Following on swiftly from its UCITS V proposals, the European Commission has recently published a consultation paper on UCITS titled “Product Rules, Liquidity Management, Depositary, Money Market Funds, Long Term Investments” (the “Consultation Paper”) which puts forward the case for a number of modifications and changes to the UCITS framework. The subject matter tabled for discussion pursuant to the Consultation Paper and the policy orientations in relation thereto are colloquially referred to as “UCITS VI”.
The European Securities and Markets Authority (“ESMA”) has also been very active in the UCITS regulatory space, most recently publishing a new set of European guidelines for UCITS ETFs and UCITS generally. These rules include provisions which apply to UCITS’ use of efficient portfolio management (“EPM”) techniques, with particular focus on securities lending activities. The Commission’s UCITS VI initiative continues on this theme and seeks to assess the EPM techniques typically utilised by UCITS managers in order to measure, appraise and review these practices. The Consultation Paper also incorporates a section which reflects the ongoing debate around eligible assets and “sophisticated” UCITS. Other matters considered include the impact for UCITS of the treatment of over the counter (“OTC”) derivatives once the new central clearing requirements for derivatives pursuant to EMIR1 are in place, the potential benefits of a passport for depositaries and how to foster a culture of long term investment in Europe.
Consistent with general international regulatory discussion and global developments, the Consultation Paper looks at establishing appropriate liquidity and redemption management tools which might be incorporated within the UCITS framework. The Commission also focuses on the operation of UCITS money market funds (“MMFs”) and how new rules and harmonisation in that area might be applied.
At the core of the Commission’s UCITS VI publication are a series of questions which range from the general to the very specific and which are addressed to the various constituencies and stakeholders within the European funds industry in a bid to initiate engagement on the key issues. In this regard, the headings as set out in the Consultation Paper are eligible assets; EPM; OTC derivatives; extraordinary liquidity management rules; depositary passport; MMFs; long term investments; and proposals for UCITS IV improvement.
For each of these headings, we have identified below the key points which in our view need to be adverted to by industry stakeholders in terms of the possible future development of the UCITS model. In each case, it will be critical to ensure that a policy approach emerges from the Commission which is (1) coherent and (2) appropriate to the relevant issue and its underlying practical detail.
- Eligible assets for UCITS
Regarding UCITS’ use of financial derivative instruments, the Commission notes that the practice of UCITS adopting highly sophisticated investment strategies which provide access to highly complex risk profiles has raised several questions as to the appropriateness of these strategies and profiles in a UCITS context. Specifically, the Commission is looking to assess whether it is necessary to review the acceptable scope of the assets and exposures that are deemed eligible for a UCITS fund, and whether further rules on the liquidity of eligible assets are required.
Regarding non-eligible assets, the Commission seeks information from funds and asset managers on the strategies used to gain exposure to non-eligible assets and the noneligible assets involved, and whether there is a need to refine the current rules on exposure to non-eligible assets. In particular, it seeks reaction from industry to the approaches of (1) preventing exposure to certain non-eligible assets (eg, by adopting a “look through” approach for transferable securities, investments in financial indices or closed ended funds); (2) defining specific exposure limits and risk spreading rules at the level of the underlying assets.
The Consultation Paper also canvasses industry views as to whether market risk (or value at risk “VaR”) is a consistent indicator of global exposure relating to derivative instruments and, following on from that, the consequences of moving to the commitment method as the only measure of global exposure.
- EPM and UCITS
On EPM, the Commission sets out the proposition that UCITS’ utilisation of EPM techniques is widespread, and can involve a substantial proportion of a portfolio. Attention is drawn to the economic substance of certain EPM techniques which is articulated by the Commission as equivalent to borrowing or granting loans, against the backdrop of the explicit prohibition within the UCITS Directive on borrowing and granting loans. Key concerns raised in the Consultation paper relate to the current levels of transparency and disclosure around EPM transactions; the counterparty risks assumed by funds using EPM; the quality of collateral received and the reinvestment of collateral.
Specific matters highlighted for respondents’ feedback include whether limits should be applied to the amount of fund assets that may be subject to EPM; the prescription of mandatory haircuts on received collateral; the consequences of making all EPM transactions recallable at any time by the UCITS; and the need to define criteria regarding collateral provided by a UCITS.
A substantial number of the questions raised by the Commission in this section will be familiar to readers of the ESMA discussion document and consultation on UCITS ETFs and other UCITS issues in 2011 and early 2012 respectively. In this regard, the Commission states that the guidelines developed by ESMA (which issued on 25 July, the day before the Consultation Paper was released) “have provided an important first response to the issues raised by certain EPM techniques in the context of UCITS”.
