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ESMA calls for modification of the UCITS Directive

The European Securities and Markets Authority (ESMA) published an Opinion on 22 May 2015 addressed to the European Union (EU) institutions on the impact of EMIR on UCITS. In the opinion, ESMA calls for a modification of the UCITS Directive to take into account the clearing obligations for certain types of over-the-counter (OTC) financial derivative transactions under EMIR.

By way of background, EMIR subjects certain OTC financial derivative transactions to a clearing obligation. The issue which ESMA’s opinion aims to address is how the limits on counterparty risk in OTC financial derivative transactions that are centrally cleared should be calculated by UCITS and whether UCITS should apply the same rules to both OTC financial derivative transactions that are centrally cleared and exchange-trade derivatives (ETDs).

As part of its research into this matter, ESMA published a discussion paper in July 2014 on the calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations which distinguished between different clearing arrangements. For each of those clearing arrangements, ESMA analysed the impact of a default of the clearing member and the client for the calculation of the counterparty risk by UCITS.

ESMA opinion on the impact of EMIR on UCITS Directive

Following that research and the responses received to the discussion paper, ESMA believes that:

  • the UCITS Directive should no longer distinguish between OTC financial derivative transactions and ETDs. ESMA suggests that the distinction should instead be between cleared and non-cleared OTC financial derivative transactions.
  • there is no need to modify the UCITS Directive for OTC financial derivative transactions that are not centrally cleared, and suggests that the current counterparty risk limits of Article 52 of the UCITS Directive should continue to apply.
  • counterparty risk limits should be calibrated to the different types of segregation arrangements taking into account elements such as the portability of the position in the case of a default of the clearing member. In particular, under individual segregation, UCITS should not apply counterparty risk limits to clearing members whereas under omnibus client segregation UCITS should apply some counterparty risk limits.
  • UCITS’ counterparty risk limits regarding (i) EU CCPs and some (ii) non-EU CCPs recognised by ESMA should take into account the relatively low counterparty risk of these entities.

“The clearing obligation under EMIR has a significant impact on the calculation of counterparty risk of cleared OTC financial derivative transactions by UCITS which cannot be appropriately resolved under the current UCITS Directive. ESMA therefore invites the EU institutions to consider amending the UCITS Directive to make it more compatible with the clearing obligation under EMIR.” Steven Maijoor, ESMA Chair.

Next steps

ESMA’s Opinion provides a general outline of what it considers to be appropriate counterparty risk limits. It is likely that further analysis will need to be carried out before a final decision on ESMA’s recommendation is made by the EU Institutions, which probably will not be until the end of the year at the earliest.

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