The European Securities And Markets Authority’s New Guidelines On Exchange Traded Funds And Other UCITS Issues

On July 25, 2012, the European Union’s European Securities and Markets Authority (“ESMA”) published guidelines on exchange traded funds (“ETFs”) and other undertakings for collective investment in transferable securities (“UCITS”) issues (the “Guidelines”), which follow on from a process of discussion and consultation in 2011 and 2012 with industry stakeholders. On the same date, ESMA also launched a consultation on certain aspects of the use of repo and reverse repo arrangements by UCITS (the “Consultation”).

This article provides an overview of some of the key features of these developments.

ESMA Guidelines on ETFs and Other UCITS Issues

Key points which we have identified from ESMA’s Guidelines are as follows:

UCITS ETFs: Use of Identifier

The Guidelines stipulate that a UCITS ETF must use the identifier “UCITS ETF” in the fund’s name, its instrument of incorporation, prospectus, key investor information document (“KIID”) and marketing communications. The fund must also disclose clearly in its prospectus, KIID and marketing communications the policy regarding portfolio transparency and where information on the portfolio may be obtained (including where the indicative net asset value, if applicable, is published). ESMA provides that the fund must also disclose clearly in its prospectus how the indicative net asset value is calculated (if applicable) and the frequency of calculation.

A requirement to use an identifier to distinguish between physical and synthetic ETFs has not been included in the Guidelines.

Actively Managed UCITS ETFs

The Guidelines specify that an actively managed UCITS ETF should inform investors clearly in its prospectus, KIID and marketing communications that it is actively managed and how it will meet the stated investment policy (including, where applicable, the fund’s intention to outperform an index).

Treatment of Secondary Market Investors of UCITS ETFs

The Guidelines provide that, if the stock exchange value of the units or shares of a UCITS ETF significantly varies from its net asset value (for example, in the case of market disruption such as the absence of a market maker), investors who have acquired their units or shares on the secondary market should be allowed to sell these directly back to the UCITS ETF. In such situations, the Guidelines require that information should be communicated to the regulated market indicating that the UCITS ETF is open for direct redemptions at the level of the UCITS ETF. The prospectus of the UCITS must also contain a description of the process to be followed by such investors together with disclosure on the costs involved, which the Guidelines mandate “should not be excessive”.

Efficient Portfolio Management Techniques

A UCITS entering into efficient portfolio management techniques (“EPM”), such as securities lending activities, must inform its investors clearly through its prospectus about these activities, the related risks and the impact EPM will have on the performance of the UCITS.

On the question of costs arising from EPM and revenues generated, the Guidelines specifically state that the fund’s prospectus must disclose the policy regarding direct and indirect operational costs/fees arising from EPM which may be deducted from the revenue delivered to the UCITS and that “these costs and fees should not include hidden revenue”. ESMA’s rules then go on to provide that “all the revenues arising from [EPM], net of operating costs generated by these activities should be returned to the UCITS”. The identity of the entities to which direct and indirect costs and fees are paid, including whether these entities are related parties to the management company or the depositary, must be disclosed in the prospectus. Further disclosures are required in the annual report, comprising details of the exposure obtained through EPM, the identity of the counterparties, the type and amount of collateral received by the UCITS to reduce counterparty exposure and the revenues arising from the use of the EPM, together with the direct and indirect operational costs and fees involved.

As regards liquidity, EPM operations are required to be taken into account in the context of the liquidity risk management process and the ability to comply with redemption obligations.

A further point to note arising from this section of the Guidelines is that ESMA requires UCITS entering into securities lending arrangements to be able, at any time, to recall any securities lent or to terminate any agreement into which it has entered. This is already applied by the Central Bank of Ireland, which also requires that the relevant agreement must provide that, once notice is given, the borrower is obligated to redeliver the securities within five business days or another period as normal market practice dictates.

