ESMA issues final guidelines on ETFs and other UCITS issues but consults further on repos
On 25 July, ESMA published final guidelines on exchange-traded funds (ETFs) and other UCITS issues. At the same time, it launched a consultation on the recallability of repo and reverse repo arrangements. These guidelines will greatly increase the disclosure UCITS funds provide to investors, and will result in a number of other substantive changes to UCITS products.
The final guidelines produced by ESMA contain a number of changes following feedback to its consultation last January. Controversially, the ESMA guidelines confirm all income generated through securities lending arrangements should be given to the fund, except for direct and indirect operational costs. Currently, market practice in many EU Member States is for the UCITS management company or a facilities agent of the securities lending arrangement take a cut of the revenue generated from securities lending, but this may no longer be possible under the guidelines.
Some of the other main changes include:
- introducing a definition of an ‘index-tracking UCITS’
- amending the definition of a ‘UCITS ETF’ slightly to include a reference to the indicative net asset value (iNAV) of the ETF
- requiring UCITS ETFs to allow direct redemptions from secondary market investors only when they are unable to redeem at their request in the usual market
- not imposing a hard limit on the amount of a fund that can be involved in securities lending arrangements
- allowing more freedom to invest cash collateral received by a UCITS, rather than only allowing it to be invested in risk-free assets.
However ESMA stuck to its guns in a number of areas where its proposed policy redrew widespread criticism from industry. In particular in relation to use of indices, ESMA will require UCITS using indices to disclose information on the indices’ calculation methodology. Index providers may not want to publish such information as they view it as proprietary. Therefore the ultimate result of this requirement may be that we have fewer index-based UCITS funds, and reduced investor choice.
The guidelines for indices cover all indices used by UCITS, not just strategy indices as proposed. ESMA disagreed with feedback and will still require UCITS that use total return swaps or other similar derivatives to apply the diversification rules after receipt of collateral as part of the derivative arrangement, not before as is current market practice.
ESMA outlined its strong views on ETFs which are not UCITS, stating it is “concerned by other exchange-traded products which are not UCITS and that may use the word ‘ETF’ in their name” because this use “may create confusion for investors and ESMA believes the appropriate actions should be taken to address this issue”. This statement implies that only UCITS ETFs should be allowed to use ‘ETF’.
The guidelines will become effective two months after the date they are published on the ESMA website. In line with the ESMA Regulation, the guidelines have been issued on a “comply or explain” basis, with every national supervisor and financial market participants expected to make every effort to comply. National authorities have 2 months after publication of the guidelines to advise ESMA of whether or not they intend to apply the guidelines locally. It is not clear what national authorities will do at this stage: some have already highlighted difficulties posed by possible duplication with amendments to the underlying legislation through UCITS VI. If some local regulators are not prepared to adopt these guidelines at this stage, this could lead to significant variation across Member States in what is permissible in a UCITS funds. This disconnect could in turn lead to problems with passporting between countries taking substantially different approaches.
From the date the final guidelines are published, new UCITS funds will have to comply fully with them. Existing UCITS funds will have to comply with most other aspects guidelines after a 12 month transitional period. However, UCITS ETFs are required to offer investors the option of direct redemption from the date the final guidelines are issued, so they will have only a short time to put in place the necessary documentation and disclosures.
In ESMA’s consultation on repo and reverse repo arrangements, it states that repo and reverse repo arrangements differ from securities lending because UCITS cannot recall their assets on demand. ESMA proposes introducing a hard limit on the amount of a UCITS that could be subject to repo and reverse repo arrangements, but would like industry’s feedback on an appropriate limitation.
The consultation paper closes for comments on 25 September 2012
EC starts the ball rolling on UCITS VI
The EC initiated the process that will lead to UCITS VI, in its consultation paper issued on 26 July “Product Rules, Liquidity Management, Depositary, Money Market Funds, Long-term Investment”. The UCITS VI proposal comes fast on the heels of the proposal to amend the UCITS Directive in relation to depository functions, remuneration and sanctions issued on 3 July 2012 (UCITS V). ESMA also issued guidelines on ETFs and other UCITS issues, bombarding in late July as well, asset managers with another onslaught of regulation.
