EUROPE: EU Commission Invites Consultation on UCITS VI Proposed Measures

Thursday July 26 2012

General Information

The EU Commission has invited regulators, market participants, industry and other interest parties to consult on a range of measures proposed as part of the planned UCITS VI measures. The main areas that are being considered by the EU Commission are considered below.

Parties interested in submitting opinions are required to so by 18 October 2012 to MARKT-UCITS-CONSULTATIONS@ec.europa.eu

A copy of the full consultation report can also be found at the below link;

UCITS VI – EU Commission Consultation Paper

Please also note that the Consultation report should also be read in conjunction with ESMA’s “Guidelines on ETF’s and Other UCITS Issues” as published on 25 July 2012, where the issue of certain EPM techniques has also been addressed. At the same time as publishing its Guidelines, ESMA has also started a consultation in relation to guidelines in respect of the use of sale and repurchase repo agreements by UCITS. Click the below links for more details on these items.

ESMA Guidelines on ETF`s and Other UCITS Issues

ESMA Consultation on Repo Arrangements

Introduction

The genesis of the consultation request is recent work carried out by the Financial Stability Board (“FSB”) on shadow banking which identified certain areas that they believe require further scrutiny namely Money Market Funds and the use of sale and repurchase repos and / or securities lending by UCITS schemes as part of their efficient portfolio management (“EPM”) techniques.

Some of the proposed measures for UCITS VI could have far reaching implications for the investment strategies that UCITS employ including investor redemption requirements, liquidity management, calculation of counterparty risk, the operation of Money Market Funds, the usage of OTC Derivatives, how collateral received is managed etc.

The 9 key areas the commission is seeking opinion upon via consultation, including proposed measures (where applicable) are detailed below;

1. Eligible Assets – The recent emergence of UCITS schemes utilising sophisticated investment strategies to gain access to highly complex risk profile instruments and assets considered not eligible under section 50 of the UCITS IV directive has raised concerns as to the appropriateness of these strategies and instruments in the context of UCITS schemes. The highlights of the concerns and possible measures being considered in this area are;

• One area that is being considered is a look through approach in relation to non-eligible assets to prevent or limit the exposure by UCITS to such assets or alternatively defining the exposure limits to these particular types of non-eligible assets as distinct from the current global exposure regime currently applied to Financial Derivative Instruments (“FDI’s”);

• The consultation also wishes to consider the continued viability of the VaR approach in the calculation of global exposure; and

• Another area being considered is question of whether a UCITS usage of derivatives should be limited to FDI’s that are traded on multi-lateral platforms in accordance with the legislative proposals outlined in the MiFIR?

• Efficient Portfolio Management (“EPM”) – EPM techniques such as Sale & Repurchase Repo’s and Securities Lending are currently widely used by UCITS schemes but concerns have been raised with regards to the following:);

• transparency of these techniques;

• the counterparty risk being assumed by the scheme in the course of these techniques;

• the quality & liquidity of collateral or the re-investment of collateral obtained by the scheme under these techniques; and

• A UCITS is not permitted to borrow or grant loans but certain of these techniques amount to the same thing.

• OTC Derivatives (“OTC’s”) – OTC’s are also widely employed by UCITS but again the usage of such OTC’s and their suitability for UCITS Investors have raised some concerns which are set out below;

• The ability of a UCITS scheme to use collateral to reduce its exposure to counterparty risk can lead to scenarios where in practice the entire portfolio of the scheme is exposed to a single counterparty albeit whilst still being within existing counterparty exposure limitations. This has created concerns re: conflicts of interest and / or issues surrounding liquidity viability of the UCITS scheme in the event of the insolvency of the counterparty;

• Currently Global exposure must be calculated on a daily basis but there is no requirement to calculate either counterparty risk or issuer concentration on a daily basis which can lead to differing market practices with associated inherent risks to investors;

• Counterparty risk is calculated on the basis of Marked to Market (“MTM”) values of the FDI, the collateral and the portfolio of the scheme. However UCTIS are also permitted to hold eligible assets which are not traded on regulated markets, therefore the price of the asset in question may be stale and as such the exposure calculation to the counterparty may not be “market accurate”, e.g. for closed-ended CIS; and

• How should OTC’s cleared through central counterparties be treated and how should OTC’s not cleared through central counterparties be treated.

• Extraordinary Liquidity Management Tools – The consultation aims to seek in this area to further determine how to protect investors wishing to redeem their units whilst not damaging the interests of investors wishing to remain in the scheme.

