UCITS- Risk Measurement and Calculation of Global Exposure and Counterparty Risk

The European Securities and Markets Authority (ESMA) issued a Questions and Answers document on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS. It:

  • analyses whether certain strategies should be considered as hedging strategies;
  • clarifies issues concerning the disclosure of leverage by UCITS using VAR;
  • considers concentration rules (in particular clarifying that the 100% diversification rule is to be applied on the net assets); and
  • clarifies that the look –through approach is not compulsory for the calculation of global exposure for fund of funds.   

Notification of UCITS and exchange of information between competent authorities

ESMA has issued a Questions and Answers document concerning the notification of UCITS and exchange of information between competent authorities. It looks at:

  • arrangements for the notification of new sub-funds (e.g. marketing a new sub-funds needs a new notification, a single notification can be used for a several sub-funds);
  • filing requirements for amendments and updates of documents (attestation letters are only to be transmitted on the original notification);
  • UCITS host Member State’s access to documents ( UCITS should be put on a website as soon as possible after they are informed that the notification of marketing has been transmitted and the use of password protected documents is not permitted for this purpose);
  • that self- managed UCITS companies give details of their contact person in Part A of the notification letter;
  • exchange of information between regulators in the context of establishment of a branch of a UCITS management company ( should be in a language customary in the sphere of international finance); and
  • requirements for the attestation of payment of notification fees (a scan of the transfer form should be attached to the notification as proof of payment).

Draft UCITS V Directive

On 3 July 2012, the EU Commission published its long awaited draft UCITS V Directive . UCITS V is a response to the various financial crises (such as Madoff and Lehman) and is in line with other global and EU initiatives (such as AIFMD and banking reform). The draft will pass to the EU Parliament and EU Council for consideration and adoption under the co-decision procedure. Member states will then have 2 years to transpose the provisions into national law (possibly late 2014), by which time the implementing measures should be in place. The draft covers:

  • Remuneration of UCITS managers – UCITS management companies (in common with Alternative Investment Fund Managers under the Alternative Investment Funds Managers Directive (AIFMD)) will be obliged to implement remuneration policies which promote sound risk management, do not encourage excessive risk-taking and are linked with the long-term interests of investors and the achievement of the investment objectives of the UCITS. The provisions are detailed. These policies will apply to senior management and persons whose professional activities have a material impact on the risk profile of the management company or the UCITS. Implementation of remuneration policy is subject to review. Some commentary is pointing out that the requirement to implement these remuneration policies may not apply where a self-managed UCITS or UCITS management company does not receive an asset based fee so these provisions may be refined. Larger UCITS managers may need a remuneration committee.
  • Eligibility to act as a depositary – the draft provides that only two categories of entities will be capable of acting as a UCITS depositary ; EU authorised credit institutions, or  MiFID authorised investment firms providing safekeeping and administration services. The draft contains a one-year grandfathering period. Lobbying is ongoing so that additional categories of eligible depositaries will be permitted in line with the AIFMD and the Central Bank’s rules for UCITS and Non-UCITS funds.
  • Detail on depositary’s duties – the draft elucidates the depositaries duties regarding cash monitoring and safe-keeping, distinguishing between assets in custody (meaning assets capable of registration/physical delivery) and other assets. Member states must ensure that where the depositary becomes insolvent, the UCITS assets will not be available to the depositaries creditors.
  • Delegation of Custody – the draft sets out due diligence and on-going monitoring requirements and conditions upon which the depositary’s safekeeping duties can be delegated to a sub-custodian. The depositary must be able to show that that there is an objective reason for the delegation. Where the sub-custodian becomes insolvent, securities held by the sub-custodian must not be available for distribution to its creditors. In general, the conditions and requirements for delegation to a sub-custodian are aligned with AIFMD.
  • Depositary liability – the existing standard of liability for loss of a financial instrument held in custody is that liability arises in case of “unjustifiable failure to perform obligations” or “improper performance” of such duties. These words have been interpreted differently in various member states, and this has resulted in different levels of investor protection. As regards loss of assets in custody, the draft obliges depositaries to return financial instruments lost in custody without undue delay, unless the depositary can prove that losses are caused by an external event beyond the depositary’s reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. Investors will be able to invoke the liability directly or indirectly. Depositaries will be liable for the loss of assets in cases where safekeeping duties have been delegated to a sub-custodian. The draft (unlike the AIFMD) holds the depositary liable for the return of the financial instrument, even if the loss occurred with the sub-custodian, and does not permit the discharge the liability by contract. The draft provides that the depositary is liable to the UCITS and its investors for all other losses suffered as a consequence of the depositary’s negligent or unintentional failure to properly fulfil its obligations. Many commentators have argued that these provisions will make depositaries liable for investment losses which are outside their control and so  their costs will increase and these costs will inevitably be passed on to investors.
  • Prospectus Disclosure – the UCITS prospectus must set out a description of any safekeeping functions delegated to a sub-custodian, identifying the sub-custodian and any conflicts of interest which may arise from the delegation. The AIFMD, on the other hand requires that this information is provided to investors (rather than set out in the prospectus), which is far more time and cost effective in circumstances where changes of sub-custodian may arise on a regular or urgent basis. Lobbying is ongoing on this provision also.
  • Sanctions – the sanctions regime is to be revised in order to tackle the differences between member states in the criteria being applied in issuing sanctions and in the level of sanctions being applied to specific breaches. The draft sets out to harmonise how breaches are to be sanctioned and to ensure that sanctions act as an effective disincentive.
  • Level 2 measures – the EU Commission will adopt Level 2 measures on topics such as defining more specifically the depositary's initial and on-going due diligence duties, the depositary's initial and on-going due diligence duties regarding the selection and appointment of a sub-custodian and the circumstances in which financial instruments held in custody should be considered as lost.