- OTC derivatives
The obligation in EMIR for a variety of OTC derivatives to be cleared through central counterparties raises the question of how OTC derivative transactions should be dealt with when assessing UCITS limits on counterparty risk. In this context, the Commission notes that UCITS are permitted to reduce their exposure to a counterparty on an OTC derivative transaction through the receipt of collateral and so, where a counterparty provides sufficient collateral (covering more than 90% of the UCITS exposure to this counterparty), an investment strategy where the entire UCITS portfolio consists of an exposure to a single counterparty will not breach the counterparty risk exposure limits in the UCITS Directive. The Commission articulates the view that exposure to a single counterparty, even if highly collateralised, raises concerns relating to insolvency or potential conflicts of interest. Applying this view, opinions as to the specific operational or other risks which might result from UCITS contracting with a single counterparty are sought, together with detail as to what specific mitigation techniques might be applied.
The Commission also highlights the contrast between the requirement for UCITS to calculate UCITS global exposure on at least a daily basis with the absence of a corresponding frequency for calculating OTC counterparty risk and issuer concentration. The possible application of a requirement that counterparty risk and issuer concentration of the UCITS be calculated on at least a daily basis to correspond to the existing requirement with respect to the calculation of UCITS global exposure is presented to stakeholders for reaction.
- Extraordinary liquidity management tools for UCITS
Regarding liquidity management, the Commission highlights that current UCITS rules permit suspensions “in exceptional cases where circumstances so require” but does not give guidance as to what this means. In this regard, the Commission queries whether the term “exceptional cases” should be defined in order to move away from the status quo where individual EU member states apply different interpretations. With respect to the operation of temporary suspensions, the question of introducing time limits which would require liquidation of the fund once exceeded is also raised.
Within the Consultation Paper, the deferral of redemptions to mitigate a situation in which a UCITS would be obliged to sell a large part of its portfolio in a short period of time and at a potentially deflated price because it is confronted with an unusual amount of redemption orders is also considered as a potential liquidity management tool. Related questions are around the application of appropriate quantitative thresholds and time limits.
Side pockets are also tendered in terms of developing harmonised rules on liquidity management techniques. The Commission notes in this regard however the provision in the UCITS Directive that member states cannot permit UCITS to transform themselves into non-UCITS funds.
Finally, in a discussion which will be familiar to respondents to the ESMA engagement on UCITS ETFs, the Consultation Paper articulates the view that special measures may be necessary to guarantee liquidity for ETF investors – and asks respondents whether ETF providers should be directly involved in providing liquidity for secondary market investors.
A final matter of note which the Commission highlights relates to the current approach in the UCITS Directive to redemptions – “a UCITS shall redeem units on request by investors”. The actual exercise of such right has not been harmonised at EU level and, in this regard, the Commission asks stakeholders to consider whether common rules which would apply in normal circumstances should be developed and applied across member states with respect to the execution of redemption orders.
- A passport for depositaries
The Commission acknowledges that members of the European funds industry have already for some time been debating whether UCITS should be limited to the services of depositaries located in the same jurisdiction as the fund. The Consultation Paper endeavours to engage discussion on the passport, seeking evidence on the potential advantages and disadvantages and with respect to specific practical matters, such as whether its introduction would require harmonisation in other areas such the calculation of net asset value (“NAV”), conduct of business rules and capital requirements. Submissions are also sought as to whether a specific depositary authorisation regime for UCITS should be introduced or whether it would be sufficient to rely on other EU regulatory frameworks (eg, credit institutions and investment firms). Issues around UCITS supervisory difficulties where the UCITS and its depositary are not located in the same jurisdiction are also broached.
We would note that, in terms of timing, it is anticipated that any possible introduction of a single passport for UCITS depositaries would not occur until such time as the harmonising provisions for depositaries to be introduced under UCITS V are bedded down.
- UCITS money market funds
An overarching matter broached by the Commission in the Consultation Paper is the potential establishment of a detailed and harmonising set of rules for MMFs at EU level, and whether this should be incorporated within the UCITS Directive or instituted outside of it. Granular business questions which the Commission seeks evidence on relate to the types of investors MMFs are targeted at and the assets MMFs are mostly invested in, with figures in relation to each called for. The extent of securities lending, recallability of assets and specific information on collateral practices are also focussed on.
With respect to the constant NAV ("CNAV") versus variable NAV (“VNAV”) debate, the Commission presents the estimate that 60% of European MMFs follow a VNAV model and 40% apply CNAV. It expresses the concern that CNAV funds give the impression of a capital guarantee to investors. Views are sought as to whether CNAV MMFs ought to be subject to additional regulation; have their activities reduced; or be phased out completely. The idea of applying capital buffers is articulated, together with a comment from the Commission that their practical implementation remains an unresolved issue but that possibly, buffers would service to absorb first losses and maintain a stable NAV, thus limiting downside risk.
The Commission also addresses the question to respondents whether valuation other than mark to market should be permitted in stressed market conditions, together with a call for evidence on the current policies applied by funds and investment managers to deal with these situations.
On liquidity and redemptions in the context of MMFs, proposed mechanisms are liquidity fees which might reduce incentives for investors to redeem first; redemption restrictions such as limits on share repurchases, redemption in kind and retention scenarios which might serve to limit the number of shares that a manager has to redeem; and liquidity constraints (in addition to the existing ESMA guidelines) so that managers would hold highly liquid assets to service redemptions.