• Article 84 of the UCITS IV Directive permits an investor to redeem their units in the scheme at any time but does not set down any time limits within which such redemption is required to take place. During the financial crisis instances did occur where investors were unable to redeem their units.

• Suspensions of redemptions are also permitted in “exceptional cases” on a temporary basis but no guidance is given as to what constitutes an exceptional case and the length of a temporary suspension is not defined leading to variations in practical application of this article across the member states;

• Concerns have also been raised re: UCITS schemes creating side pockets of illiquid assets despite Article 1 (5) of the directive prohibiting a UCITS scheme transforming themselves into a non-UCITS scheme and the consultation wishes to considers ways of addressing these concerns; and

• Concerns have also been raised in relation to secondary markets for ETF’ and the impact this may have on liquidity. Specific measures may need to be considered to guarantee liquidity for ETF investors.

• Depository Passport – Article 23 (1) of the UCITS IV Directive does not entitle a Depository to a UCITS to have an EU passport. In light of AIFMD and UCITS V, consideration is now been given to the granting of an EU passport to Depositories and opinion is being garnered by the consultation in relation to thoughts on same and any positives or negatives that could arise from the introduction of such a passport.

• Money Mark Funds (“MMF’s”) – Concerns have also been raised in relation to the susceptibility of MMF’s too runs and in turn the systemic risk they pose to the market. As such the consultation is designed to explore options in relation to preventing massive redemptions in relation to MMF’s including placing stipulations in relation to MMF schemes in the AIFMD and / or the new UCITS Directive. Some of the concerns and measures being considered in relation to MMF’s are outlined below;

• MMF’s with Constant Nav’s (“CNAV’s”) may give the impression to investors that capital is guaranteed and therefore when the CNAV drops below par, it can cause investors to make a run on the scheme;

• The amortized cost valuation method used by CNAV’s also doesn’t value the portfolio of the scheme at MTM values;

• Also as CNAV’s are deemed by some investors to be equivalent to bank deposits consultation is invited on the merits of treating such schemes with the equivalent capital requirements of bank deposits such as, for example, the introduction of capital buffers;

•  As MMF’s permit investors to withdraw on demand, but hold within their portfolios assets which mature at a future date, this has the potential to create liquidity issues for the scheme. Possible ideas to address these issues include, introducing liquidity fees and / or redemption restrictions. Liquidity constraints could also be introduced re: the assets of the portfolio of the scheme;

• A drop in the credit rating of a fund may instigate a run on a scheme. Therefore consideration is being given to banning the credit rating of MMF’s; and

• MMF’s are required to invest in highly rated assets. A drop in the rating of said asset can cause the manager to have to sell this asset. Consideration is being given to introducing a purely internal assessment of the assets without reference to credit ratings of instruments held.

• Long Term Investments – Thoughts are sought from the industry as to how to promote investments that have a longer time horizon and benefit within the EU region, e.g. channelling monies into the European Social Entrepreneurship Funds (“EUSF”).

• UCITS IV Improvement – Since the introduction of UCITS IV concerns and potential areas of improvement have been identified. Opinions are invited in relation to the below suggestions on improving the regime introduced by UCTI IV.

• Self-Managed Companies – Article 31 of the Directive does not currently empower the EU commission to adopt delegated acts specifying the administrative procedures and internal control mechanisms for investment companies as Article 12 does for Management Companies. It is proposed to align Article 31 for Investment Companies Article 12 as it stands for Management Companies;

• Master-Feeder Structures – Article 64 (1) does not currently require a UCITS to provide information to investors when a feeder UCITS converts into an ordinary UCITS. It is proposed that this be amended so that information must be provided to an investor in this instance;

• Fund Mergers – There is currently legal uncertainty surrounding the time limits re: Fund Mergers particular in relation to the 20 working day time limit that the competent authorities have in relation to the authorisation of the merging UCITS in addition to the 20 day limit that the competent authority of the receiving UCITS have for their assessment of the modified information of the information to investors. It is proposed to amend this to give more legal certainty to the time limits in both instances and how they should be applied;

• Notification Procedure – UCITS IV introduced electronic regulator to regulator communication except for Article 93 (8) which requires changes to the marketing arrangements or the marketing of a new share class of a UCITS scheme to be communicated to the UCITS Host member state in written form. It is proposed to amend this to facilitate electronic notification; and

• Alignment with AIFMD – Opinions is invited in relation to improving the consistency of harmonising the UCITS Directive with AIFMD. Opinion should consider both the costs and benefits of any suggestions.

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