In July this year the European Commission (the “Commission”) published its UCITS VI Consultation Document, inviting comments on a very broad range of topics.
These topics were as follows: (i) eligible assets and the use of derivatives; (ii) efficient portfolio management techniques; (iii) OTC derivatives; (iv) extraordinary liquidity management rules; (v) a depositary passport; (vi) money market funds; (vii) long term investments; and (viii) addressing issues arising under UCITS IV. The Consultation also raised the question of a general alignment of the UCITS Directive with the AIFMD (including on delegation, risk and liquidity management rules, valuation, reporting or calculation of leverage). The IFIA, of which William Fry is an active participant member, recently issued its response to the Consultation.
The Commission had asked whether there was a need to review the scope of assets and exposures that are deemed eligible for a UCITS fund. The response from the IFIA made a number of points.
- The flexibility available to UCITS following the introduction of UCITS III has been embraced by promoters and investors alike and has been a significant factor in the success of the UCITS product
- The appropriate focus when considering the future evolution of UCITS should be on the protections which attach themselves to the use of investment products and strategies (including requirements in relation to back-testing, stress testing, regulatory reporting and disclosures to investors), rather than closing off certain categories of asset class in their entirety to retail investors
- The implementation of the AIFMD should not be grounds for restricting certain sophisticated investment strategies to non-UCITS products regulated under the AIFMD or recasting UCITS as a more limited investment product in terms of permitted investments
- The fact that an investment structure or policy is complex should not be the determining factor in considering UCITS eligibility. In many cases, the complexity of the structure may serve to reduce risk.
The IFIA emphasised that that the focus of UCITS VI and the future evolution of UCITS should be to ensure that the protections in the UCITS framework in respect of risk management, liquidity management, organisational rules and internal audit are fit for purpose.
Industry and media commentators have raised the possibility that UCITS VI could permit investment in certain categories of assets that are currently deemed ineligible for investment by UCITS. These include commodities, property and loans (or FDI whose underlying assets consist of such assets). The IFIA indicated its support for creating new categories of eligible assets provided that any such investment would be subject to the same considerations as are outlined above in relation to the balancing of flexibility of investment against investor protection.
The Commission indicated in the Consultation that it is contemplating the development of further rules on the liquidity of eligible assets. The IFIA expressed its support for this proposal. It floated the idea of a consistent liquidity reporting framework at portfolio level which would demonstrate that the investment manager’s investment process is being managed in a manner that ensures that the ability of the UCITS to satisfy redemption requests on a frequent basis, in line with the UCITS Regulations, is not compromised. Such a framework may include, for example, an assessment of the portfolio on a security basis (including OTC derivatives). Any such liquidity assessment could form an enhancement to the current risk management process conducted by UCITS investment managers.
The Commission requested feedback on the consequences of preventing exposure to certain ineligible assets by adopting a look through approach for transferable securities, investments in financial indices or closed-ended funds and defining specific exposure limits and risk spreading rules at the level of the underlying assets. The IFIA highlighted that there may be some practical difficulties with this approach and also a conceptual difficulty in that the assessment of levels of exposure to certain ineligible assets in this manner suggest that it is acceptable for a UCITS to obtain exposure to ineligible assets provided it does not exceed certain de minimis limits. The IFIA concluded that obtaining exposure to an ineligible asset through an “equivalent” collective investment scheme, listed transferable security or as part of a financial index, addresses the concerns around liquidity, custody, volatility, lock-up provisions or similar features which render the underlying asset non-eligible in the first instance.
Use of Derivatives
The Commission had queried what would be the consequence of using only leverage (as calculated under the commitment approach) as a measure of global exposure. The IFIA made it clear in its response that it would have a number of concerns with any proposal to move to a regime where a leverage test (whether the commitment approach or “sum of the gross notionals” test) becomes the only method available to calculate global exposure. It stressed that:
- The commitment approach will not take account of investment strategy, portfolio of assets (e.g. equities or fixed income) or the purpose for which derivatives are used. For example, positions which economically off-set risk, such as interest rate or currency hedges, would be required to be included in the commitment approach calculation, even though such transactions would ultimately reduce risk in a portfolio.
- The determination of global exposure solely by reference to leverage could have an adverse effect on investor protection. Many strategies utilise derivatives and higher leverage limits to reduce risk to investors, whereas those that are heavily utilising equities or fixed income securities may actually be of more risk to an investor’s capital than those using derivatives. This limit may, in effect, have the result of encouraging riskier strategies by discouraging the use of derivatives to reduce the risk in the portfolio.