Regarding investment criteria and credit rating, the Commission’s move to reduce reliance on credit rating agencies is evident in the MMF section of the Consultation Paper which considers the consequences of rating downgrades. Matters and scenarios which the Commission asks respondents to consider include a review of the current definition of money market instruments, a possible ban on the rating of MMFs, and the prohibition of MMF investment criteria related to credit ratings.
Globally, MMFs are already subject to an extensive, well-defined and rigorous regulatory framework, including the Committee of European Securities Regulators’ (“CESR” now ESMA) guidelines on a common definition of European money market funds which came into effect in 2011. The proposals to differentiate between the treatment of CNAV and VNAV funds fail to recognise that all MMFs have the same susceptibility to runs on the basis that investors regard them as safe investments and could redeem when they perceive the possibility of loss. The main objective of MMF reform should be to ensure that funds have sufficient natural liquidity to meet redemption payments.
- Long term investments
The Consultation Paper outlines the role of long-term investment (“LTI”) as a factor for growth, and seeks submissions on whether a common European framework dedicated to LTI for retail investors ought to be created. By way of background, the Commission notes that LTI involve a low level of liquidity; are generally associated with long lock-up periods; and that asset types characterised as “long-term” include direct investments into unlisted companies (early or mature stage), infrastructure projects, “real” assets (real estate, other physical assets), and third-party managed funds making investments in unlisted companies. Stakeholders are asked whether modifications of this existing UCITS rules or a stand-alone initiative would be more appropriate for this initiative should it proceed.
- Changes to UCITS IV
Key areas of the UCITS IV project which the Commission has identified as requiring clarification relate to aspects of the UCITS mergers provisions and the UCITS notification procedure (the marketing passport).
On fund mergers, a 20 working day time limit is set for the regulator of the merging UCITS to issue its decision on the authorisation of the merger. The ambiguity identified by the Commission relates to how this 20 day limit sits with the provision that the regulator of the receiving UCITS has a right to request a modified version of the information to be provided to investors from the fund within 15 days of receipt of a copy of the completed application, and would then appear to have a further 20 working day time limit to assess the modified version of information. The Commission suggests clarifying these provisions to increase legal certainty.
Regarding the notification procedure which UCITS must satisfy in order to start marketing shares on a cross-border basis, an important modification articulated in this Consultation Paper by the Commission (which if introduced would be very welcome) relates to extending the electronic regulator to regular notification regime for any changes to the notification file. This single change, if implemented, would mark a substantial step forward in passporting efficiencies, as it would remove the current burden for the fund of having to notify all relevant host state regulators individually of the relevant changes to the notification file, prior to effecting the relevant change. Currently, the only stage of the passporting process during which the regulator to regulator electronic notification applies is the initial notification. The Commission also advocates clarifying in any new UCITS rules that notification of changes to information regarding a share class is limited to the relevant share class marketed in a host member state.
Under the final section of the Consultation Paper titled “UCITS IV improvement”, we note that the Commission seeks views as to whether adjustments to the UCITS regime are required in order to further align it with the Alternative Investment Fund Managers Directive (“AIFMD”) to improve “the consistency of rules in the European asset management sector”. Specific provisions of the AIFMD which the Commission has identified as more detailed than the comparable sections in the UCITS Directive include measures on organisational rules, delegation, risk and liquidity management rules, valuation, reporting and calculation of leverage. For such a short part of the Consultation Paper, this piece could potentially anticipate some very significant changes.
In terms of an insight into the Commission's frame of reference for this new stage in the development of the UCITS project, it is worth noting its statement in the Consultation Paper that “issues under discussion by international bodies, such as IOSCO2 or the FSB3, might require updates to relevant EU rules”. From this perspective, it is apparent that, on a number of levels, the current brief is informed by the international regulatory focus on key themes such as liquidity, securities lending and repos, aspects of MMFs and ETFs, and issues connected with the use of OTC derivatives which are being scrutinised in the context of strengthening financial stability, transparency and mitigating perceived systemic risks.
Alongside the progress of the global financial regulatory agenda sits the ever present challenge for UCITS to keep pace with market developments, and the reality that UCITS do not exist in a vacuum. This in turn must be balanced with the fundamentals behind the UCITS philosophy, and maintaining the international reputation and appeal of the UCITS product.
As can be seen from the Consultation Paper queries, the Commission is taking quite a granular approach to the topics covered in terms of some of the feedback, information and evidence which it seeks from industry. Some of the questions issued go to the heart of business models in order to determine the practical implications of change for the various players in various jurisdictions. Responses from stakeholders will be critical in terms of shaping the policy direction of the matters raised. A key concern will be to ensure that any proposed changes to the UCITS framework, and the consequences thereof, are fully thought through, taking into account cost benefit analysis, industry efficiencies and a forward-looking mindset which seeks to foster the positive evolution of UCITS.
Submissions in response to the issues, questions and policy orientations raised in the Consultation Paper are invited by 18 October 2012. The partners at Matheson Ormsby Prentice will be involved in formulating a response to the matters put forward by the Commission. If you would like to discuss your views with us, we would be delighted to hear from you.
The Consultation Paper can be accessed through the following link: UCITS VI Consultation.