013.
  - On-going supervision:
    - Multidimensional approach including desk reviews (based on notifications of changes, complaints and other periodic data) and on-site inspections (horizontal/thematic and vertical/individual).
    - Conducted on-site inspections of three global CRAs to better understand business models and operations.
      - Sent individual reports to each CRA with requests for changes and a plan for implementation which ESMA is monitoring.
      - Published a report summarizing main findings (available on ESMA’s website).
    - Based on inspection findings, ESMA is conducting a review of banking rating methodologies.
    - Based on risk analysis ESMA decided to conduct a vertical individual on-site inspection on the internal controls of another CRA.
    - Per the CRA Regulation, the CRA Unit must conduct inspections on all CRAs by 2014; conducting these inspections is in the Unit’s work plan.
  - Development of central repository (CEREP):
    - ESMA developed CEREP to make available information on past performance of ratings (six months lag) via ESMA’s webpage.
    - CRA3 will require such data to be available in real time.
    - Another IT tool, SOCRAT, will facilitate processing of ratings data in a standard and automatic manner to support supervisory activities and provide input for the Unit’s risk assessment framework.

*Source: _cr1369 - 17.      The BoS has met regularly. In 2011, it met seven times. As indicated by the BoS (excerpt).*

### 45.      In addition, the Unit has made progress in the development of a CRA Risk

### In addition, the Unit has made progress in the development of a CRA Risk Assessment Framework, as the basis to support its supervisory program

### CRA Risk Assessment Framework and supervisory program
- The work program will be risk-based.
- Risk factors included in the framework: environmental risk, operational risk, business model risk and governance risk.
- The Unit developed criteria/alerts for each type of risk to foster a consistent view of risk by the officers.
- It is estimated that roughly 70 percent of the supervisory resources would be spent on the large CRAs.
- The Unit’s approach: at least some engagement with all CRAs, even the small ones.
- Each CRA has been assigned a relationship manager in charge of continuous monitoring of such CRA.
- Feedback from the relationship managers would be one of the inputs for the risk assessment framework.
- Minimum engagement includes periodic (annual) meetings with the compliance officers of the CRAs.
- Once inspections on all CRAs are concluded, on an on-going basis the Unit will conduct two thematic reviews and two vertical reviews per year, in addition to other supervisory work (registrations, handling of complaints, etc).

### International coordination and MoUs
- ESMA has finalized MoUs with jurisdictions including the United States, Canada, Australia, Hong Kong, Japan, Brazil, Singapore, Mexico and Argentina.
- ESMA has been actively involved in IOSCO’s consultation on the establishment of a global “college” for CRAs; expectation is that regulators would share information and be able to conduct joint inspections.

### Enforcement tools, fines, and appeals
- With approval of secondary legislation on the amount of fines and procedures for their imposition, all enforcement tools can now be used by ESMA.
- Pursuant to the CRA Regulation, ESMA powers include: withdraw a firm's license if licensing requirements are no longer met; (i) temporarily prohibit the CRA from issuing ratings with effect in the EU, (ii) suspend the use for regulatory purposes of ratings with effect in the EU, (iii) require a CRA to bring the infringement to an end, (iv) issue notices, and (v) impose fines.
- The EC established minimum and maximum fines assigned to infringement categories.
  - Example ranges provided in the report:
    - “Lowest” category: sanctions ranging from €10,000 to €50,000.
    - “Highest” category: sanctions ranging from 500,000 to 750,000.
- Overall, the maximum fine that could be imposed is €750,000 for a first time infringement.
- Sanctions can be appealed to the Appeal Board; decisions of the Appeal Board can be appealed to the European Court of Justice.

### Internal oversight and public accountability
- A system of internal oversight has been developed: medium term objectives are prepared by staff and discussed and approved at BoS level; applies to annual work plan and risk based supervisory approach.
- Implementation of the work plan is monitored via reporting to the MB; major changes to objectives are to be reported to the BoS during the year where necessary.
- Public accountability mechanisms: ESMA will make available a public version of the work program, an annual report, and reports following thematic reviews (such as the one published in March 2012).

