Whilst the UCITS provisions don’t specifically state this, the UK COLL 5.4 rules provide that a UCITS cannot lend more than it has.

The stocks lent remain within the portfolio and hence continue to be included in all rules.

The stock lending does not need to be taken when considering the UCITS Global Exposure rules.

In contrast, any additional leverage that comes from the reinvestment of the collateral, does need to be included. See under Reinvestment of Collateral.

The net exposure to a counterparty generated through a stock-lending or repurchase agreement, must be included when calculating the aggregated issuer concentration limits of 20% specified in Article 52.2 and 52.5.(*2)

The net exposure is the amount receivable by the UCITS less any collateral provided to the UCITS.

Eligible Counterparties

The UCITS provisions and various ESMA Guidelines do not actually specify the criteria for eligible counterparties for stock lending transactions.

In contrast the UK does specify the requirements for a stock lending counterparty and these are different to the requirements for being an approved deposit taker or approved OTC Counterparty(*3).

Whilst not in the UCITS provisions, in the UK there are provisions on the “adequacy of collateral” for stock lending(*4).

This includes a requirement that:

• For a UCITS, the Collateral received must at all times be equal in value to the market value of the securities transferred by the depositary plus a premium;(*5)

• for a non-UCITS retail scheme, at all times at least equal in value to the value of the securities transferred by the depositary.(*6)

This means in effect that in the UK, the stock lending should not be making any contribution towards the aggregated issuer group exposure limits referred to above. Whether this remains intentional or not is unclear.

It is not explicitly stated that the assets received as collateral need to be UCITS eligible assets, although that seems a fair assumption.

Rather, the specific eligibility rules are based around(*9) their:

• Liquidity(*10)

• Ability to be valued(*11)

• Issuer credit quality rules(*12)

• Correlation rules(*13)

• Operational and legal risk(*14)

These are considered in turn below:

Liquidity and ability to be valued

Collateral received must be cash or be highly liquid collateral received and have daily valuation.

ESMA define this as:

• Liquidity – “any collateral received other than cash should be highly liquid and traded on a regulated market or multilateral trading facility with transparent pricing in order that it can be sold quickly at a price that is close to pre-sale valuation.”(*15)

• Valuation – collateral received should be valued on at least a daily basis and assets that exhibit high price volatility should not be accepted as collateral unless suitably conservative haircuts are in place.

It would seem from the above that other UCITS funds or even short term money market funds cannot be given as collateral as they are not traded on a regulated market or multilateral trading facility. Certainly only UCITS funds with daily redemption would be eligible. Whether this is intentional or not is unclear.

ESMA Guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS (Ref. CESR/10-788) box 26 provides that:

“Issuer credit quality – as collateral provides secondary recourse, the credit quality of the collateral issuer is important. This may involve the use of haircuts in the event of a less than ‘very high grade’ credit rating. It should be reasonable to accept collateral on assets that exhibit higher price volatility once suitably conservative haircuts are in place.”

ESMA’s Guidelines on ETFs and other UCITS issues, at 43 c) provides that: “Issuer credit quality – collateral received should be of high quality.”

These terms of “high” and “very high” are not defined further. In our view, it is reasonable to define this rule rule to be Investment Grade or above, with haircuts to be applied where below AAA.

The Haircut is relevant when considering the extent to which the collateral can be used to reduce the Counterparty exposure.

The collateral received by the UCITS should be issued by an entity that is independent from the counterparty and is expected not to display a high correlation with the performance of the counterparty.

In other words, collateral received by the UCITS should be issued by an entity that is independent from the counterparty.”

Collateral received should also comply with the provisions of Article 56 of the UCITS Directive. [NOTE, these are the significant influence and ownership rules].(*16)

It seems that this requirement applies to the collateral received individually, rather than when considered in conjunction with the UCITS portfolio (although we have written to ESMA to ask them to confirm this).

Collateral must also be sufficiently diversified.(*17)

These diversification rules apply to the collateral alone and do no need to be aggregated with the portfolio holdings.

However, the UCITS does need to aggregate non-cash collateral and re-invested cash collateral when assessing the diversification requirements of collateral received by UCITS(*18).

The diversification requirement is satisfied if the UCITS 20% in any one issuer requirement is met.(*19)

This is the requirement to have a maximum of 20 % of its assets in a single body, any of the following:

1. Investments in transferable securities or money market instruments issued by that body;

2. Deposits made with that body; or

3. Exposures arising from OTC derivatives transactions undertaken with that body.

In respect of Government bonds, this means that as a starting point a maximum of 20% in any one Government bond issuer(*20).

There is a derogation from the 20% in any one issuer provision, in respect of Government and Public Securities.(*21)

The derogation is up to 100%, so long as:

• Maximum 30% in any one issue

• Minimum 6 different issues.

There is also a requirement that the UCITS should also identify the Member States, local authorities, or public international bodies issuing or guaranteeing securities which they are able to accept as collateral for more than 20% of their net asset value.(*22)

Please note, that, this is potentially not the same derogation as under the UCITS investment and Borrowing rules. In particular, there is no automatic derogation up to 35% of the NAV for Government and Public Issuers.