Efficient Portfolio Management (“EPM”) Techniques
The Consultation contains a number of proposals regarding the use of EPM techniques by UCITS. The IFIA requested that any consideration of risks related to the use of the EPM techniques should be prioritised in advance of the implementation of the European Securities and Markets Authority (“ESMA”) Guidelines on ETFs and other UCITS Issues (“ESMA Guidelines”). The IFIA had the following responses to the various proposals raised by the Commission:
- It would not be appropriate to prescribe a limit as to the amount of fund assets that may be the object of EPM techniques.
- UCITS should not be required to match collateral received under an EPM technique or instrument with its investment policy.
- Any collateral received under an EPM technique or instrument should not be required to comply with the UCITS diversification rules.
- It should be permissible for a UCITS to engage in EPM transactions which are not re-callable provided a right of substitution exists and the UCITS complies with the overall requirement in relation to liquidity.
- A regime whereby EPM counterparties are permitted to offer UCITS funds the option of EPM transactions with non-rehypothecation of collateral as well as EPM transactions with rehypothecation of collateral, would be desirable.
- There is no merit in imposing criteria on the collateral provided by a UCITS. The investment manager of the UCITS is best placed to make the appropriate judgments at the time in accordance with the requirements of the ESMA Guidelines and Risk Management.
The Commission queried whether, when assessing counterparty risk, the treatment of OTC derivatives cleared through central counterparties should be clarified. The IFIA pointed out that the investment manager of an Irish domiciled UCITS is required to determine whether exposure is to an OTC counterparty, the broker or the clearing house and to calculate counterparty exposure accordingly. It is the view of the IFIA that if the investment manager determines that the exposure is to the clearing house / central counterparty, then, there is merit in clarifying that such OTC derivatives should be treated in the same manner as exchange traded derivatives. The IFIA noted that the timeline for the implementation of the centralised clearing of derivatives will need to be considered prior to any UCITS VI implementation.
The IFIA also stated its opinion that the requirements of OTC derivatives not cleared through central counterparties are consistent with the requirements for EPM transactions. The Consultation referred to operational or other risks resulting from UCITS contracting with a single counterparty. The IFIA noted that a requirement to transact with a larger pool of counterparties could limit the ability to net exposures and might also involve disadvantages and operational challenges such as the requirement for an investment manager to source additional counterparties who would be able to provide an exposure to a proprietary strategy or index.
Extraordinary Liquidity Management Tools
The Commission had requested feedback as to whether respondents saw any need to further develop a common framework, as part of the UCITS Directive, for dealing with liquidity bottlenecks in exceptional cases. The IFIA, in its response, stated that it would recommend the development of a common framework which leads to greater flexibility in dealing with liquidity bottlenecks in exceptional cases. It cautioned that there may be disadvantages to imposing a “one size fits all” approach as liquidity issues can vary significantly depending on the specific fund/market situation. It would be difficult to create a regime with sufficient flexibility to allow different types of UCITS to respond effectively in a wide variety of situations. Furthermore, the IFIA believes that it should be left to the relevant local competent authorities to determine how to deal with liquidity bottlenecks, in conjunction with the local funds industry.
The IFIA also recommended that the occurrence of “exceptional cases” should be left to the UCITS directors' self-assessment, in conjunction with the investment manager, with a notification being made to the competent authorities.
The IFIA does not believe that time limits on the temporary suspension of redemptions would be helpful. Regarding deferred redemption, the IFIA pointed out that the funds industry in Ireland, in conjunction with the Central Bank, has developed quantitative thresholds and time limits to deal with deferred redemption. This mechanism is equitable and is in the best interests of all shareholders in the UCITS and works well for UCITS in the current environment.
The IFIA suggested that UCITS should be permitted to use side pockets provided that any future requirements imposed on the use of side pockets take account of the existing protections and safeguards in place for UCITS. This should ensure that the interests of redeeming and more particularly continuing investors are protected in the event that side pockets are created / permissible in a given situation. Given the strict diversification requirements for UCITS, it would be worthwhile to obtain clarification that any side pocketed assets would not be included in the 5/10/40 or other tests which are applied to UCITS on an ongoing basis.
The IFIA noted that it would be very difficult to give secondary market shareholders the same rights as shareholders of an ETF.