### Conclusions and recommendations — CRA supervision
- ESMA needs to finalize implementation of its risk-based supervisory approach for CRAs over the next couple years.
- The mission agrees the risk-based approach is sound provided minimum engagement is kept with small CRAs; ESMA envisions this.
- After initial on-site inspections for all CRAs, small CRAs should be included from time to time in samples for thematic on-site inspections, in addition to engagement via relationship managers and meetings with compliance officers.
- Meetings with senior management of CRAs should also be considered.
- Key supervisory challenge: strike the right balance between ensuring methodologies used by CRAs are “rigorous, systematic, continuous and subject to validation, without interfering with their content, as required by the Regulation.”
- ESMA should keep close coordination with the NCAs, which could provide valuable information for ESMA’s risk-based approach.
- Oversight mechanisms: monitoring of specific and supervisory work should remain at MB level whilst BoS role should be oversight via discussion and approval of work plan and risk based approach and periodic reporting; engagement in individual supervisory work should remain at management level.
- The mission recommends that the enforcement framework for CRAs be reviewed as part of the ESAs review by the EC; current sanction levels may be rigid and, depending on CRA size, could be too low to have a deterrent effect, although publication of sanctions may influence behavior; pecuniary sanctions are only one tool to influence behavior.

### Identification and monitoring of risks
- Responsibility: Economic Research and Stability Unit.
- Staffing: as of November of 2012 the Unit was composed of 6 staff; expected to grow to 11 staff by 2013.
- There is a Standing Committee for Economics and Market Analysis (CEMA).
- Risk identification is mainly based on continuous monitoring of a set of indicators feeding into two periodic reports that must be approved by the BoS; currently analysis is done based on publicly available data.
- Periodic reports:
  - A quarterly risk dashboard. ESMA has produced seven risk dashboards. Publication is a market trends analysis divided in four categories (risk overview, liquidity risk, market risk, contagion risk, and credit risk). Q2 2012 included an indicator of stress in securities markets. A challenge is to adjust categories/indicators to securities markets and develop a set of early warning indicators based on risks originating in securities markets (e.g., related to hedge funds).
  - Bi annual report of Trends, Risks and Vulnerabilities (mandated by ESMA’s Regulation). ESMA produced its first report last year. Report structure: systematic analysis of markets; replica of the dashboard(s); thematic analysis of risks.
- Complementary thematic work completed: (i) risks associated with industry trends toward structured and complex retail products; (ii) assessment of the size of shadow banking.
- On-going thematic analyses include: (i) credit default swaps market, (ii) contribution of the hedge fund sector to systemic risk, (iii) high frequency trading in European equity markets, and (iv) bank funding issues and securities financing transactions (the latter coordinated by the ESRB).
- Stress testing development: Unit is working on techniques for stress testing of securities firms, focusing on trading venues, hedge funds and CCPs. Informal ESMA data requests to NCAs met opposition; NCAs requested strategic discussion at BoS level on ESMA’s stress testing strategy; at review time such discussion had not taken place.
- Data needs: Unit intends to build a data warehouse incorporating publicly available data and incoming regulatory data; gaps exist where data is not collected at the NCA level and will need to be filled; incomplete data hampers complete and accurate analysis.
- Note: There is also weekly Financial Monitor.

### Conclusions and recommendations — risk identification and monitoring
- Projects under way will allow ESMA to make a qualitative jump in its contribution to financial stability and crisis management, provided that it has access to data.
- The work-plan is reasonable and on-point, but critical that ESMA has access to data with the granularity necessary for in-depth analysis, including stress testing.
- Article 35 of the Regulation provides ESMA with the power to request information to the NCAs as long as such information is necessary to fulfill its mandate; only when information is not made available in a timely fashion and after following certain steps, ESMA can request it directly to market participants.
- Practical challenges exist: requiring a vote from the BoS to provide data for particular studies might hinder ESMA’s timeliness.
- The BoS should take a more active responsibility in risk identification and monitoring; risk identification should be a recurrent agenda item for all BoS meetings and input from those discussions should be given to the Economic Research and Financial Stability Unit and CEMA.

