Financial regulators across Europe are keeping a close eye on their Luxembourg counterpart CSSF, which is reviewing its rules that tell investment firms how to handle errors in calculations of Net Asset Values, or NAVs. “I think that we may consider the CSSF approach as a best practice.”
NAV errors are currently not addressed at the level of the European Union, said an official at the European Securities and Markets Authority, ESMA. The authority is particularly keen to move towards a standardised EU approach on valuations of funds with less liquid assets such as alternatives, a part of the market that is drawing increasing interest from investors.
Market conditions under the Covid-19 pandemic and the Ukraine war have also been such that it was harder to accurately determine net asset values. CSSF data shows the number of errors last year was up 48 percent from 2019. Industry representatives told Investment Officer that they welcome the CSSF’s efforts to update and harmonise its guidance.
“A clear regulatory framework supports asset managers in their efforts to become more efficient and to be able to better respond to investors’ needs and reduce errors in the investment activity as well as in the assets administration,” said Ricardo Lamanna, country head Luxembourg at State Street.
‘Materiality threshold’
A specific focus will be on the so-called “materiality threshold”. When it comes to calculation errors, different firms currently use different definitions of what is material and what is not when. CSSF has acknowledged to the industry that the NAV calculation process is “not an exact science”, a specialist at a major asset services firm said. In some cases, errors are so small that a correction that can involve a long and costly process is not justified.
“This is very important as it defines a level playing field for all market participants,” said Frederic Bilas, CEO of Apex Fund Services. “Such materiality thresholds vary depending on the type of investments… CSSF confirms that in some cases, the immateriality of the errors does not justify the recourse to a relatively long and costly process, which is often a topic between the UCIs and their accounting agent.”
In their investment contracts, fund managers are increasingly asking for lower materiality thresholds to be applied than those defined in the circular. “This is of course a commercial discussion between the UCIs and their central administrators, but there seems to be an expectation from the market,” Bilas said.
Optional or mandatory?
Luxembourg investment lawyer Claire Guilbert, partner at Norton Rose Fulbright, said the threshold currently defined by CSSF still is optional. “ The question is whether this will now become mandatory for all funds and all funds will have to apply the same standards? Or if the option would still be open, but with maybe more guidance?”
A higher number of errors in recent years also is a factor that inspired CSSF to review its guidelines, as currently defined in Circular 02/77.
“This is not what we would normally expect, as the circular also requests that for each error, a corrective action plan be implemented to avoid the subsequent occurrence of the same problems,” Bilas said. “With increased automation and new technology, one could expect that better operational processes lead to less errors, but that is not confirmed. This is for sure a topic that needs to be looked at.”
CSSF said publication of the updated rules, which it considers “a key piece of regulation when it comes to investor protection”, is targeted for the end of this year or early 2023.
Investment breaches
Asked to elaborate on its announcement in its latest annual report, CSSF told Investment Officer said that the review will “integrate the significant legal and regulatory developments that occurred in the investment fund sector since the issuance of that circular back in 2002 and to duly consider them in the context of the handling of net asset value calculation errors and investment breaches.”
The scope of the CSSF guidance will likely be expanded to include also new types of investment funds that were enabled by legislation introduced after 2002, such as alternative investment funds, as well as investment companies in risk capital known as Sicars, and specialised investment funds, known as SIFs, said CSSF.
“There have been more notifications of errors during Covid, and the Ukrainian war is also impacting business in general, creating some operational issues at the level of the information that is being reported from underlying investments,” said Norton Rose Fulbright’s Guilbert. “At the same time, we have more and more sophisticated products of different kinds and shapes compared to 20 years ago.”
AIFMs may be required to report
Guilbert said that, generally speaking, the increasingly mixed nature of investment funds, with a growing component of less liquid alternative investments, also means risks for investors are increasing. “If you have an error, and you need to reimburse investors, you may not be able to as an illiquid fund, or as manager of an illiquid fund. And there is also the question in the other way round: if you underestimated the value, how can you get the money back from investors that have had too much? There are currently no legal mechanisms for that.”
Given the increasing role for alternative investments, CSSF may also want to expand the scope of its guidelines to AIFMs, the managers of alternative funds. “That’s a question mark,” she said, “but I would not be surprised if we are heading there. Or at least that AIFMs have to… do a reporting on the topic.”
Luxembourg in 2000 became one of the EU member states to issue specific rules on NAV errors and investment breaches.