On 13 September 2010 the Central Bank issued guidance on its disclosure requirements regarding the use of leverage by UCITS. The Central Bank has confirmed that it will be updating the relevant UCITS Notices and Guidance Notes in light of the above as part of the implementation of UCITS IV.
This update follows the review process introduced in April 2010 whereby the Central Bank announced its intention to focus on the coherence between the UCITS investment policy and its risk management process (the “RMP”). Particular attention is being given to the derivatives intended to be used and the disclosures in the offering memorandum relating to leverage.
It also follows new guidelines issued at the end of July 2010 by CESR, the Committee of European Securities Regulators, setting out detailed methodologies for UCITS for calculating global exposure using either the commitment approach or a Value-at-Risk (“VaR”) approach.
For UCITS using the VaR approach, the CESR guidelines included reference to additional considerations such as stress testing and back testing obligations of the VaR model, validation of the model etc. In the guidelines, CESR also defines a set of high level principles relating to assets that may be used as collateral and cover rules for transactions in financial derivative instruments.
The key purpose of CESR’s guidelines is to provide both regulators and companies managing UCITS with detailed methodologies to calculate the global exposure and counterparty risk for UCITS, whilst at the same time, developing a level playing-field in the area of risk measurement across EU Member States. CESR’s guidelines are to accompany the Level 2 implementing measures of the UCITS Directive, which will become applicable from 1 July 2011.
CESR intends to carry out further work to assess whether it would be appropriate for certain types of structured UCITS to use other methodologies to calculate the global exposure.
Summary of Guidance Issued by the Central Bank
A summary of the guidance issued by the Central Bank on 13 September for the leverage disclosure which is required by UCITS employing either the commitment approach or VaR is set out below.
Value at Risk:
It has been provisionally decided by the Central Bank that the expected level of leverage to be disclosed in respect of each UCITS can be calculated using VaR. This should normally be sufficient, however, if there is the possibility that leverage could exceed the expected level in a material way, this will also need to be disclosed.
If a higher leverage level is required, the Central Bank may query how the spread between the expected level and higher level of leverage ties in with the risk profile/volatility/strategy of the fund (if this is not apparent from reading the fund disclosures).
It can be noted that CESR's Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, issued on 28 July 2010, state the following in respect of the disclosure required by a UCITS in its prospectus:
"UCITS using VaR approaches should disclose the expected level of leverage and the possibility of higher leverage levels in the prospectus".
The Commitment Approach:
The commitment approach is a transparent methodology for measuring leverage. Under the commitment approach, a UCITS’s use of Financial Derivative Instruments (“FDI”) for investment or efficient portfolio management purposes will generally result in the UCITS being leveraged.
In order to provide clarity on this, the Central Bank has issued the following two examples to assist in understanding the approach adopted when reviewing fund documentation.
- A UCITS may leverage up to 100% of NAV under the commitment approach. If the UCITS' use of FDIs is consistent with the maximum limit being availed of by the UCITS, no comments will be raised by the Central Bank. However, the following leverage disclosure (and other variations of this) is not acceptable to the Central Bank:
"The Fund may be leveraged as a result of its use of financial derivative instruments”.
The Central Bank sees the use of leverage as a critical piece of information for retail investors (representing increased levels of risk) and accordingly it should be clear whether the fund is leveraged or not.
- If the UCITS is using FDIs solely for hedging purposes the Central Bank expects that any leverage will be minimal, therefore it is not coherent to insert the maximum leverage limit which a UCITS using the commitment approach may avail of.
The FDI review applied by the Central Bank only applies to those UCITS deemed to be complex. In respect of UCITS applications deemed to be 'non-complex', the Central Bank continues to review these applications in the context of:
- The consistency of the FDI listed in the prospectus with those listed in the RMP; and
- The consistency of disclosure in relation to leverage with the Derivative Unit's understanding of the strategy employed and instruments used.