UCITS ETF Guidelines and REPO consultation

ESMA has issued guidelines on Exchange-Traded Funds (ETFs) and other UCITS issues. The guidelines will apply to national securities markets regulators and UCITS management companies (this will include self-managed investment companies or SMICs also). The guidelines’ key provisions are:

  • UCITS that meet the definition of UCITS ETFs will have to carry the identifier “UCITS ETF” in their name;
  • UCITS ETFs will have to ensure appropriate redemption conditions for secondary market investors by opening the fund for direct redemptions when the liquidity in the secondary market is not satisfactory;
  • UCITS entering into efficient portfolio management techniques (EPM) like securities lending activities will have to inform investors clearly about these activities and the related risks. All revenues net of operating costs generated by these activities should be returned to the UCITS. When a UCITS enters into securities lending arrangements, it should be able at any time to recall any securities lent or terminate any agreement into which it has entered;
  • UCITS receiving collateral to mitigate counterparty risk from OTC financial derivative transactions or EPM techniques should ensure that the collateral complies with very strict qualitative criteria and specific limits in relation to the diversification; and
  • UCITS investing in financial indices will have to ensure that investors are provided with the full calculation methodology of financial indices. Also, UCITS should only invest in financial indices which respect strict criteria regarding, inter alia, the rebalancing frequency and their diversification.

ESMA has opened a consultation (closing 25 September 2012 and incorporated into the guidelines document above) on the appropriate treatment of repo and reverse repo arrangements in the context of the guidelines on ETFs and other UCITS issues. In particular, ESMA is proposing a distinct regime for repo and reverse repo arrangements which, unlike securities lending arrangements, would allow a proportion of the assets of the UCITS to be non-recallable at any time at the option of the UCITS. The proposed guidelines include safeguards to ensure that the counterparty risk arising from these arrangements is limited, and that UCITS entering into such arrangements can continue to execute redemption requests. When adopted by ESMA, the guidelines on repo and reverse repo arrangements will be integrated into the guidelines on ETFs and other UCITS issues in order to have a single package of rules.

The final guidelines, comprising both the guidelines detailed above and the rules on repo and reverse repo agreements, will become effective two months after publication on the ESMA website of the translations into the official languages of the European Union.

UCITS VI Consultation

The European Commission is expected to open a consultation on UCITS investment rules (apparently closing 15 October 2012). Reports indicate that it will look at:

  • the systemic implications of portfolio management tools, including securities lending, repurchase transactions and collateral management;
  • money market funds – their role in investors’ liquidity management, their engagement in the securities lending and repo markets, as well as their systemic involvement in the overall financial marketplace;
  • ETFs;
  • systemic issues EPM techniques may raise (the Financial Stability Board is concerned that EPM techniques can be used to build leverage and can create liquidity disruptions); and
  • the quality of the collateral used in securities lending programmes, and possible conflicts of interest when the counterparty has ownership links with the manager.

The Commission is reviewing the impact of securities lending as part of its work on shadow banking. Money market funds and ETFs are being looked at as possible shadow banking activities that may need to be regulated under possible prudential rules. The consultation should help in clarifying the position of investment funds within the shadow banking sector.  