### Crisis management role, powers, and framework
- ESMA’s role and powers in crisis management generally focus on coordination; ESMA only has direct powers where sectoral legislation provides it or when an emergency has been declared by the European Council.
- Short-selling regulation grants ESMA and NCAs temporary intervention powers; measures available to NCAs include:
  - (i) increased transparency requirements;
  - (ii) prohibiting or restricting natural and legal persons from engaging in short sales on a trading venue, or otherwise limit transactions on a specific financial instrument in such trading venue for a maximum of three days in certain circumstances;
  - (iii) an outright prohibition on short-selling for a period of time;
  - (iv) imposition of conditions on a short sale or transactions that indirectly create short positions.
- If a NCA intervenes it must notify ESMA, which has to issue an opinion within 24 hours on whether it considers the measure necessary; if ESMA considers a threat to financial stability is not adequately addressed by the NCA's actions, it has power to take any measures available to NCAs.
- ESMA had not yet made use of such powers as of review; in November of 2012 two NCAs issued bans on short-selling and ESMA issued an opinion but did not use direct intervention powers.
- Legal action: the United Kingdom brought a suit against the European Parliament and the Council of the European Union for granting such powers to ESMA; the suit is pending (C-70/12).
- ESMA has started work on crisis management: developed a definition of “crisis” for securities markets (one that seriously affects orderly trading or financial stability, with cross border implications and an urgency element), identifying six types of events:
  - (i) EU wide trading suspension,
  - (ii) EU wide ban on short selling,
  - (iii) EU wide suspensions of redemptions of units in UCITs,
  - (iv) settlement fails on a pan-European basis,
  - (v) EU wide product intervention measures,
  - (vi) failure of clearing members and CCPs.
- Framework development is ongoing; first output is a protocol for exchange of information in connection with CCPs that: (i) identifies potential emergency situations faced by a CCP, (ii) establishes principles for exchange of information, (iii) sets mechanisms for such exchange, and (iv) identifies the information to be exchanged.

### Conclusions and recommendations — crisis management
- Mission concern: use of direct powers on short-selling — short term effects may slow downward spirals but medium term restrictions affect liquidity and price formation.
- If NCAs use such measures, they should aim at non-conflicting and preferably identical measures unless domestic market differences warrant differences.
- Work on developing frameworks for crisis scenarios is shaping up well; starting with CCPs is reasonable.
- The mission recommends that ESMA coordinates simulation exercises in addition to developing frameworks for each identified “crisis” type.

### Single Rulebook work and transparency
- ESMA is required to conduct public consultations when developing implementing technical standards and when providing technical advice to the EC; required to consult the Securities and Markets Stakeholders Group; technical standards must be endorsed by the EC.
- During first two years ESMA dedicated significant resources to the single rulebook. Policy work summary:
  - Forty technical standards were developed, involving significant work for the implementation of EMIR.
  - Four technical standards were developed for the new CRA supervisory regime.
  - Seven technical standards were developed for the new short-selling and credit defaults swap regime.
  - Five pieces of advice were provided to the EC on secondary legislation in areas such as prospectuses, UCITs, alternative investment funds (AIFs) and short-selling.
  - Six sets of detailed guidance and recommendations were developed in areas such as automated trading, AIF managers (AIFMs), exchange traded funds (ETFs), suitability of advice and the investment firm compliance function.
- ESMA delivered some technical standards under very tight deadlines; consultation processes have at times been squeezed, raising stakeholder concerns about insufficient time to analyze proposals and assess costs and impacts.
- Future workload: work on the single rulebook likely to continue with pieces of legislation in the pipeline requiring technical standards or advice, including MiFID2/MiFIR, MAD/MAR, CRA3, the Transparency Directive, and UCITs VI.
- Conclusions and recommendations: EC’s authority to make changes to technical standards could be troublesome but procedure is subject to high transparency; ESMA is technical authority and any EC intervention via endorsement should be motivated by technical reasons; process ensures deviations are visible and no major problems apparent at this time.

