CSSF publishes its expectations on the use of Efficient Portfolio Management techniques (EPM) and securities financing transactions by UCITS

Context

On 18 December 2020, the Commission de Surveillance du Secteur Financier (CSSF) published the results of the Thematic Review on Efficient Portfolio Management – Revenues and Costs/Fees (“the Review”) and of the Frequently Asked Question on the use of Securities Financing Transactions by UCITS.

That Review launched at the end of 2019 by the CSSF focused on the rules on revenues and costs/fees raising from Efficient Portfolio Management techniques (in particular securities lending, repurchase agreement and reverse repurchase agreement transactions, hereinafter denominated as “EPM techniques”) as stated in ESMA Guidelines on ETFs and other UCITS issues dated August 2014 as transposed into Luxembourg regulation.

Alongside the results of the Review, the CSSF published a FAQ to provide further clarity concerning the use by a Luxembourg-domiciled UCITS of the three EPM techniques as aforementioned.

The consolidated key takeaways from the Review and the FAQ are as following:

Disclosure

• The CSSF recommends to disclose the information on the identity of the concerned entity(ies) to which the direct and indirect operational costs are paid in both the prospectus and in the annual report for informing investors in a comprehensive manner.
• The CSSF reminds UCITS management companies to control, in accordance with the applicable regulation, the compliance of the UCITS they manage with the disclosure requirements as described just above, including the disclosure requirements on EPM techniques.
• The CSSF considers that the prospectus should disclose the percentage of gross revenues generated by the use of EPMs on the basis of arm’s length transactions which is returned to the UCITS. In addition, the prospectus should disclose a breakdown of the overall percentage of direct and indirect operational costs/fees by service provider with an indication of the category of service provided.
• As UCITS are required to inform investors in the prospectus clearly of its intention to use EPM techniques, the CSSF expects this disclosure to be included for each UCITS (i.e. at sub-fund level for umbrella funds). To ensure compliance with this requirement, the CSSF provides disclosure points that need to be adequately addressed in the UCITS prospectus: (i) general description of the EPM techniques (ii) the precise conditions under which those EPM techniques will be used and (iii) the rationale/objectives and impact of using those EPM techniques.
• As regards the disclosure of the risks involved by the use of EPM techniques, the CSSF considers that the prospectus of a UCITS must include a risk description that adequately covers the risks for every single EPM technique and the ones linked to collateral management, and as a minimum refers to operational, liquidity, counterparty, custody and legal risks and, where applicable, the risks arising from its reuse.
   

Conflicts of interest

The CSSF expects UCITS management companies to perform a comprehensive documented assessment of the operational model (whether on a principal or model basis) and related processes underlying the EPM techniques in order to identify and record the circumstances which constitute or may give rise to a conflict of interest entailing a material risk of damage to the interests of the UCITS.

In addition, UCITS management companies have to mitigate the conflicts of interest identified and to manage those if they cannot be prevented, including by adequate disclosure of material conflicts of interest to investors by means of the UCITS prospectus. It is worth noting that the CSSF considers that EPM techniques concluded with or involving related parties lead to conflicts of interest that have to be managed accordingly.
 

Best execution controls

UCITS management companies shall cover EPM techniques in their best execution policy and have robust and comprehensive control processes in place to ensure that the UCITS obtain the best possible result regarding both  the revenues arising from EPM techniques (lending fee and interest rates underlying repurchase agreement transactions and reverse repurchase agreement transaction) and the costs / fees charged to the UCITS when executing such transactions.

The UCITS management companies have to perform the best execution controls either themselves or, notably in case of a portfolio management delegation, to have robust initial and on-going due diligence/oversight set up to ensure that the best execution controls performed by the delegate are adequate.
 

Costs/fees

Only effective costs/fees, corresponding to services rendered to the UCITS in the context of EPM techniques, can be charged to the UCITS. To ensure that costs/fees do not include any hidden revenues and all the revenues coming from EPM techniques net of direct/indirect operational costs are returned to the UCITS, the UCITS management companies must perform a comprehensive assessment of the adequacy of the operational costs/fees and must be able to prove their relevance by means of quantitative information notably.
 

Investment restriction controls

The CSSF clarifies that the reinvested cash collateral placed on deposit with a credit institution has to be taken into account in the 20% deposit limit laid down in the UCITS regulation. In addition, the reinvestment of the cash collateral in other eligible reinvestments (e.g. high-quality quality government bonds) has also to be taken into account in the relevant diversification requirements laid down in the UCITS regulation.
 

Next Steps

UCITS using EPM shall ensure that the necessary disclosure requirements are met by 30 September 2021 at the latest.

Specifically in relation to the costs/fees, on 6 January 2021, ESMA announced that it was launching a Common Supervisory Action (CSA) with Member State national competent authorities (NCAs) on the supervision of costs and fees of UCITS across the EU. The CSA will be conducted in 2021. The CSA will assess entities’ compliance with the relevant cost-related provisions in the UCITS framework and the obligation of not charging investors with undue costs, taking into account the ESMA supervisory briefing on the supervision of costs published in June 2020. The CSA will also cover entities employing EPM techniques to assess whether they adhere to the requirements set out in the UCITS framework and ESMA Guidelines on ETFs and other UCITS issues, the latter being the basis of the CSSF Thematic review and was mentioned already in the ESMA supervisory briefing.

As result, UCITS managements shall pay a specific attention to the prevention of undue costs in particular when using EPM techniques as it is definitely a hot topic at the European Level.
 

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