Key changes have been made to UCITS Notice 10.

Valuation of OTC Derivatives

A key change has been made to UCITS Notice 10 (the “Notice”) in the context of the valuation of OTC Derivatives. The following requirements previously appeared in the Notice:

A UCITS must be satisfied that: 

  • The counterparty will value the OTC derivative with reasonable accuracy and on a reliable basis
  • The OTC derivative can be sold, liquidated or closed by an offsetting transaction at fair value, at any time at the UCITS initiative

The UCITS must subject its OTC derivatives to reliable and verifiable valuation on a daily basis and ensure that it has appropriate systems, controls and processes in place to achieve this.  The valuation arrangements and procedures must be adequate and proportionate to the nature and complexity of the OTC derivative concerned and should be adequately documented.

Reliable and verifiable valuation shall be understood as a reference to a valuation, by the UCITS, corresponding to fair value which does not rely only on market quotations by the counterparty and which fulfils the following criteria:

  • The basis for the valuation is either a reliable up-to-date market value of the instrument, or, if such a value is not available, a pricing model using an adequate recognised methodology
  • Verification of the valuation is carried out by one of the following:
    • An appropriate third party which is independent from the counterparty of the OTC-derivative, at an adequate frequency and in such a way that the UCITS is able to check it; or
    • A unit within the UCITS which is independent from the department in charge of managing the assets and which is adequately equipped for such purpose

These requirements were typically satisfied by the inclusion of the following wording in the valuation provisions of the Prospectus of each UCITS that could invest in derivatives:

“the value of any OTC FDI contract shall be the quotation from the counterparty provided that such quotation is provided on at least a daily basis and is approved or verified at least weekly by a person independent of the counterparty.”

The Central Bank recently revised the Notice to delete the wording in (a), (b) and (c). The rationale for this deletion was that EMIR requires that counterparties value outstanding non-centrally cleared OTCderivatives contracts on a daily basis on a mark to market basis or, where market conditions determine otherwise, a “reliable and prudent marking to model” may be used. It is not yet clear whether the Notice will be further updated to insert the requirement under EMIR.

Novation of OTC Derivatives

The Notice has also been amended by the insertion of a requirement that in the case of the subsequent novation of a OTC derivative contract, the counterparty is:

  • A credit institution authorised in the European Economic Area (EEA) (European Union Member States, Norway, Iceland, Liechtenstein), a credit institution authorised within a signatory state, other than a Member State of the EEA, to the Basle Capital Convergence Agreement of July 1988 (Switzerland, Canada, Japan, United States) or a credit institution authorised in Jersey, Guernsey, the Isle of Man, Australia or New Zealand or an investment firm, authorised in accordance with the Markets in Financial Instruments Directive in an EEA Member State, or is an entity subject to regulation as a Consolidated Supervised Entity (“CSE”) by the US Securities and Exchange Commission; or
  • A central counterparty (CCP) authorised, or recognised by ESMA, under EMIR or, pending recognition by ESMA under Article 25 of EMIR, an entity classified as a derivatives clearing organisation by the Commodity Futures Trading Commission or a clearing agency by the SEC