Commitment Exposure – The Difference between UCITS and AIFMD

AIFMD requires calculation of the commitment exposure of the AIF whereas UCITS requires calculation of the global exposure of the UCITS, using the commitment methodology.

It is not at all clear that any differences between UCITS Global Exposure and AIFMD Commitment exposure are intended. Indeed, it is worth noting that in the AIFMD Regulation, Recital (11) simply states that: “In order …. to grant an objective overview of the leverage used, it is necessary to provide two methods to calculate the leverage. As it results from market studies, the best results can be achieved by combining the so-called ’gross’ and ’commitment’ methods.”

Nevertheless, based on the current regulatory wording, there are potentially significant differences between the two calculations and the resulting system logic required.

These are discussed below:

TERMINOLOGY AND THE DISCLOSURE OF LEVERAGE TO INVESTORS

According to the AIFMD Regulation at Article 6, the leverage of an AIF shall be expressed as the ratio between the exposure of an AIF and its net asset value.

For example, an AIF with 100 equity investment and a further 200 derivative exposure would have total commitment exposure of 300. If its NAV is 100, then it would have 3 times leverage, at 300% AIFMD Commitment Exposure.

UCITS Global Exposure in contrast is a measure of the incremental exposure and, therefore, in the above example, the UCITS global exposure would be 200%.

This difference is unnecessary and confusing to investors. Further, the UCITS calculation is not always simply 100% less that than the AIFMD calculation. This is explained further below.

PORTFOLIO EXPOSURE VS. INCREMENTAL EXPOSURE FROM DERIVATIVES

CALCULATION METHODOLOGY DIFFERENCES

As set out in the table in Part 1, both AIFMD and UCITS require the calculation of exposure from derivatives based on the conversion of derivatives into the equivalent underlying positions; both provide for netting and hedging; both provide for delta adjustment and both provide for the same exceptions (with minor differences in wording) including in respect of cash and cash equivalents (see below).

Whilst AIFMD Commitment Exposure and UCITS Global Exposure are overwhelmingly similar and both in practice (as explained above) require you to consider all portfolio assets in the calculations, nevertheless the UCITS calculation is not always simply 100% less than the AIFMD calculation. This is explained further below.

This is caused by, amongst other issues, differences in the treatment of borrowing and inclusion of unrealised gains or losses on derivatives. All of these differences stem from the fact that the UCITS Guidelines prescribe a mechanical calculation for UCITS Global Exposure as follows, at Box 2, Para

2. The following steps must be taken by a UCITS when calculating global exposure using the commitment approach:

a. Calculate the commitment of each individual derivative (as well as any embedded derivatives and leverage linked to EPM techniques).

b. Identify netting and hedging arrangements. For each netting or hedging arrangement, calculate a net commitment as follows:
– Gross commitment is equal to the sum of the commitments of the individual financial derivative instruments (including embedded derivatives) after derivative netting; –
– If the netting or hedging arrangement involves security positions, the market value of security positions can be used to offset gross commitment;
– The absolute value of the resulting calculation is equal to net commitment.

c. Global exposure is then equal to the sum of:
– The absolute value of the commitment of each individual derivative not involved in netting or hedging arrangements; and
– The absolute value of each net commitment after the netting or hedging arrangements as described above; and
– The sum of the absolute values of the commitment linked to EPM techniques (Ref Box6

CASH AND CASH EQUIVALENTS

AIFMD Gross Exposure provides that you should not take into account the exposure from cash and cash equivalents.

Cash equivalents is defined at AIFMD Regulation, Article 7(a) as “highly liquid investments held in the base currency of the AIF, that are readily convertible to a known amount of cash, are subject to an insignificant risk of change in value and provide a return no greater than the rate of a three-month high-quality government bond.”

AIFMD Commitment approach and UCITS Global Exposure take a different approach of permitting the reduction of derivative exposure to the extent that they are backed by cash and cash equivalents / risk free assets. In practice, though different, these calculations very often reach exactly the same conclusion.