It seems that the Prospectus must provide for the Member States, local authorities, or public international bodies issuing or guaranteeing securities which they are able to accept as collateral for more than 20% of their net asset value.23 In otherwords, it seems that this is specific disclosure in respect of the collateral to be received, rather than covered by a general disclosure that the fund may invest up to 100% in transferable securities and Money Market Instruments issued by Member States, local authorities, or public international bodies issuing or guaranteeing securities.

Not applicable. Collateral received does not need to be taken into account for the Global Exposure rules.

In the UK, the FCA have set out some additional requirements in respect of the eligibility of collateral for NURS funds. This is specifically in the context of NURS funds and in respect of Collateral in respect of stock lending.

COLL 5.4.6 provides that:

(c) for a non-UCITS retail scheme ,[collateral received can be] in the form of one or more of:

(i) cash; or

(ii) [deleted]

(iii) a certificate of deposit; or

(iv) a letter of credit; or (v) a readily realisable security; or (vi) commercial paper with no embedded derivative content; or (vii) a qualifying money market fund.

Collateral received may be used to reduce counterparty risk exposure provided it complies with the eligibility criteria set-out above.

A UCITS receiving collateral for at least 30% of its assets should have an appropriate stress testing policy in place to ensure regular stress tests are carried out under normal and exceptional liquidity conditions to enable the UCITS to assess the liquidity risk attached to the collateral.(*24)

As well as the general UCITS Eligible Asset restrictions, there are ESMA restrictions on the re-investment of collateral.(*26)

ESMA provides that Cash collateral received should only be:

• Placed on deposit with entities prescribed in Article 50(f) of the UCITS Directive;

• Invested in high-quality government bonds;

• Used for the purpose of reverse repo transactions provided the transactions are with credit institutions subject to prudential supervision and the UCITS is able to recall at any time the full amount of cash on accrued basis;

• Invested in short-term money market funds as defined in the Guidelines on a Common Definition of European Money Market Funds.

In this regard, note that:

• There is no definition for high-quality government bonds. A reasonable definition would be that this includes government bonds issued by UK, US, Canada, Australia, New Zealand, France, Germany and Japan.

• Reverse repos are purchase of securities with an obligation to return the assets. The text on reverse repos is unclear but seems to imply that you have a repo transaction on any UCITS eligible assets, so long as they are with the relevant credit institutions subject to prudential supervision and the UCITS is able to recall at any time the full amount of cash on accrued basis.

In the UK, in respect of collateral received in respect of stock lending, it is provided that, the collateral can be reinvested into the following(*27)

(b) deposits, provided they:
( (iii) a certificate of deposit; or
(iv) a letter of credit; or
(v) a readily realisable security; or
(vi) commercial paper with no embedded derivative content; or
(vii) a qualifying money market fund.

“Readily realisable investments” is a defined term meaning

• (a) a government or public security denominated in the currency of the country of its issuer;

• (b) any other security which is:
  1. (i) admitted to official listing on an exchange in an EEA State; or
  2. (ii) regularly traded on or under the rules of such an exchange; or
  3. (iii) regularly traded on or under the rules of a recognised investment exchangeor (except in relation to unsolicited real time financial promotions) designated investment exchange;

• (c) a newly issued security which can reasonably be expected to fall within (b) when it begins to be traded.

The UK version is wider than the ESMA version, particularly as regards the references to certificate of deposit, a letter of credit, a readily realisable security; or commercial paper with no embedded derivative content or “Readily realisable investments.”

At this stage we are assuming that the UK provisions have been superceded by the ESMA Guidelines. Further, it is worth noting that the UK rules are written specifically. in respect of Collateral received in respect of stock lending.

However, in respect of deposits: the deposits must also be:

• are capable of being withdrawn within five business days, or such shorter time as may be dictated by the stock lending agreement.

The diversification rules are somewhat complex.

As above, all the UCITS investment restriction rules apply, including all of the diversification rules.

However, additionally, it is provided that the 20% diversification limit applies to the Collateral reinvested plus non-cash collateral received:

• The re-invested cash collateral should be diversified in accordance with the diversification requirements applicable to non-cash collateral(*28i).

• When assessing the diversification limits of collateral received [FA: this is the 20% limit] by the UCITS, the UCITS needs to aggregate non-cash collateral and any reinvested cash collateral.(*29)

This seems to be additional to the other diversification rules, rather than a derogation from them.

See under Part 2.3 on Collateral Received for further details of the rule.

If UCITS undertake repurchase transactions or securities lending transactions in order to generate additional leverage through the reinvestment of collateral, these transactions must be taken into consideration for the determination of the global exposure. UCITS that reinvest collateral in financial assets that provide a return in excess of the risk-free return, must include in their global exposure calculations.(*30)

Accordingly, collateral reinvested is included in the standard UCITS Global Exposure rule, as it is for all UCITS investment restrictions.

As above, all the UCITS investment restrictions apply, including in respect of counterparty exposure.

Additionally, it is provided at COLL 5.4.6 (1a), that

“Where the collateral is invested in units in a qualifying money market fund managed or operated by (or, for an ICVC, whose ACD is) the authorised fund manager of the investing scheme or an associate of that authorised fund manager, the conditions in ■ COLL 5.2.16 R (Investment in other group schemes) must be complied with whether or not the investing scheme is a UCITS scheme or a non-UCITS retail scheme.”