A Passport for Depositaries
The Consultation asked what advantages and drawbacks would a depositary passport create. The IFIA‘s view is that there will be significant technical and operational issues to consider in the course of constructing a depositary passport and that the harmonisation of depositary standards, including eligibility and liability standards as contemplated under UCITS V, together with cross border regulatory standards and supervision, will need to be well established as an important first step in this process. The IFIA suggested that an assessment of implementation of the UCITS V and AIFMD depositary measures in each Member State be conducted by ESMA prior to making any decision on further harmonisation. While limited, there are a number of national discretions afforded to Member States in these measures. Accordingly, an assessment would be required to determine their relevance to a possible depositary passport. In addition, the IFIA believes that there is significant work required to harmonise the regulatory obligations of the depositary and the operational practices followed by depositaries in the discharge of their duties.
Money Market Funds (“MMFs”)
The Consultation had indicated that the Commission regards MMFs as representing a source of systemic risk. This view was emphatically rejected by the IFIA which stated that the risks they pose to the financial system in Europe are extremely limited. The suggestion that MMFs are banks or “banklike” reflects a misconception of MMFs and the role they play in the financial markets in as much as MMFs do not: (i) use leverage; (ii) take deposits; and (iii) make loans as a proprietary commercial activity on behalf of the lender.
Whilst the IFIA agrees that a detailed and harmonised system of regulation at EU level is preferable, it believes that the current EU regulations do not need to be enhanced. In its opinion, the UCITS Directive and the ESMA Guidelines on European MMFs have significantly reduced the potential risks that MMFs present to the financial system.
The IFIA supported the position that the definition “MMF” should only be applied to those funds which meet the ESMA definition of Short Term MMF. Funds which do not meet these requirements should be required to use a further adjective to describe the fund, for example, “Enhanced”.
The IFIA stated in its response that constant NAV (“CNAV”) funds should not be phased out. It also emphasised that it does not believe there is a substantive difference in the risks associated with, and shareholder behaviour within, CNAV and variable NAV (“VNAV”) funds. Any fund, including a VNAV fund, would remain prone to redemptions if investors lost confidence in its assets, and such redemptions would cause short-term funding to be withdrawn from financial institutions, businesses and governments. Changing the pricing mechanism of MMFs will neither dis-incentivise investor redemptions, nor better enable them to meet such redemptions that arise without relying on secondary money markets. It will merely undermine their utility to a large number of investors.
The IFIA also believes that it would be inappropriate to apply capital buffers on CNAV funds. Instead, it is of the view that the Institutional Money Market Funds Association minimum liquidity requirements are sufficient to address the issues that arose during the credit crunch.
The IFIA believes that current minimum liquidity requirements directly address the issues which arose in 2008 and better enable MMFs to meet redemptions in cash. However, the IFIA agrees that MMFs should be required to know their investor base and, as currently required by the U.S. Securities and Exchange Commission, to disclose portfolio holdings on a monthly basis.
Long Term Investments
The Consultation requested clarification as to whether there was a need to create a common framework dedicated to long-term investments for retail investors. The IFIA noted that there is an appetite for long-term investments for retail investors as retail investors may typically have a need for long-term pension planning. The IFIA believes that a passportable and standardised fund structure as an avenue for retail investment into previously unavailable investment products would be welcome from an industry perspective and would be aligned with the long-term savings requirements of retail investors across the EU. However, the requirements to modify the liquidity provisions within a UCITS structure mean that a standalone initiative may be preferable. It also believes that provisions should be put in place to allow an investment manager holding a UCITS, MiFID or AIFMD authorisation to utilise such authorisation for the purposes of this "long-term investments" framework.
Changes to UCITS IV
The Consultation sought industry feedback on certain areas of UCITS IV. The IFIA’s response is below:
- Self-Managed Investment Companies
The IFIA would welcome an amendment to Article 31 of the UCITS Directive to empower the Commission to adopt delegated acts specifying administrative procedures and internal control mechanisms.
- Master-Feeder Structures
The IFIA agreed with the Commission's suggestions that similar information standards should apply (i) where an ordinary UCITS converts into a feeder UCITS; (ii) where a master UCITS changes; and (iii) where a feeder converts into an ordinary UCITS.
- Fund Mergers
The IFIA agreed with the proposed clarification of the timeline involved in the authorisation of a merger of two UCITS.
- Notification Procedure
The IFIA were in favour of the Commission's suggestion to adopt a regulator to regulator approach for changes to the notification.