*Source: _cr1369 - 45. In addition, the Unit has made progress in the development of a CRA Risk Assessment Framework, as the basis to support its supervisory program.*

### 73.      Going forward, it is important that ESMA be given sufficient time to deliver on

### _cr1369 - 73.      Going forward, it is important that ESMA be given sufficient time to deliver on

### Supervisory Convergence — tools, practices, and capacity
- ESMA tools to foster supervisory convergence: issue guidelines and opinions, conduct peer reviews and training, develop practical instruments and convergence tools.
- Review panel:
  - Main standing committee for supervisory convergence.
  - Conducts peer reviews (assessment or comparison of provisions or practices).
  - Reviews reports and sends them to the BoS; monitors implementation according to agreed timetable and makes recommendations to the BoS on delays.
- Legal, Cooperation and Convergence Unit staffing:
  - "two staff directly dedicated to convergence work and three more lawyers that support all of ESMA’s work, including the standing committees."
  - "The Unit is recruiting four more staff members in 2013 (including additional lawyers)."
- Peer review methodology and process:
  - ESMA approved a methodology to conduct peer reviews in January 2012.
  - Peer review teams: experts from NCAs; methodology allows hiring external experts.
  - Process: questionnaire sent to NCAs → answers with evidence → team compares answers to evidence → team report discussed in review panel → sent to BoS.
  - Procedures require monitoring of implementation and reporting to BoS; review panel to recommend how to deal with implementation delays.
- Peer review activity:
  - "Since 2011, ESMA has conducted four peer reviews; two of them have been finalized."
  - Examples:
    - Review of the use of sanctions under the Market Abuse Directive (MAD): showed significant differences in the type, amount and use of sanctions by NCAs.
    - Prospectus approval: found majority of countries in full compliance; report developed best practices for prospectus approval.
- Opinions and other instruments:
  - Examples of opinions: (i) treatment of sovereign debt under International Financial Reporting Standards; (ii) consistency with MiFID of a large number of pre-trade transparency waivers.
  - Opinions and guidelines of the ESAs do not have status of enforceable EU law; expected that NCAs transpose them into national law so they become legally enforceable in national courts.
  - Member states that do not integrate guidelines/opinions must ensure domestic provisions do not breach Level 1 and level 2 EU legislation.

### Challenges in enforcement, mediation, and culture of complaints
- ESMA has not used mediation and breach of laws procedures:
  - No mediation cases filed by NCAs (NCA filing is a requirement).
  - One case brought by an NCA on application of one provision in the UCITs framework; BoS issued an opinion on interpretation.
- Cultural factors: lack of a culture of filing complaints by firms or NCAs.
- ESMA can start breach procedures on its own initiative; expects stakeholder involvement and increased staff to enable a more proactive stance.
- Historical limitations under CESR: prior work focused on mapping rather than assessments; assessments were desk-based, leading to most countries usually rated fully compliant and limited follow-up on partial compliance.

### Reengineering peer reviews — mission view and planned work
- ESMA Chair intends to revamp peer reviews to be more rigorous and produce sharper outcomes.
- Planned peer reviews for 2012 and 2013 (three reviews already planned):
  - (i) review of the money market guidelines developed by ESMA,
  - (ii) review of MAD supervisory practices,
  - (iii) review of MiFID requirements for fair, clear and not misleading information.
- Mission recommendations for reengineering:
  - Objectives: (i) make reviews more rigorous (e.g., rely more on onsite work); (ii) sharpen outcomes (e.g., link reports to development of best practices and/or guidelines whose implementation can be monitored and followed up, and if necessary lead to stronger actions such as breach of law).
  - Use regulations to produce systematic follow-up and link with agreed mechanisms for follow-up and measures.
  - Consider a stronger role for ESMA in peer review groups and review panels.
  - Develop a comprehensive strategy; annual peer review plan should consider input from all standing committees.