Management of Collateral for OTC Financial Derivative Transactions and EPM

The Guidelines require that the risk exposures to a counterparty arising from OTC financial derivative transactions and EPM should be combined when calculating counterparty risk limits. Whilst this operates as a modification to ESMA’s existing guidelines on OTC counterparty risk exposure, this is already the position followed by Irish domiciled UCITS.

For UCITS engaging in OTC financial derivative transactions or EPM, all collateral used to reduce counterparty exposure must comply with the list of prescribed criteria which are set out in the Guidelines. These are a modification of the existing ESMA high level principles on collateral, and include requirements for liquidity, valuation, issuer credit quality, correlation, diversification and the enforceability of OTC financial derivative transactions and EPM collateral. Some of the main changes relate to:

• Issuer credit quality: The Guidelines require that “collateral received should be of high quality”. Previously, collateral rated below A-1 or equivalent was subject to “conservative haircuts”. The revised position would appear to preclude this approach.

• Liquidity: The Guidelines specify that any collateral received other than cash should be “highly” liquid (as opposed to the previous threshold of “sufficiently” liquid). The Guidelines reflect that collateral received other than cash must be traded on a regulated market or multilateral trading facility with transparent pricing in order that it can be sold quickly at a price that is close to pre-sale valuation.

• Valuation: As per the existing guidance, collateral received should be valued on at least a daily basis. The Guidelines go on to specify, however, that assets which “exhibit high price volatility should not be accepted as collateral unless suitably conservative haircuts are in place”.

• Rules on collateral diversification (asset concentration): The existing high level principles stated that “there is an obvious risk if collateral is highly concentrated in one issue, sector or country”. The ESMA Guidelines provide that collateral must be sufficiently diversified in terms of country, markets and issuers; that the requirement for sufficient diversification with respect to issuer concentration will be deemed to be satisfied if the UCITS receives from an EPM or OTC financial derivative transaction counterparty a basket of collateral with a maximum exposure to a given issuer of 20 percent of its net asset value; and when UCITS are exposed to different counterparties, the different baskets of collateral must be aggregated to calculate the 20 percent limit of exposure to a single issuer.

It might be noted that these collateral diversification rules do not appear to provide for any exception for governmental securities received as collateral, which may be an oversight.

• Investment of cash collateral: The ESMA Guidelines revise the previous high level ESMA principle which simply stated that “cash collateral can only be invested in risk free assets”. The Guidelines mandate that cash collateral received must only be:

• placed on deposit with entities prescribed in Article 50(f) of the EU UCITS Directive;

• invested in high-quality government bonds;

• used for the purpose of reverse repo transactions, provided the transactions are with credit institutions subject to prudential supervision and the UCITS is able to recall at any time the full amount of cash on an accrued basis; or

• invested in short-term money market funds as defined in ESMA’s money market fund guidance.

The Guidelines add that re-invested cash collateral should be diversified in accordance with the diversification requirements applicable to non-cash collateral.

These mandatory categories for investment of cash collateral would appear to be narrower in certain respects than the corresponding provisions which are currently applied by the Central Bank of Ireland within its rules on EPM (and note that, for OTC financial derivative transactions, the Central Bank of Ireland rules apply the previous ESMA high level principle referred to above regarding investment of cash collateral in risk free assets). Furthermore, we would note that, in terms of the diversification requirement within the ESMA Guidelines, there is no exception for cash collateral invested in government or other public securities or money market funds.

• Correlation: Existing ESMA guidance stated that correlation between the OTC counterparty and the collateral received “must be avoided”. The newly issued Guidelines specify that collateral received by UCITS should be issued by an entity that is 1) independent from the counterparty and 2) not expected to display a high correlation with the performance of the counterparty.

With respect to stress testing, ESMA’s Guidelines apply a regular stress testing requirement in circumstances where a UCITS receives collateral for at least 30 percent of its assets.