The UCITS VI consultation considers eight areas:
- Eligible assets and use of derivatives - looking at how UCITS gain exposure to ineligible assets and whether complex derivatives should be banned.
- Efficient portfolio management techniques - examining at the requirements around the liquidity of collateral and whether new restrictions should be imposed on posting collateral to counterparties.
- OTC derivatives - with more OTC derivatives being centrally cleared under EMIR, considering whether new UCITS rules are needed to limit counterparty risk, e.g. involving the daily calculation of both counterparty exposure and the value of UCITS assets.
- Extraordinary liquidity management tools – suggesting new rules to help funds maintain liquidity in periods of market stress, further defining the current use of 'exceptional case' in the UCITS Directive, under which funds are allowed to suspend redemptions.
- Depositary passport -bringing in a depositary passport to allow depositaries authorised in one EU Member State to passport their activities to other Member States, like the management company passport introduced under UCITS IV.
- Money market funds (MMFs) – reducing perceived systemic risks posed by MMFs through enhancing their liquidity, to prevent massive runs on MMFs. The EC would also like to remove any investor perception that funds in MMFs are somehow guaranteed like bank deposits. It may consider introducing capital buffers for Constant NAV MMFs (which the EC believes represent 40% of EU MMFs). New rules could also be introduced to ban valuations on an amortised cost basis rather than mark-to-market in market stress conditions and to impose a 'liquidity fee' or other limits on redemptions. Imposing such a fee could hinder the success of MMFs in future because they may become more expensive to hold than deposits.
- Long-term investments – considering changes to the eligible assets to allow retail investors to invest in long-term investments, such as real estate or private equity, either through a UCITS or another type of retail vehicle. Some Member States have discretion under AIFMD to permit such funds to be marketed to retail investors.
- Improving UCITS IV – assessing possible changes to UCITS Directive to improve UCITS IV measures relating to master-feeder structures, fund mergers, and regulator-to-regulator notification procedures.
- Alignment to AIFMD – requesting industry’s feedback on areas where the UCITS Directive and AIFMD should be better aligned.
The industry should engage early in the dialogue with the EC on these proposed changes to the UCITS framework - they have far reaching implications for fund managers and funds, as well as their service providers.
Clearly regulators and industry will need to debate a number of key issues, e.g. the trade-off to be struck between the need for liquid assets to facilitate prompt redemptions, and longer-term investment in (far) less liquid assets to diversify and seek to generate greater returns. Allowing long term investment funds would be a real sea-change in thinking around UCITS. It may even lead some alternative fund managers to consider converting their products to UCITS, giving retail investors a wider choice of investments. Such a move could give a much needed boost to much-needed infrastructure investment as well, which many Member States with budget deficits will struggle to fund over the next few years.
The consultation document closes to comments on 18 October 2012
Countdown starts on EMIR
The EU Regulation on OTC derivatives, central counterparties and trade repositories (commonly known as EMIR) was published on 27 July in the Official Journal of the European Union (EU) and comes into force on 16 August 2012. This is the final leg of the ‘Level 1’ legislative process. This version contains no significant change from the text adopted by the -EcoFIN Council on 4 July 2012.
The European Securities and Markets Authority (ESMA) is now tasked with developing and finalising the necessary technical standards for implementation, which are in various states of readiness. ESMA is expected to submit the majority of its proposals to the European Commission (EC) as scheduled by 30 September. However, the European Supervisory Authorities confirmed on 30 July that submission of the technical standards relating to risk mitigation requirements for non-cleared OTC derivatives will be delayed, pending finalisation of work in this area at the international level. The EC will confirm the new date for submission after the original date (30 September) has expired. We do not expect these requirements to come into effect until the third quarter of 2013 at the earliest.
The first clear operational date for firms is 1 July 2013, when firms will be required to commence transaction reporting to trade repositories (TR). While the reporting regime starts next year, the rules require firms to report transactions from 16 August 2012.
