On 30 July 2018 the European Supervisory and Markets Authorities (ESMA) published its final report following its peer review of the compliance and supervisory framework of six national competent authorities (NCAs) with aspects of the UCITS framework for Efficient Portfolio Management (EPM). The peer review covered the NCAs for Ireland, the UK, Luxembourg, Germany, France and Estonia and was limited to assessment of four areas (set out below) of the ESMA Guidelines on ETFs and other UCITS issues (the Guidelines).
The findings are directed at NCAs but UCITS engaged in EPM and in particular securities lending should take note of the findings and the potential for enhanced supervisory focus. It would be prudent to health check on current arrangements in light of the findings and to take note of the likelihood of further policy work by ESMA in light of the recommendations mentioned below.
Disclosure to investors
The Guidelines require that clear information should be provided in the prospectus on the intention of a UCITS to engage in EPM together with the associated risks, any conflicts of interest and the UCITS' policy on costs, fees and revenues arising from EPM. The Guidelines also require detailed disclosures around the collateral policy of the UCITS. The annual report of the UCITS must address disclosures regarding EPM activities and collateral received over the reporting period.
The report recognises that the CBI applies adequate supervisory practices in relation to ensuring that prospectuses comply with the requirements Guidelines (both in terms of content and clarity). However, ESMA suggests greater vigilance around checking mandatory disclosures related to EPM are met in the UCITS annual reports. ESMA suggests that the current trigger-based checks (e.g. where an issue is reported to the CBI) might be enhanced through the addition of ad-hoc checks of annual reports as a supervisory tool.
Internal risk management and investment mandate compliance
The use of EPM techniques should not change a fund's investment objective or substantially change its risk profile. The risks arising from EPM should be captured in the risk management process (RMP) of the UCITS and should also be addressed in its liquidity risk management process.
The CBI's compliance and supervisory practices are regarded as broadly compliant on this aspect of the Guidelines. However, the Report highlights that the RMP should also be reviewed by the CBI where the UCITS engages solely in EPM (such as securities lending, reverse repos and/or repos) without making use of financial derivatives instruments (FDI).
It should be noted that the CBI recently revised its supervisory approach in respect of RMPs. The CBI will no longer review and approve the RMP at authorisation stage or if new instruments or techniques are intended for the UCITS. The CBI's practice is now to require filing of the RMP and there is the potential for ad-hoc checks for compliance. We do not expect any need for the CBI to revert to an approval based regime for RMPs based on the report.
All revenues arising from EPM, net of direct and indirect operational costs must be returned to the UCITS and such costs and fees cannot include hidden revenues. The CBI previously undertook a thorough market analysis on securities lending revenue arrangements and revenue splits through a thematic review and follow up work. However, no additional guidance was provided to the market on the basis of the findings of that review work.
The report suggests that NCAs should have clear internal and external guidance on the fees, costs and revenue from EPM so that the prospectus and annual report of a UCITS clearly discloses the applicable policies on direct and indirect operational costs and fees and so that no hidden revenues arise in respect of these arrangements. Divergent practices were identified across the assessed NCAs and the report recommends further policy action by ESMA to achieve greater supervisory convergence and clarity.
The Guidelines set out detailed requirements for the management and eligibility of collateral received by a UCITS from counterparties to EPM (i.e. liquidity, valuation, issuer credit quality, correlation, diversification etc). The report observes that the CBI has robust supervisory practices here and is fully compliant with this aspect of the Guidelines. One notable finding in relation to two other NCAs is that in ESMA's view their regulatory framework breaches the Guidelines in permitting exemptions from the collateral management requirements where the UCITS engages in a securities lending programme with a central securities depository.
Actions for NCAs and ESMA
The report sets out a range of suggested good practices for NCAs to consider and apply by way of appropriate enhancements to existing practices. With regard to the CBI's supervisory practices, while they are observed to be well-structured and robust, potential improvements are flagged including a more formalised and systematic approach to reviewing operational costs and revenue arrangements for EPM so as to ensure transparency and no hidden revenue. While this is also flagged for further ESMA policy action, the CBI may enhance its own focus in the meantime.
The ESMA press release accompanying the final report explains that some NCAs have already informed ESMA of their intention to revise their practices. We are not aware of specific changes as yet from the CBI but will be monitoring developments in this area. ESMA will follow up on the findings of the peer review in 24 months to assess the progress made by NCAs. Additional ESMA policy action is recommended to achieve greater supervisory convergence and clarity on aspects of the Guidelines. These include:
- Additional guidance on the definition of EPM and further clarity in respect of the use of FDI for EPM and use of FDI for investment purposes where the lines can often be blurred;
- Clarity on the permissible arrangements around collateral reuse to deal with the apparent inconsistency between the Guidelines and the UCITS Directive provisions. While the Guidelines refer to 'title transfer' and 'other types of collateral arrangement' (including, for instance, pledging) being permissible for collateral received by a UCITS, the UCITS Directive, as amended by UCITS V, appears to only contemplate title transfer arrangements.
- As noted above, further clarification is suggested to the Guidelines on fees, costs and revenues from EPM to achieve greater transparency for investors and to ensure that there is no hidden revenue arising to management companies and other parties from such arrangements.
UCITS and management companies should take note of the enhanced focus on transparency and investor protection expectations for EPM related securities financing transactions. It is a good prompt to health check current disclosures in fund documentation and annual reports and to ensure that existing RMPs adequately address risk issues around securities financing transaction.