On 15 February 2013 the Central Bank issued a revised set of UCITS Notices and related Guidance Notes which reflect the ESMA Guidelines on ETFs and other UCITS issues1 issued in December 2012. Whilst most of the changes relate to the new requirements that apply to ETFs, other significant changes (such as those relating to securities lending and collateral), also need to be considered by other UCITS funds. This briefing provides a short overview of the changes. A more detailed analysis of the ESMA Guidelines can be found on our briefings ESMA Guidelines on Repurchase & Reverse Repurchase Agreements and ESMA Guidelines on ETFs and other UCITS issues.

The ESMA Guidelines, and the Central Bank’s new UCITS rules, are effective as and from 18 February 2013. However, there is a 12 month implementation period for certain of the changes.

UCITS 2 (Organisation of management companies and SMICs) and Guidance Note 4/07 (Organisation of management companies)

The specific organisational provisions of this Notice that apply to self-managed investment companies (“SMICs”) from 1 July 2013 have been identified. With effect from 1 July 2013, SMICs will now have to comply with paragraphs 10 (Organisation requirements), 11 (Resources) and 12 (Accounting procedures) of Section B of Guidance Note 4/07 which currently only apply to management companies. This reflects the outcome of recent industry discussions on the applicability of the UCITS IV requirements to SMICs.

In addition, the Notice provides that the liquidity risk management process employed by a fund must now take into account more specifically the use of efficient portfolio management (“EPM”) techniques.

Guidance Note 4/07 has also been amended to include a new Section E in relation to the management company passport to provide guidance on the requirements for management companies who wish to avail of this passport.

UCITS 6 (Prospectus requirements)

Specific new prospectus disclosure requirements for UCITS employing EPM techniques are contained in this Notice. Detailed descriptions of the use and risks of such EPM techniques (including counterparty risk and conflicts of interest) must now be included in the prospectus. This disclosure must also include information of the impact that such EPM techniques have on a UCITS performance. In addition, details of direct and indirect operational costs and fees arising from EPM techniques must be disclosed in the prospectus.

Also, more information on the UCITS collateral policy must be included in the prospectus, such as to their type, the level of collateral required, the haircut policy and any reinvestment policy for cash collateral.

UCITS 8 (Annual and half-yearly reports)

Additional disclosure on the purpose and risks of the use of financial derivative instruments (“FDI”) and EPM techniques must now be included in a UCITS annual and half-yearly reports. The disclosure must include details of the underlying exposures of the types of FDI used and the type and amount of any collateral used to reduce counterparty exposure.

The revenue arising from the use of EPM techniques must also be included in the annual and half-yearly reports.

For index-tracking UCITS, the annual and half-yearly reports must identify the size of the tracking error at the period end. The annual report for an index-tracking UCITS must also include an explanation of the divergence between the anticipated and actual tracking error, with an explanation of the difference between the UCITS’ performance and that of the index tracked.

UCITS 10 (Use of FDI)

The cross references in this Notice to financial indices and collateral refer to the amended/new Notices and/or provisions relating to collateral.

An index-tracking UCITS must calculate its global exposure by using either the commitment approach or relative VaR.

Where a UCITS enters into a total return swap (or invests in other financial derivative instruments with similar characteristics), the assets held by the UCITS must comply with the investment limits set out in the UCITS Regulations.

UCITS 12 (Securities lending, repos and reverse repos)

This Notice has been amended comprehensively. It requires that the use of EPM techniques and instruments must be in line with the best interests of the UCITS. The requirements relating to collateral have been expanded to include new specific criteria on correlation (i.e. the collateral must be issued by an entity independent of the counterparty and should not display a high correlation with the counterparty’s performance).

New diversification requirements will also apply to the collateral, with a maximum exposure to any single issuer of 20% of a UCITS NAV. In addition, the collateral must be immediately available at any time without reference to or approval of the counterparty. Other changes relating to collateral include the need for the RMP to identify, manage and mitigate the risks of collateral.

The list of investments in which cash collateral can be invested is now more prescribed and no longer includes certain investments (such as certificates of deposit and letters of credit). Any investment of cash collateral in government bonds must be high quality. In line with the new 20% diversification requirements, cash collateral cannot be placed on deposit with a counterparty or an entity related to a counterparty.

A stress testing policy to test the collateral’s liquidity must also be put in place for any UCITS receiving collateral in respect of at least 30% of its assets. Each class of assets received as collateral should have a clear and documented haircut policy which takes account of the characteristics of the assets (such as their credit standing and price volatility) and the outcome of the stress tests.

Any UCITS that enters into a repo or reverse repo agreement must at any time be able to recall the full amount of cash or terminate the agreement either on an accrued basis or mark-to-market basis.

UCITS 19 (KIIDs)

The KIIDs of index-tracking UCITS must include information on how the index is tracked (full or sample based physical replication) and the implications of the strategy for unitholders.

Additional requirements must be included in KIIDs for index-tracking leveraged UCITS. For these UCITS details of the leverage policy must be described in the KIID, including how it is achieved and the costs and risks associated with the leverage. The impact of any reverse leverage (creating short exposure) also needs to be disclosed in the KIIDs as well as how the UCITS performance may differ significantly over time from that of the index.

UCITS 20 (Exchange-traded funds)

A new separate Notice on ETFs has been issued for the first time. The provisions reflect the ESMA Guidelines in relation to the need to use a UCITS ETF identifier and specific disclosure requirements, actively-managed UCITS ETFs and the treatment of secondary market investors of UCITS ETFs. Where units of a UCITS ETF purchased on a secondary market are generally not redeemable from the UCITS, the UCITS prospectus and marketing materials must contain a specific risk warning about this.

UCITS 21 (Financial indices) and Guidance Note 2/07 (Financial indices)

A new Notice on financial indices has also been issued. This reflects the ESMA Guidelines in relation to financial indices and is comprised primarily of express restrictions on the type of indices which a UCITS may track. Guidance Note 2/07 has also been amended for consistency with the new UCITS Notice 21.

Guidance Note 3/03 (FDI)

The principal changes to this Guidance Note are in relation to the management of collateral. The previous provisions in relation to acceptable forms of collateral, investment of cash collateral and related leverage have been replaced with a cross-reference to the updated Notice 12. Risks linked to the management of collateral, such as operational and legal risks, are required to be identified, managed and mitigated by the RMP.

The new UCITS Notices and Guidance Notes can be found on http://www.centralbank.ie/regulation/industry-sectors/funds/ucits/Pages/WhatsNew.aspx?ListID=74e95c1a-5bba-42cc-ab33-84db484abe97&ListItemID=29

Conclusion

The new UCITS Notices and Guidance Notes bring the provisions of the ESMA Guidelines into force in Irish regulation. However, no additional detail other than the ESMA Guidelines has been included in the revised UCITS Notices and Guidance Notes. Any clarification on aspects of the ESMA Guidelines will have to be postponed until the first of the ESMA Q&As on these ESMA Guidelines issue which is expected at the end of March 2013.