### Investor Protection — structure and key initiatives
- Investment and Reporting Unit:
  - "currently has 17 staff, but it covers a wide array of issues in addition to investor protection."
- New governance: Financial Innovation Standing Committee established to assist ESMA in investor protection responsibilities; main function is to identify risks to investor protection and financial stability in financial innovation area and produce a risk mitigation strategy. There is also an Investor Protection and Financial Intermediaries Standing Committee.
- Product monitoring:
  - Key initiative: monitor products sold to retail investors to determine appropriate disclosure.
  - Main tool: market intelligence via a network of regulators, industry participants, and data from private vendors.
  - Joint Committee project: determine critical information for authorities to make risk assessments (including complaints and information on products sold) and define data format.
- ESMA interventions and powers:
  - Current main tool: warnings. ESMA has issued two warnings to the public: one on forex and the other on internet trading.
  - Intervention criterion: problem exists in multiple member states; otherwise issue is domestic for NCAs.
  - Expectation: MiFID 2 will give ESMA product intervention powers; some reforms seek to extend to product pre-approval.
- Product distribution and suitability: ESMA actions have mainly been guidelines relating to process to assess client needs and suitability.
- Investor education: objective to coordinate investor education programs; start with mapping work by NCAs and consider OECD work; second part is an impact assessment.

### Conclusions and recommendations on investor protection
- Emphasis on product monitoring is warranted.
- Consumer trends data project seen as key to advance capabilities.
- Effective monitoring of financial innovation could positively affect financial stability; close cooperation between relevant units recommended.
- Product intervention powers: mission considers granting them a good development but stresses:
  - Powers must be exercised cautiously as ESMA is not a direct supervisor.
  - If granted, develop a clear and transparent protocol for exercise.
  - Proposal to provide pre-approval powers should be carefully evaluated due to risks: slowing down innovation and potential moral hazard from early approval by a supervisory body.

### Cross-sectoral arrangements — Joint Committee (JC) and subcommittees
- JC role: forum for cooperation and exchange among ESAs; foster cross-sectoral consistency. Chairs of three ESAs sit on it. EDs, a representative from EC and ESRB, and chairs of JC subcommittees participate as observers.
- Secretariat and leadership:
  - No permanent secretariat; each ESA committed one staff (the rapporteurs).
  - Chairperson rotates annually; the rapporteur from the chairing ESA leads document production and meeting agendas.
  - Annual work plan based on three ESAs' feedback.
  - Bulk of technical work conducted via subcommittees (currently four subcommittees).
- JC early experience:
  - JC had a slow start focused on setting up working procedures; subcommittees started working on important projects per 2012 plan.
- Subcommittee highlights:
  - Risk SC: produces Report on Risks and Vulnerabilities in the EU System twice a year; report shared with ESRB and EFC. SC faces challenge in identifying value added beyond ESA individual outputs. Selection of topics currently via "brainstorming." Example ad-hoc work: reference rate indices.
  - Consumer Protection and Financial Innovation SC: focuses on product oversight and measures related to Packaged Retail Investment Products (PRIPs):
    - Cross selling and complaints handling are priorities; reviewing insurance sector complaints principles for application to securities and banking.
    - JC will consider improvements and consistency between ESAs templates for collecting/analyzing/reporting on consumer trends; lessons from first data collection rounds from NCAs.
    - Product oversight and governance: considering development of high level principles for a product approval process based on results of a September 2012 mapping exercise.
    - PRIPs: subgroup initiated draft technical standards work in areas envisaged by PRIPs legislative proposal.
  - Financial Conglomerates SC: focused on response to EC call for advice on review of financial conglomerates directive.
  - Anti-Money Laundering SC: assessed application of the Third Anti-Money Laundering Directive (AMLD) resulting in two reports to support review; published a protocol on cooperation between home and host supervisors for AML supervision of agents and branches of payment institutions per the Payment Services Directive.

