ESMA’s UCITS guidelines
Further clarifications arise
ESMA’s “guidelines on ETFs and other UCITS issues” are almost a year in force. Just as the transitional period for certain requirements is due to end on 18 February 2014, ESMA issued a consultation which proposes to exempt money market funds from the imminent 20% issuer limit for collateral received. The Central Bank of Ireland has also provided clarifications in relation to the classification of financial indices and the annual report disclosure requirement covering revenues arising from efficient portfolio management techniques.
ESMA’s guidelines included new diversification requirements with respect to collateral received for the purposes of efficient portfolio management (EPM) techniques and OTC derivative transactions. Under the guidelines, a UCITS can have a maximum aggregate exposure of 20% of NAV to a single issuer from the collateral it receives. The rule is due to come into effect on 18 February 2014 for pre-existing UCITS that were able to avail of the one year transitional period.
The 20% issuer concentration rule would create significant challenges for some UCITS, and money market funds in particular, which would typically receive large quantities of collateral in the form of high-quality government securities. In response to this challenge, the industry has sought an exemption from the 20% issuer limit for government securities received as collateral by UCITS.
ESMA’s response was to issue a consultation paper, dated 20 December 2013, on a revision of the collateral diversification rule which would provide an exemption for money market funds that received government backed securities as collateral. Instead, such UCITS should receive securities from at least six different issues, but securities from any single issue should not account for more than 30 % of the collateral received.
Responses to the consultation were requested by 31 January 2014. While respondents may seek a wider exemption covering government backed securities issued as collateral to UCITS more generally, ESMA appears intent on exempting money market funds only.
For its part, the CBI announced that “in the light of [ESMA’s] consultation it is reasonable for a UCITS money market fund, authorised before 18 February 2013, to delay its compliance” with the 20% issuer limit rule “until such time as ESMA has issued its feedback and concluded the consultation process.”
The new requirements relating to financial indices were another key area where ESMA’s guidelines provided for a 12 month transitional period. The CBI issued a letter on 23 December 2013 to the Irish Funds Industry Association (IFIA) in response to ongoing interpretational matters regarding the classification of financial indices. The industry had queried whether Section IX of the guidelines (financial indices) only applies to those indices which require approval as “financial indices” as per the CBI’s guidance, i.e. those which constitute indices which are availing of the increased diversification limits under the UCITS Regulations or which contain ineligible assets. The CBI concluded that the terms “indices” and “financial indices” are used interchangeably and there is consequently no grounds to consider that Section IX is applicable only to indices which required approval as financial indices by the CBI.
The submission also noted that the ESMA guidelines could be interpreted as requiring the underlying financial indices held by a UCITS to always comply with the 20/35% rule contained in Article 53 of the UCITS Directive, i.e. the index tracking rule. However, to date UCITS have been allowed to invest in FDI on an underlying financial index which does not comply with that rule provided that the UCITS does not breach the 5/10/40 rule on a “look-through” basis.
In response, the CBI considered that there was no inconsistency between the UCITS Directive and the ESMA guidelines on the above point because the investment is not regarded as a derivative on an index but is regarded as a derivative on a combination of assets. Therefore, as long as the UCITS eligible assets and diversification requirements are applied to the underlying combination of assets, the investment can be permitted.
Furthermore, the CBI confirmed that its policy in relation to the approval of financial indices has not changed in light of ESMA’s guidelines.
EPM revenue disclosure
ESMA’s guidelines require disclosure in the annual report of revenues arising from efficient portfolio management techniques for the entire reporting period together with the direct and indirect operational costs and fees incurred. This had led the industry to consider whether share class hedging qualifies as an EPM technique for the purposes of this disclosure. This could in turn have required managers to split out revenue from derivatives in order to identify gains on share class hedging as EPM revenue. However, the CBI has now confirmed that a “reasonable interpretation” would be that the disclosure is “applicable only to revenue from securities lending arrangements and repurchase/reverse repurchase agreements”. This is subject to any clarification which may be provided by ESMA. While share class hedging is usually considered as part of EPM techniques, ESMA’s intent appears to have been to capture only revenues from securities lending, repos and reverse repos and the inclusion of gains from share class hedging could have distorted that information.