Collateral, UCITS and the re-use of assets
Entering a new era in collateral management
Collateral is either transferred by the counterparty to the UCITS or pledged on behalf of the UCITS. The aim of the collateral is obviously to protect the UCITS from the default of the counterparty and to decrease any anticipated loss in the event of default by the counterparty. In the event that the counterparty is unable or unwilling to fulfil its obligations, collateral received can be sold by the UCITS to offset the amount lost by the counterparty’s default.
Counterparty risk arising from Efficient Portfolio Management techniques (EPM) and financial derivative transactions
is commonly mitigated by the use of collateral.
Regulation in the financial industry (i.e. credit institutions, investment funds, insurance companies) has recently been reinforced, resulting in an increase in requirements surrounding collateral and could turn into a run on high quality collateral.
For UCITS funds, the ESMA guidelines 2014-937 (CSSF Circular 14-592 in Luxembourg) set up rules on received collateral. In particular, four relevant aspects are particularly impacted by the ESMA guidelines with direct consequences for UCITS: scoping of collateral, diversification, eligibility and usage. By determining that all assets received in the context of EPM techniques and OTC derivatives transactions are to be considered as collateral, ESMA sought to ensure a consistent and unified approach to collateral management across the investment funds industry. As will be seen later in this article, this provides an opportunity for a fully integrated collateral management set-up across vehicles, counterparties, strategies and financial instruments.
Nevertheless, the same studies point out that due to, for example, the non-streamlined market infrastructure in Europe, frictions are likely to arise from the changes as they pertain to collateral.
The market must move, be the spearhead
All financial actors are in scope and one can be sure that collateral management is entering a new era. The tightening of the regulatory framework regarding re-use of assets and collateral management implies a redesign of EPM techniques for Asset Managers and the need to optimise the sourcing, allocation and management of collateral. At the crossroads of EMIR, AIFMD, CRD IV and UCITS regulations and in an environment where risk management and corporate governance is a must, collateral management becomes a key function for asset managers. Some Management Companies’ Risk Management and Compliance functions may need assistance from the asset servicing industry in order to reconcile in the most efficient way compliance obligations with budget objectives.