### Cooperation with the ESRB
- Mechanisms of cooperation:
  - ESMA’s Chair: permanent member of the ESRB General board and member of the Steering Committee; participates in all ESRB decisions; General board meets "at least four times a year."
  - ESMA Head of Economic Research Unit: permanent member of ESRB Advisory Technical Committee; participates in analyses and policy recommendations; Committee meets "at least four times a year."
  - ESMA economists participate in ESRB research activities and expert groups; each group meets "at least four times a year."
  - Data exchange: ESMA sends data on number of shares and trading venues in the EEA on a quarterly basis to the ESRB.
  - Ad-hoc contributions: comments to documents (e.g., ESRB Risk Dashboard), ad-hoc meetings (Dashboard dry-run), and joint projects: CDS markets and systemic risks.

### Conclusions and recommendations — JC and cross-sectoral work
- JC must adapt to changing roles of ESAs; subcommittees are engaging in important projects (e.g., PRIPs, harmonization of consumer trends data).
- Recommendation: continue committing resources to cross-sectoral work; establishment of a single JC website should add transparency.
- Cross-sectoral risk assessment is challenging; close coordination with ESRB is key to avoid overlap.

### Looking ahead — supervisory roles, CCPs, and centralization
- Need to develop framework for ECB cooperation with ESMA in context of proposed banking union and ECB’s new supervisory role; define scope of cooperation when prudential supervision moves to ECB.
- EMIR and CCPs: ESMA needs to build expertise in new functions assigned by EMIR; will benefit from other ESAs' experience on colleges of supervisors.
- Short-term stance: mission agrees with ESMA Chair that assigning additional direct supervisory functions beyond those in EMIR is not desirable in short term; ESMA needs stability and delivery in current mandate areas.
- Medium-term exploration: consider further centralization of supervisory functions in ESMA in some areas (acknowledging fiscal, legal, and operational challenges). Potential areas:
  - Facilitating cooperation for third country regimes (mutual reliance, equivalence determinations, facilitating execution of MoUs).
  - Direct supervisory activities where domestic presence is not critical or where synergies/ expertise favor centralization: (i) issuers’ information (prospectus approval and review of periodic/ongoing issuer information), (ii) market surveillance.
  - Direct supervisory responsibilities for firms with pan-European reach or unclear home regulator: (i) CCPs (EMIR provides some role), (ii) trading venues, and potentially (iii) auditors.

### Table of Recommendations — selected high-priority actions (verbatim figures preserved)
- "Review governance arrangements of ESMA with a view to make it more independent from NCAs." — Authority: EA — Importance: High — Time: Short to medium term
- "Review budget funding structure." — Authority: EA — Importance: High — Time: Medium Term
- "Review role of the EC in ESMA’s budget proposal." — Authority: EA — Importance: High — Time: Medium Term
- "Provide more resources to ESMA." — Authority: EA — Importance: High — Time: Short Term
- "Finalize implementation of a risk based supervisory approach for CRAs that ensures an appropriate level of engagement for all CRAs." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Review the enforcement framework for CRAs." — Authority: EA — Importance: Medium — Time: Medium
- "Implement projects to enhance financial stability role, including improving risk reports and developing stress testing and data warehousing." — Authority: ESMA — Importance: High — Time: Short-to Medium Term
- "Ensure that ESMA has easy access to complete data with sufficient granularity." — Authority: BoS of ESMA — Importance: High — Time: Ongoing
- "Finalize development of frameworks for crisis scenarios, including simulation exercises." — Authority: ESMA — Importance: High — Time: Short-to Medium Term
- "Ensure that ESMA has sufficient time to conduct public consultation on technical standards and advice to the EC." — Authority: EA — Importance: High — Time: Ongoing
- "Reengineer the peer reviews, by making them more rigorous and follow up in their outcomes in a systematic manner." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Clarify the enforceability of opinions and guidelines issued by ESMA in each relevant jurisdiction." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Continue to provide priority to product monitoring, including via the development of a framework for data collection on consumer trends." — Authority: ESMA — Importance: High — Time: Short to Medium Term
- "Continue to commit resources to the JC." — Authority: ESAs — Importance: High — Time: On-going
- "Review whether further centralization of functions in ESMA is desirable." — Authority: EC — Importance: Medium — Time: Medium