Packaged retail investment products (PRIPS)

Following consultations, the EU Commission has issued a draft regulation on Packaged Retail Investment Products (PRIPs). PRIPS include investment funds, insurance-based investment products, retail structured securities (such as certificates and notes), structured term deposits and private pensions. The regulation (drawing on the UCITS KIID template) will oblige every manufacturer of PRIPs (e.g. investment fund managers, insurers, banks) to produce a Key Information Document (KID) for each PRIP. The draft will pass to the EU Parliament and EU Council for consideration and adoption under the co-decision procedure. Member states will then have 2 years to transpose the provisions into national law (possibly late 2014), by which time the implementing measures should be in place.

The draft regulation aims to achieve consistent and effective standards for investor protection across these retail investment products through enhanced product disclosure, to achieve a level-playing field for distributors and providers of these products, to enable investors to compare products and to assist investors in understanding the key features and risks of the products.

The KIDs will be a few pages long and will follow a template as regards structure, content, sequence and presentation. It will use simple language and be fair clear and not misleading. Each KID will provide information on the product's main features, performance, risks and costs. The information will be shown as answers to simple questions such as, “What is the investment? Can I lose money? What are the risks and what might I get back? What are the costs?”

UCITS will replace KIIDs with the KID with a 5 year transitional period (from the entry into force of the regulation.

Remuneration of AIFMs

ESMA has opened a consultation (closing Sept 30) on proposed guidelines on remuneration of alternative investment fund managers (AIFMs) . ESMA will hold a hearing on the guidelines on sound remuneration policies under the AIFMD at ESMA offices on 25 September.

ESMA’s guidelines will apply to managers managing alternative investment funds (AIFs) including hedge funds, private equity funds and real estate funds. These funds will be obliged to introduce sound and prudent remuneration policies and structures with the aim of increasing investor protection and avoiding conflicts of interest that may lead to excessive risk taking. The guidelines are generally aligned with remuneration policies in other financial sectors and the Financial Stability Forum’s Principles for Sound Compensation Practices. The guidelines include:

  • AIFs’ internal governance. The governing body of each AIFM has to ensure sound and prudent remuneration policies and structures exist and operate. AIFMs should select the type of staff for which a remuneration policy is put in place and disclose according to which criteria the staff was selected.
  • Types of remuneration. For the purposes of the guidelines, remuneration consists of all forms of payments or benefits paid by the AIFM, any amount paid by the AIF itself, including carried interest, and any transfer of units or shares of the AIF, in exchange for professional services rendered by the AIFM staff. All remuneration is to be divided into either fixed remuneration (payments or benefits without consideration of any performance criteria) or variable remuneration (additional payments or benefits depending on performance or, in certain cases, other contractual criteria). Both components of remuneration (fixed and variable) may include:
    • monetary payments; or
    • benefits (such as cash, shares, options, cancellation of loans to staff members at dismissal, pension contributions, remuneration by AIFs e.g. through carried interest models) or non-monetary benefits (such as, discounts, fringe benefits or special allowances for car, mobile phone, etc.);
  • Other payments. Ancillary payments or benefits that are part of a general, non-discretionary, AIFM-wide policy and pose no incentive effects in terms of risk assumption can be excluded from this definition of remuneration for the purposes of the AIFMD-specific risk alignment remuneration requirements;

Any payment made directly by the AIF to the benefit of the selected staff which consists of a pro-rata return on any investment made by those staff members into the AIF should not be subject to any of the remuneration requirements.

Bonuses and fees. A "retention bonus" should be considered as a form of variable remuneration and only be allowed to the extent that risk alignment requirements are properly applied. Fees and commissions received by intermediaries and external service providers in case of outsourced activities are not covered by the guidelines.


The Final EMIR Level 1 text  is expected to be published in the Official Journal of the European Union later this month.  Work on EMIR Level 2 continues, with the final rules set to be implemented by the G20 deadline of the end of 2012. The EU Council has confirmed that EMIR will apply from the end of 2012. ESMA has launched a consultation paper (closing 5 August 2012) on its technical standards under EMIR, which is aimed at improving the functioning of OTC derivatives markets in the EU by reducing risks via the use of central clearing and risk mitigation techniques, increasing transparency via trade repositories (TR) and ensuring sound and resilient central counterparties (CCPs). An open hearing will take place on 12 July 2012. EMIR provides for the mandatory clearing of standardised OTC derivative contracts and all derivative contracts (not only OTC derivatives) will have to be reported to TRs which will publish aggregate positions by class of derivatives. CCPs will have to apply for authorisation within six months of standards being adopted.  ESMA will be able to block the authorisation of CCPs, and CCPs from third countries will be recognised in the EU if the legal regime of the third country provides for an effective equivalent system of recognition.