Central counterparties (CCPs) and TR which are already authorised under home state rules will continue to operate, but must reapply for authorisation within six months of the date of effect of technical standards setting out their new authorisation requirements.
So the countdown for EMIR has officially begun. To prepare for this fundamental regulation, firms must start overhauling:
- reporting systems
- credit risk quantitative models
- clearing arrangements
- collateral management systems
- technical IT architectures
- business and operational clearing arrangements.
Firms planning to align their approach to EMIR with measures adopted to comply with similar US measures under the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) should note that, although both are based on the G20 commitment, there is likely to be significant differences in the detail of the two regulatory regimes.
The shift towards centrally clearing OTC derivatives has already begun in earnest in the EU but EMIR heaps a host of additional requirements to the current clearing environment. Smaller firms with less compliance and operational support may bear the brunt of the pain but all firms will need to undertake substantial work as EMIR changes run deep.
EBA finalises remuneration templates under CRD III
On 27 July 2012, the European Banking Authority (EBA) published its final data collection requirements for high earners at financial institutions under the Capital Requirements Directive by Directive 2010/76/EU (CRD III). Firms will need to identify the number of high earners across each business line and their total fixed and variable remuneration. Information on variable remuneration must be broken down into the total discretionary pension benefits paid and the total variable remuneration deferred in the applicable year.
On the same day, the EBA finalised the templates associated with its remuneration benchmarking exercise. Under CRD III ‘significant’ financial institutions are required to provide EU consolidated data on remuneration for all their staff on an annual basis.
A significant financial institution is defined as a large, cross-border banking group which is active in the EU, or institutions determined as significant by national supervisors.
The data requirements will be graduated: all staff versus ‘identified’ and high-earning staff. Staff reporting requirements is usually comprised of total number of staff, net profits, and the total fixed and variable remuneration in the relevant year. The number of ‘identified’ staff (i.e. in senior management, risk taking and control positions) will need to be collected together with details of their fixed and variable remuneration packages. Other data collection requirements include:
- the total amount of variable remuneration deferred for identified employees
- the number of staff with guaranteed variable remuneration
- details of number and amount of severance payments made
- discretionary pension benefits paid.
These Guidelines have to be applied by national supervisors as soon as possible and in any case no later than the end of September 2012. National supervisors must submit the first tranche of data, on fixed and variable remuneration awards for the 2010 and 2011 performance year, to the EBA by year end.
Basel Committee widens the scope of own credit risk adjustments
On 25 July 2012, the Basel Committee issued its revised Basel III rules on own credit risk adjustments to derivatives, recommending that firms should fully deduct debit valuation adjustments from the calculation of Common Equity Tier 1.
In calculating Common Equity Tier 1, Basel III requires banks to disregard any unrealised gains and losses in the fair value of liabilities that are due to changes in banks’ own credit risk. While this rule was originally developed in the context of debt issued by banks, in December the Basel Committee proposed that this requirement should be extended to fair valued over-the-counter (OTC) derivatives and has now changed the rule to reflect this.
The Basel Committee believes that valuation adjustments to derivative liabilities harbour a wide range of prudential risks and conservatism should drive the policy framework in this area, despite concerns from some banks that the move is heavy handed and unnecessary.
Euroarea lending conditions stabilise
The European Central Bank (ECB) published its quarterly Euroarea Lending Survey on 25 July 2012. The Survey found that banks tightened their lending standards in the Q2 2012 compared to the previous quarter. Credit tightened slightly for corporate loans, eased for housing loans and rose marginally for consumer credit.
The markets were surprised, having expected lending standards to deteriorate across all sectors given the region’s deepening sovereign debt crisis and EU banks’ ongoing balance sheet adjustments.
The ECB’s 3-year longer-term refinancing operations in December and January may explain the stabilisation of lending conditions. The Survey indicated that access to retail and wholesale funding improved across all funding categories this year but particularly with regards to debt securities and money markets. Banks also said that sovereign debt market tensions had a smaller impact on funding conditions than in the first three months of the year. Looking ahead, banks expect the fall in demand for mortgages in Q3 to be much less than anticipated; demand for corporate loans is expected to increase this year.