*Source: IMF FSAP chapter text provided in content unit _cr1369 - 73.*

### ANNEX I. FINANCIAL SECTOR REFORM AGENDA-SELECTED ISSUES

### ANNEX I. FINANCIAL SECTOR REFORM AGENDA-SELECTED ISSUES

### Market structure, market integrity, and resilience (paragraph 102)
- The approval of MiFID2 and reforms to MAD are key to fostering market resilience and market integrity; current texts still require adjustments.
- Overall assessment: MiFID2 appears to address challenges from market fragmentation and technological innovations; reforms to MAD will foster market integrity.
- Key provisions of particular importance:
  - Definition of Organized Trading Facilities (OTFs) and definition of OTC markets. The mission supports the general objective of fostering trading in organized facilities, as well as transparent and open markets.
  - Obligations on markets to have arrangements in place to manage volatility. These provisions should foster market resilience.
  - Enforcement framework (MiFID2 and MAD). The mission supports further harmonization of sanctions available to deal with infractions to MiFID and MAD, in line with ESMA’s recent peer review; as well as the extension of the market abuse provisions to MTFs.
  - High frequency trading. The mission supports the introduction of obligations for high frequency traders to set up strong risk controls. Other requirements should be analyzed further in order to get better insight on the costs and benefits that they might bring.
  - Framework to report data on market transactions, impose client identification, develop a consolidated tape, and ensure access by NCAs to order book data. These provisions should help NCAs to strengthen their market surveillance arrangements and the consolidated tape should allow for better supervision of best execution obligations.
  - An enhanced framework for commodities derivatives markets. The provisions require registration of commodities derivatives firms. They will also provide the NCAs with powers to manage positions, an important tool both from market resilience as well as from a market integrity perspective.

### Shadow banking, transparency, and FSB-related issues (paragraph 103)
- Priority should continue to be given to initiatives addressing risks from shadow banking; considerable work has already been done.
- Existing and forthcoming measures:
  - CRA3 contains provisions to encourage authorities to reduce reliance on ratings.
  - Implementation of EMIR would impose post-trade transparency on OTC derivatives transactions.
  - Implementation of the AIFMD should bring further transparency to the hedge fund industry.
- Areas where further work is warranted relative to Financial Stability Board (FSB) work:
  - Money market funds and ETFs. The mission acknowledges that ESMA has issued guidelines—including in connection with their use of securities lending and repos—which should be the starting point for the reforms to be incorporated in UCITSVI. Feedback from the consultation on the EU green paper should provide further input on other areas where additional work is warranted.
  - Securities lending and repos.

### Consumer protection and product intervention (paragraph 104)
- Consumer protection issues should receive sufficient priority in the financial sector reform agenda.
- Cross-sectoral harmonization:
  - The mission supports initiatives to level the playing field for investment-like products.
  - PRIPs would address disclosure requirements, and MiFID2 and Insurance Mediation Directive (IMD) would address selling practices.
  - For disclosure, it is important that the text provides sufficient flexibility to address differences in disclosure for certain insurance products.
  - Concerning IMD, it is critical that the reforms remain consistent.
- Inducements in MiFID2:
  - The mission highlights the importance that the ban on inducements not be dropped.
- Product intervention powers for NCAs and ESMA in MiFID2/MiFIR:
  - The mission believes these powers should exist in light of lessons from the crisis, but emphasizes they must be used cautiously.
  - Reforms to provide these institutions with product pre-approval powers should be reevaluated, as they seem to bring more drawbacks than potential benefits.

*Source: ANNEX I. FINANCIAL SECTOR REFORM AGENDA-SELECTED ISSUES (paragraphs 102–104).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr1369.pdf_