Including updates on UCITS ETFs, remuneration and Solvency II


ESMA outlines guidelines for UCITS ETF

On 30 January 2012, the European Securities and Markets Authority (ESMA) published a consultation setting out its future guidelines for UCITS exchange traded funds (ETFs) and other UCITS-related issues. The consultation paper also sets out ESMA’s response to feedback it received on the discussion paper published in July 2011 and at the open hearing held in September 2011.

Some of the key proposals and policy changes include:
  • Index-tracking funds: ESMA proposes that further information should be made available in the prospectus and report and accounts of such funds, particularly information regarding on tracking errors and how a fund is designed to track the index (e.g. physically or synthetically).
  • Index-tracking leveraged UCITS: Additional information should be included in the prospectus on the leverage techniques used.
  • UCITS exchange traded funds (ETFs): ESMA defines ETS as funds that are continuously traded on a regulated market and which have at least one market maker. All UCITS that meet this definition must include “ETF” in their name and all other UCITS are prohibited from using “ETF” in their name or marketing. The fund name would not have to distinguish between physical and synthetic ETFs.
  • Actively-managed UCITS ETFs: The prospectus should make clear that the fund is actively managed rather than passively managed.
  • Redemptions by secondary market investors: ESMA proposes two options: (1) require market makers to offer secondary market investors redemption whenever the market is open for trading and require an investor warning that there may be a variation between the redemption price and the published NAV; or (2) require UCITS ETFs to offer continuous secondary market redemptions.
  • Efficient portfolio management (EPM) techniques: ESMA proposes new guidelines for UCITS that use EPM. Proposals address the following issues: securities lending, repos and similar transactions, the eligibility of collateral and diversification requirements for collateral and disclosure of the fees arrangements between the UCITS, the manager and third parties.
  • Total return swaps: Guidelines are proposed for funded and unfunded swaps, eligibility of collateral, haircut requirements, and the role the counterparty plays in any investment decisions of the UCITS. If a counterparty exercises discretion over the composition or management of the portfolio this action will be treated as a delegation of asset management responsibilities and the counterparty will become an investment manager of the UCITS.
  • Strategy indices: ESMA proposes new guidelines on the use of indices. Indices based on undisclosed proprietary information will not be eligible.
Fund managers will need to amend fund documentation to incorporate the new requirements within a year after ESMA issues the final guidelines. ETF names must also be changed to include an “ETF” identifier within this time frame.

In a number of cases ESMA widened the proposals in its initial discussion paper to encompass all types of UCITS, rather than just ETFs and structured UCITS. However, it refrained from taking a position on splitting UCITS into complex and non-complex - it will await the outcome of this issue in the MiFID II deliberations on that issue.

ESMA’s decision to sidestep this issue for a future date was unsurprising. Discussions around the relative complexity of synthetic versus physical ETFs are particularly contentious, presenting uncertainties for global regulators. In April 2011, the Financial Stability Board flagged that the growth of some ETFs ‘warranted closer surveillance’ by supervisors. It suggested that the synthetic ETF market was likely to mushroom (in terms of complexity and size) in the current low interest-rate environment as investors seek higher returns. The European Banking Authority’s Standing Committee on Financial Innovation and Consumer Protection (the Committee) has also undertaken detailed research into ETFs. The Committee’s report, published on 01 February 2012, provides analysis of the ETF market in Europe, the different structures of both physical and synthetic ETFs and the current international regulatory framework. The Committee focussed heavily on the various risks (counterparty, liquidity, transparency etc.) facing ETF investors, providers, swap counterparties and market makers and the general supervisory concerns on this rapidly evolving market.

The European Fund and Asset Management Association (EFAMA), and a number of market participants, believe that many of the supervisors’ concerns about synthetic ETFs (or ETFs in general) are not unique and apply to many other products. For example, ‘complex' practices of synthetic ETFs are shared by mutual funds and other UCITS-compliant products. In some areas such as counterparty risk, swap-based ETFs actually offer greater transparency that physical ETF or mutual funds, according to a September 2011 report by Morning Star. While most regulators remain concerned about any ETF which includes a derivative contract, two months ago the Hong Kong's Securities and Futures Commission (SFC) approved synthetic ETFs for the first time since July 2012, perhaps reflecting a shift in the continuing debate.

BlackRock, in its formal response to ESMA’s discussion paper, strongly opposed the ‘complex' designation for UCITS on the grounds that it would ‘not improve investment outcomes’ for end-investors. It stated that the categorisation would result in ‘confusion’ in the market place as the complexity inherent in designing synthetic ETFs is not necessarily related to its ‘risk’ but more generally associated with specific requirements of end-investors. According to BlackRock, the criteria for labelling products ‘complex’ should be based on the factors underpinning its risk (i.e. economic exposure, leverage and payoff) and not on the methods or instruments used to engineer this exposure or payoff. Some observers point out the risk mitigation strategies within synthetic ETFs may actually make them less risky than physical ETFs. However, some firms take a different view; Fidelity, together with a minority of other respondents, has argued strongly for UCITS being split into complex and non-complex categories, with all complex UCITS falling within the remit of the Alternative Investment Fund Management Directive (AIFMD).

We are at a cross-road on ETFs. The direction ESMA takes is likely to shape the ETF market for years to come, as well as having wider implications for other products employing similar techniques. How these issues will play out remains unclear but it is important that market participants ensure their voice is heard again on this issue—consultation on the ESMA guidelines closes on 30 March 2012.