Margin requirements for non-centrally-cleared derivatives

During 2011, G20 Leaders agreed to include margin requirements on non-centrally-cleared derivatives within the reform programme for OTC derivatives markets in order to help mitigate systemic risk, to encourage standardisation and to promote central clearing. On 7 July 2012, the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organisation of Securities Commissions (IOSCO) published a ‘Consultative Document on margin requirements for non-centrally-cleared derivatives’ which sets out high-level principles on margining practices and treatment of collateral and proposes margin requirements for non-centrally-cleared derivatives. The principles contained within the Consultation are intended to apply to all transactions involving either financial firms or systemically important non-financial entities. The consultation closes on 28 September and will feed into a final joint proposal on margin requirements for non-centrally-cleared derivatives, to be released by BCBS and IOSCO by the end of 2012.

Short selling

On 5 July 2012, the EU Commission adopted a Delegated Regulation and regulatory technical standards supplementing Regulation (EU) No 236/2012 of the European Parliament and of the Council on short selling and certain aspects of credit default swaps (Short Selling Regulation).

The Short Selling Regulation prohibits persons from entering into uncovered sovereign CDS transactions, as such transactions are considered speculative. An uncovered CDS position (or naked CDS) is one where the credit protection buyer is not exposed to the credit risk of the underlying reference entity). However, sovereign CDS transactions which are executed to hedge exposures to correlated assets or liabilities are deemed to be covered transactions and are not prohibited under the Short Selling Regulation. Articles 14 to 20 of Chapter V of the delegated regulation set out the criteria for a CDS transaction to qualify as a covered sovereign CDS position.

The Delegated Regulation sets out the technical rules relating to the reporting of short positions in shares and the calculation of net short positions, including how such calculations should be performed for entities within a group. The regulatory technical standards specify the method of calculation of the 10% fall in value for liquid shares for the purposes of the Short Selling Regulation. Both the Delegated Regulation and the regulatory technical standards apply from 1 November 2012 (the Delegated Regulation is subject to a three month objection period by the EU Parliament and the Council).

PD; ESMA Q&A (versions 15 and 16)

On 2 July 2012, ESMA published the 15th version of its Prospectuses: Questions and Answers (Q&As). The key change was the addition of a new question 80, dealing with the formatting requirements of the prospectus summary and specified wording to be incorporated in the introduction to the summary.

On 1 July 2012 the amended Prospectus Directive and Commission Delegated Regulation entered into force. Therefore some Q&As may no longer be valid or contain references to legislation that is incorrect. ESMA is in the process of updating and revising the Q&A document accordingly and , for this reason, on 23 July, ESMA published the 16th version of its Prospectuses: Questions and Answers (Q&As) to deal with issues concerning the consent to use a prospectus in retail cascades.  In a funds context the Prospectus Directive only applies to closed ended funds.


The EU Parliament has indicated that the proposed MiFID II Directive and MiFID II Regulation (MiFIR) will be considered in its plenary session 19 to 22 November 2012. The MiFID II legislative proposals will replace and recast the Markets in Financial Instruments Directive (2004/39/EC) (MiFID). This will expand the scope to fixed income and derivatives markets, including commodities. It also aims to regulate or better regulate new players (dark pools, crossing networks, algorithmic traders) and to improve market transparency (pre- and post-trade), as well as increasing investor protection. Provisions deal with pre- and post-trade transparency, exchange trading of derivatives, product intervention by national authorities. Derivatives will be brought into scope as well as a new category of trading platform – the Organised Trading Facility (OTF) and entities engaged in the activity of High Frequency Trading (HFT) and provision of certain services without a branch by non-EU firms.

ESMA also published two final sets of guidelines aimed at enhancing the protection of investors in the EU. The guidelines relate to the provisions under MiFID relating to the suitability of investment advice and the compliance function. These are of interest in the investment funds context because they apply to many investment managers and also because the requirements under MiFID, AIFMD and UCITS are converging increasingly.


The EU Parliament has indicated that the proposed Regulation on insider dealing and market manipulation (MAR) (extending the existing market abuse regime to include instruments trading on MTFs and OTFs, OTC derivative trading and HFT) and the proposed Directive on criminal sanctions for insider dealing and market manipulation (CSMAD) will be considered in its plenary session 19 to 22 November 2012. Together, the proposals are known as MAD II and will replace the Market Abuse Directive (2003/6/EC) (MAD). On 5 July 2012, the Presidency of the Council of the EU published a compromise proposal (dated 4 July 2012) on the proposed MAR.