EUROPE: CESR consultation on UCITS Global Exposure

Monday April 19 2010

As part of UCITS IV implementation, CESR has published a Consultation on proposed “level 3” guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS. CESR invites responses to this consultation paper by 31 May 2010.

These proposals will contain useful clarifications and European consistency on issues such as VaR calculation and the need to take account of broker exposure when calculating counterparty exposure. There also a number of points which Funds-Axis do not quite understand the rationale for: including the need to calculate counterparty risk when OTCs have been novated to Central Clearing.

An overview of key points is set-out below and the consultation will be covered in the Funds-Axis UCITS, Eligible Assets & Derivatives Workshop on 20th and 21st May 2010.

We will also respond to the CESR Consultation in due course.

How this fits with UCITS IV

In October 2009, CESR provided technical advice to the European Commission dealing with level 2 measures related to the UCITS management company passport. This advice included proposed level 2 measures for the calculation of UCITS global exposure. This advice also recommended that certain implementing measures dealing with the calculation of global exposure be accompanied by level 3 Guidelines. This current consultation is in respect of the level 3 Guidelines. These guidelines will then accompany the level 2 implementing measures for the revised UCITS Directive (2009/65/EC) that should be adopted by the European Commission by July 2010.

Summary

The Guidelines cover a number of issues including:

Commitment Approach calculations

The Consultation includes:

Guidelines and illustrative examples of the conversion of financial derivatives into the equivalent position in the underlying assets of those derivatives.

Box 2 usefully sets outs conversion methodologies for a series of financial instruments. Whilst useful, in our opinion, the guidelines on how to convert plain vanilla options (both bought and sold puts and calls) could usefully be extended to clarify that the calculations should be looking at the incremental exposure created through the use of derivatives.

The inclusion in the Guidelines of reference to variance / volatility derivatives would also seem to confirm the eligibility of these derivative types for UCITS.

The methodologies for netting and hedging arrangements and principles to be respected when calculating global exposure;

One example given is the practice of offsetting the risks linked to an investment in a well diversified portfolio of shares by taking a short position on a stock market index future. The Box 5 Guidelines refer to the fact that there needs to be a “verifiable reduction of risk” and the explanatory text refers to “highly correlated” and “unquestionable reduction of the general market risk.” However, CESR stop short of specifying a minimum level of correlation that must be observed; in earlier CESR papers, 90% had been mooted as a potential minimum level of correlation.

The explanatory text provides that in calculating global exposure you would not be able to hedge if the aim of the transaction is in fact to “keep the alpha of a basket of shares [whilst] hedging out the beta (market risk) of the transaction” through the short index future. In such cases, and equally with pairs trading, you would need to aggregate together the absolute exposures of the long and short positions when calculating global exposure using the commitment approach: something that would push Managers towards using a VaR approach instead.

The calculation of global exposure when using Efficient Portfolio Management techniques (e.g. stock lending, repo and collateralisation) .

Essentially, the proposed Guidance provides that the exposure from such transactions needs to be taken into account in calculating UCITS global exposure.

Identification of two-possible methods for calculating commitment approach exposure for interest rate-related financial derivatives.

VaR Methodologies

The Guidance, which seems largely consistent with Luxembourg CSSF Circular 07/308, covers

The principles to be applied for the choice between Relative and Absolute VaR;

The explanatory text clearly indicates that Relative VaR should be used where there is a leverage free benchmark which can be used for comparison purposes.

The criteria to be used in the selection of the reference portfolio for use in the Relative VaR calculation;

The methodology for the computation of the global exposure when using Relative and Absolute VaR with a set of quantitative and qualitative requirements to be respected;

This provides for European consistency for usage of a Relative VaR limit of 2 times a benchmark portfolio and an Absolute VAR approach based on a 99% confidence, 20% loss limit over a 20 day holding period.

Additional safeguards which UCITS should put in place when calculating the global exposure with the VaR approach.

These provisions include stress testing, a program of back-testing to be performed at least quarterly and for every day. Back testing will require the calculation of a daily VaR level (as well as the 20 day VaR calculation) and the comparison of the VaR calculation with the actual portfolio movement.

Box 17 provides that the number of “overshoots” compared to the VaR model must be recorded and “the UCITS senior management and, where applicable, the UCITS competent authority should be informed at least on a quarterly basis of the number of overshooting for each UCITS in the most recent 250 days.”

However, it remains to be seen what consistency we will have between Luxembourg, Ireland and UK as regards the reporting that needs to be made to the regulatory authorities.

Counterparty Risk

Collateral

At Box 25, CESR defines a set of high-level principles relating to assets used as collateral to reduce counterparty risk and cover rules for transactions in financial derivative instruments. These points are familiar from the EC Recommendation on UCITS and Derivatives from 2004 and from the Luxembourg and Irish Guidance.

The proposed Guidance covers such matters as liquidity of collateral, valuation, issuer credit quality, diversification, to be held by a third party custodian and be fully enforceable at any time by the UCITS.

Reinvestment of collateral

Perhaps the surprise is at Box 25, point 1, last indent which provides that “Collateral cannot be … reinvested.” Box 6 and Box 26, in contrast, refer to the reinvestment of collateral and that this needs to be taken into account for the calculation of global exposure and the issuer-concentration calculations (i.e. the 5/10/40 rule) respectively.

Where counterparty exposure arises

Box 26 identifies that as regards the 5% and 10% counterparty exposure rule, UCITS should be considering not only their exposure to the OTC derivatives counterparty, but also their exposure to brokers to whom initial and variation margin are posted for exchange traded derivatives, unless there is client money protection etc.

Box 26 also provides that counterparty exposure arising through stock lending arrangements, repurchase transactions and reinvestment of collateral must also be taken into account.

Perhaps a useful addition to Box 26 would be a simple statement along the lines of that contained in Ireland Guidance Note 3/03: “The total exposure to a single counterparty arising from all activities should be captured in the risk management systems.”

Central Clearing of OTCs

There has been a international push, following on from last years G20 meeting, to get OTC derivatives, particularly credit derivatives, onto central clearing such as provided by EUREX and ICE.

In our experience, the uptake by fund managers has to date been slow but with projects now being put in place. This has the potential to provide significant benefits in terms of both risk management and cost savings (including avoidance of costs re. collateral management and independent pricing where these can be provided by the Exchange).

A key question, however, is whether the counterparty exposure to the clearing house needs to be taken into account for the 5% and 10% counterparty rule.

Box 26 clearly indicates that the answer to this is “Yes”. In our view, this is not the ideal approach as it may possibly limit the uptake of getting OTCs onto Central Clearing. It is also inconsistent with the provisions in place for exchange traded derivatives.

As regards exchange traded derivatives, the EC Recommendations on UCITS and Derivatives, as implemented in the UK as a rule at COLL 5.2.10 (14) R provides essentially (and sensibly) that even for Exchange traded derivatives, counterparty exposure should be taken into account unless there is a clearing house and the clearing house meets the following conditions : it is backed by an appropriate performance guarantee, and is characterised by a daily mark-to-market valuation of the derivative positions and an at least daily margining.

The question is, that if the clearing houses to which the OTCs have been novated meet the same requirements as required for the clearing houses for exchange traded derivatives, then why should you still have to calculate counterparty exposure in the case of these novated OTC transactions?