On 15 June 2009, the Committee of European Securities Regulators (CESR) launched a consultation paper in response to the European Commission's request for technical advice on Level 2 implementing measures for the UCITS IV Directive. The consultation paper suggests technical guidance for risk measurement in respect of UCITS funds. Dualta Counihan looks at the content of the paper and the implementing measures for UCITS IV.

In February 2009, the European Commission published a Call for Evidence on the possible implementing measures for the new UCITS Directive. As part of this process and to prepare implementation measures, CESR intends to issue a number of Consultation Papers during the summer to provide Level 2 advice with regard to the application of the provisions of the UCITS IV Directive. The first of these papers is the Consultation Paper on Risk Measurement for the Purposes of the Calculation of UCITS Global Exposure.

Among other things, the Consultation Paper seeks advice on the principles for calculating the global exposure and the measures that UCITS must undertake to ensure that global exposure relating to derivative instruments does not exceed the net asset value of the UCITS.

The topics addressed by the Consultation Paper are:

Calculation of global exposure using the commitment approach

Global exposure measures the incremental exposure and leverage generated by a UCITS through the use of financial derivative instruments (FDI). CESR examines the appropriateness of using the commitment approach (where FDI are convented into their underlying positions) to calculate the global exposure, outlines the methods to be applied to calculate global exposure for certain instruments and clarifies how global exposure may be reduced by netting and hedging effects.

In the context of the existing Irish standards, it is worth noting that CESR has proposed that UCITS will need to include any incremental leverage generated through repurchase or securities lending transactions.

CESR has also introduced the concept of a "sensitivity based approach" for any UCITS using interest rate related FDI in order to allow for the maturity of the relevant instrument. This approach calls for a UCITS to disclose its "sensitivity interval" in its prospectus and provides for a conservative (low) sensitivity interval to be applied if there is no such prospectus disclosure. If implemented, this proposal could require updates to existing prospectuses for UCITS using interest rate related FDI.

Calculation of global exposure using the Value at Risk (VaR) approach

CESR has sought feedback as to how the Value-at-Risk (VaR) approach enables a UCITS to comply with the requirements of the UCITS Directive and whether any additional requirements concerning the calculation of total leverage generated by a UCITS through FDI should be considered. CESR has also invited responses to their proposals regarding the relative and absolute VaR approaches and as to whether any additional safeguards are necessary for UCITS who use these approaches. The Consultation Paper implicitly acknowledges that a UCITS using, for example, a 200% long/200% short strategy can meet all UCITS requirements using a VaR approach while generating a global exposure greater than 100% of NAV. Accordingly, CESR has proposed additional safeguards to prevent a UCITS taking on excessive risk as well additional disclosure requirements for funds using absolute and relative VaR methodologies. CESR has also invited views on their proposals to prohibit the use of VaR by UCITS holding certain assets (ie structured securities, credit-linked financial instruments or financial derivative instruments designed to limit the maximum loss at a given confidence level) unless additional risk management methods are used (ie, stress-testing and Conditional VaR)

Calculation OTC counterparty risk exposure and the treatment of collateral

CESR has examined the over the counter (OTC) counterparty risk calculation methodology for UCITS and proposed that additional safeguards required by the UCITS IV Directive that mitigate this risk should be taken into account in determining an appropriate methodology for calculating counterparty risk exposure. CESR has proposed a standardised methodology to calculate counterparty risk exposure. This may in fact result in a simplification of the calculation methodology currently used by an Irish UCITS as CESR has indicated that the "add-on" for future risk exposures from FDI is not necessary. CESR has invited views as to whether any collateral passed to a derivative counterparty should be included in either the 20% aggregate issuer concentration limit or the 5%/10% OTC counterparty limit.

How the above methodologies apply to the concept of sophisticated/non-sophisticated UCITS

CESR has highlighted the fact that different practices have evolved in Member States regarding both the use of commitment versus VaR methodologies and the distinction between a sophisticated and non-sophisticated UCITS.

The consultation has invited views as to whether the distinction between sophisticated and non-sophisticated UCITS should be abandoned, leaving the decision on using commitment approach or VaR to the individual UCITS instead.

Risk management principles for UCITS consultation  

On 27 February 2009, CESR published its response to the risk management principles consultation which reflects CESR’s view that sound risk management systems for UCITS should be set out through common principles, so that the principles can help foster convergence amongst competent authorities and provide guidance for market participants. The principles proposed apply to both management companies and self-managed UCITS, and reflect the need to ensure, on the one hand, that investors are adequately protected and, on the other hand, that the risk management process is appropriate and proportionate in view of the nature, scale and complexity of the asset management company’s activities and of the UCITS it manages.

Next steps  

The consultation on Risk Measurement for the Purposes of the Calculation of UCITS Global exposure closes on 15 July 2009 and CESR has been asked to deliver its advice by 30 October 2009. The outcome of this work will be divided between Level 2 and Level 3 measures. It is proposed that the principles surrounding risk measurement techniques will form part of the Level 2 implementing measures and the detailed technical issues will be included in Level 3 CESR guidelines.

The UCITS Directive which was formally adopted by the European Council of Ministers on 22 June is to come into force in all member states from 1 July 2011, at the latest. The Directive imposes a strict deadline of 1 July 2010 for the adoption of certain Level 2 measures, notably in relation to management companies' organisation, risk management and assessment of the value of OTC derivatives. There is still a considerable amount of work to be done by the European Commission and CESR with regard to the implementing measures in order to ensure that the new provisions are introduced in a functional manner whilst continuing to ensure a high level of investor protection.  

This article was first published in Finance Magazine Online (July 2009).