Barnier considers further reforms on remuneration

The EC are considering enacting a pay ceiling for senior executives at banks that would set a maximum multiple between a firm’s highest and lowest-paid salaries, according to Michel Barnier, European Commissioner for Internal Market and Services. In a speech to the European Parliament on 06 February, Barnier warned he ‘will not hesitate’ to introduce further clamp-downs on remuneration practices, if banks continue to pay excessive bonuses. Barnier is also keen to give shareholders greater powers in this space, suggesting that they could have a binding vote on banks’ executive compensation at their annual general meetings.

Together with proposals to set a constant ratio between the fixed and variable part of a banker’s remuneration package - an idea which Barnier first floated in London last month - these changes could have far-reaching implications on EU banks’ ability to attract the best personnel as they seek to re-build their businesses.

As we have seen recently in RBS and further afield, remuneration continues to be a political hot potato. Barnier believes it’s ‘simply unacceptable’ for banks to continue to pay ‘ridiculously’ high bonuses to their staff given the burden of public support they have and continue to receive. He notes that despite calls for banks to exercise ‘the utmost restraint’ when paying bonuses; the situation remains far from acceptable.

Banks have been subjected to significant remuneration reforms since the financial crisis. EU banks are now forced to cap the proportion of their bonuses that are paid out in cash and stocks, deferring some payments over a five-year period. Also, as part of the EBA’s recapitalisation proposals, banks which are unable to meet new capital adequacy requirements will be expected to not pay any bonuses, instead using any discretionary capital as retain earnings.

Clearly the language used, and the measures proposed, indicate that further significant remuneration reform could be on the cards this year, most likely annexed to the Capital Requirement Directive (CRD) IV.


Third countries pursue equivalence assessments under Solvency II

Jonathan Faull, Director General for Internal Market and Services, outlined the progress the EC has made on third country equivalence assessments of third countries under the Solvency II Directive (2009/138/EC). In a letter sent to Gabriel Bernardino, Chairman of the European Insurance and Occupational Pensions Authority (EIOPA), Faull indicated that Australia, Chile, Hong Kong, Israel, Mexico, Singapore and South Africa have all expressed an interest in being part of a transitional regime under Solvency II.

Some jurisdictions are proving a bit harder to tackle. A different approach for equivalence will need to be adopted for the US insurance regime, according the Faull, who outlined details of initial discussions with the US regulator. Japan would like to be included in a transitional regime for third country equivalence in relation to group solvency and group equivalence; opening discussions with the Japanese regulator is being planned for later this year.

The results above are provisional. We expect formal details on the inclusion of third countries into the transitional regime to be published sometime in 2013, following further analysis and discussions between all parties involved.


Implementing complex reforms: lessons learnt from the CCD

The implementation process for the Consumer Credit Directive (CCD) could provide useful insights as to how future financial legislative reforms across the EU may pan-out. The CCD, which came into effect in May 2008, required Member States to harmonise tricky consumer credit legislation across very different legal systems in a relatively short period of time.

This month, the European Parliament’s Committee on Internal Market and Consumer Protection (the Committee) has published a study into the implementation of the CCD in a sample of 14 Member States. As well as considering the implementation of the CCD itself, the study considered the extent to which Member States had applied the CCD's provisions to credit agreements falling outside the CCD's scope.

The study concluded that the time period for transposition was ‘very short’ given the relatively complex subject matter of the Directive. This complexity led to delays in transpositions in some of the Member States. The study also pointed to incorrect implementation of the Directive in some cases which subsequently required further amendments to national legislation.

However, the Committee found that overall most of the fully harmonised aspects of the CCD were been transposed correctly.


EC publishes proposed changes to data protection rules

The European Commission has published its long-awaited proposal to overhaul the Data Protection Directive (DPD). The DPD sets out EU rules on collecting, using, and storing personal information (personal data). It is based on the 1980 OECD ‘Recommendations of the Council Concerning Guidelines Governing the Protection of Privacy and Trans-Border Flows of Personal Data’ which contains the seven personal data principles enshrined in the DPD.

The EC commenced extensive stakeholder consultation in 2009 on revising the DPD. The EC’s General Data Protection Regulation (the DP Regulation) is the result of the resulting consultation is the key piece of a package of revision measures released by the EC, including a Communication outlining the EC’s strategy, a proposed directive containing rules for data processing and other supporting documents.

Significantly, the DP Regulation will further harmonize data protection rules across the Member States, saving firms an estimated €2.3 billion. Further, companies with operations in multiple Member States would be subject to a single data protection authority (DPA), instead of multiple national authorities and simplified procedures will apply to transfers of personal data outside the European Union.

But it presents significant changes to the way that organisations manage data and tougher rules for firms because it:
  • restricts the use of consent to legitimise certain data processing operations
  • eliminates certain bureaucratic requirements, such as notification of data processing to the DPAs, but introduces others (such as maintaining extensive internal documentation about data processing)
  • requires companies with more than 250 employees to appoint a data protection officer
  • introduces new fundamental rights (such as the ‘‘right to be forgotten’’) and
  • requires firms to notify regulators and affected individuals of data security breaches.
The most contentious proposal is a new administrative power which will allow regulators to fine firms up to 2% of their annual worldwide income for breaches.

The EC stated that it will work closely with the European Parliament and the EU Council to ensure an agreement on the DP Regulation by the end of 2012. While member states will have two years after passage until the legislation takes effect, firms will need to begin assessing the impact of the proposed regulations on their operations, business models and terms of business much earlier.