Example:

	NAV	DERIVATIVE EXPOSURE
CASH	100,000
FUTURE		100,000
NAV	100,000

In the above example, the calculations for AIFMD Gross Exposure, AIFMD Commitment Exposure and UCITS Global Exposure all lead to the result that there is no leverage, but achieve this through 3 different calculation methodologies:

The AIFMD Gross Exposure would be 100%, being 100,000 Derivative exposure and 0 cash exposure;
The AIFMD Commitment Exposure would be 100%, being 0 derivative exposure (as it is backed by the 100,000 cash) and 100,000 cash exposure; and
The UCITS Global Exposure would be 0%, being 0 derivative exposure (as it is backed by the 100,000 cash).

There are also differences in the wording between AIFMD Commitment Exposure and UCITS Global Exposure.

AIFMD COMMITMENT EXPOSURE

AIFMD Regulation – Article 8 provides that

“…. a derivative instrument shall not be converted into an equivalent position in the underlying asset when calculating the exposure according to the commitment method if it meets both of the following conditions: (a) the combined holding by the AIF of a derivative instrument relating to a financial asset and cash which is invested in cash equivalent as defined in Article 7(a) is equivalent to holding a long position in the given financial asset; (b) the derivative instrument shall not generate any incremental exposure and leverage or risk.

UCITS GLOBAL EXPOSURE

For UCITS Global Exposure, it is provided in the UCITS Guidelines that a financial derivative instrument is not taken into account if the combined holding by the UCITS of a financial derivative instrument relating to a financial asset and cash which is invested in risk free assets is equivalent to holding a cash position in the given financial asset. (see UCITS Guidelines at Box 4).

In this context, Risk Free Assets means: Assets which provide the return of short-dated (generally 3-month) high quality government bonds, for example 3-month US T-bills.

DIFFERENCES

Intentional or otherwise, there are the following differences in wording, albeit the same could be quite possibly inferred for UCITS:

AIFMD specifies that the cash equivalents must be in the base currency of the Portfolio; and
AIFMD specifies that this is only available for “long” derivatives.

CASH BORROWING

Under AIFMD Regulation, Article 6, AIFs shall exclude borrowing arrangements entered into if these are temporary in nature and are fully covered by contractual capital commitments from investors in the AIF. Other than that, borrowing should be included. This is clarified further at Schedule 3, Annex 1 – methods of increasing exposure.

“Unsecured cash borrowings: When cash borrowings are invested they have the propensity to increase the exposure of the AIF by the total amount of those borrowings. Therefore, the minimum exposure is always the amount of the borrowing. It might be higher if the value of the investment realised with the borrowing is greater than the borrowed amount. To avoid double counting, cash borrowings that are used to finance the exposure shall not be included within the calculation. If the cash borrowings are not invested but remain in cash or cash equivalent as defined in Article 7(a) they will not increase the exposure of the AIF.”

Under UCITS, there is good argument that borrowing does not need to be included when calculating Global Exposure. Our understanding is that only the UK FCA have specifically dealt with this, stating that borrowing need not be included – COLL 5.3.10(4).

The implication would be that 2 different UCITS could report the same Global Exposure, notwithstanding that one has in fact 11% more leverage that the other, see Example 4 in Part 4. In our view, this is unhelpful as well as confusing to investors.

There is an equally good argument that borrowing should also be included for UCITS, but it is unclear whether that would be within the 100% limit or an increased 100% limit.

In this regard, whilst acknowledging that ESMA does not refer to taking into account borrowing in its Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS, it should also be noted that

Luxembourg and Ireland regulations have historically taken the approach that UCITS cannot use borrowing for investment purposes and therefore the issue is not relevant. Other jurisdictions, however, have not taken the same approach as regards reinvestment of borrowings.
The definition in the Guidelines is outdated given that the ESMA Guidelines and Q&A on Efficient Portfolio Management (EPM) techniques and reinvestment of collateral etc. require you to include in the global exposure calculation the leverage from EPM activities of reinvestment of collateral into bonds etc. By the same logic, this should extend to where borrowings are reinvested.

EXAMPLES

Useful Links