Finally, it should be noted that, in terms of disclosure requirements, the ESMA Guidelines require the prospectus to disclose the collateral policy of the UCITS, including the permitted types of collateral, the level of collateral required, the fund’s haircut policy (adapted for each class of assets received as collateral) and the re-investment policy in respect of cash collateral. The Guidelines also provide that the haircut policy must be documented and should justify each decision to apply a specific haircut, or to refrain from applying a haircut, to a certain class of assets.

Financial Indices

As expected, the Guidelines introduce significant limitations on indices which may be deemed as eligible for investment by UCITS. In particular, a UCITS should not invest in the following financial indices:

• financial indices whose rebalancing frequency prevents investors from being able to replicate the financial index. Indices which rebalance on an intra-day or daily basis may not be deemed as eligible indices;

• financial indices for which the full calculation methodology is not disclosed by the index provider, including detailed information on index constituents, index calculation, rebalancing methodologies, index changes and information on any operational difficulties in providing timely or accurate information;

• financial indices that do not publish their constituents together with their respective weightings; and

• commodity indices which are not sufficiently diversified. In this regard, sub-categories of the same commodity (e.g., WTI Crude Oil, Brent Crude Oil, Gasoline, and Heating Oil) should be considered as being the same commodity for the calculation of the diversification limits unless it can be demonstrated that their prices are not highly correlated.

The UCITS must be able to demonstrate that a financial index it invests in has a clear, single objective in order to represent an adequate benchmark for the market, and the universe of index components and the basis on which these components are selected for the strategy should be made clear to investors and competent authorities. An index will not be considered as being an adequate benchmark of a market if it has been created and calculated on the request of one market participant, or a very limited number of market participants, and according to the specifications of those market participants.

UCITS Entering into a Total Return Swap or Investment in Other Financial Derivative Instruments with Similar Characteristics

The Guidelines state that where a UCITS enters into a total return swap or invests in other financial derivative instruments with similar characteristics, the assets held by the UCITS should comply with the investment limits set out in the EU UCITS Directive. This is consistent with existing Irish requirements. The prospectus disclosures required by ESMA include information on the underlying strategy and composition of the investment portfolio or index; information on the counterparty/ies; and a description of the risk of counterparty default and the effect on investor returns.

If a UCITS’ counterparty has discretion over the composition or management of the UCITS’ investment portfolio or of the underlying of the financial derivative instrument, then the agreement between the UCITS and the counterparty is deemed an investment management delegation arrangement. OTC swap arrangements which provide for such terms will need to be reviewed carefully, and possibly restructured, to ensure compliance with this requirement.

Index Tracking UCITS

The Guidelines introduce a new requirement for index tracking UCITS to disclose their anticipated level of tracking error in normal market conditions, and a description of the factors likely to affect the ability of the UCITS to track the performance of the index.

The annual and half yearly reports of the index tracking UCITS will be required to disclose the size of the tracking error at the end of the period under review, together with an explanation of any divergence between the anticipated and realised tracking error for the relevant period. The annual report must also disclose and explain the annual tracking difference between the performance of the UCITS and the performance of the index tracked.

Regarding information on the index to be disclosed in the prospectus, the ESMA Guidelines mandate a clear description of the relevant index, to include information on underlying components. A further direction from ESMA relates to the exact composition of an index, with respect to which the Guidelines state that investors can be directed to a website from the prospectus where the exact compositions of the indices are published.

Effective Date and Grandfathering Provisions

New UCITS created after the date of application of the Guidelines are required to comply immediately with the new rules. With respect to existing UCITS, ESMA has set out a number of grandfathering provisions to apply in specific cases, as follows:

• Existing UCITS with revenue sharing arrangements relating to EPM must comply with the new disclosure rules within 12 months of the application date of the Guidelines.

• Existing UCITS that invest in financial indices and which do not comply with the Guidelines should align their investments with the Guidelines within 12 months of the application date.

• Structured UCITS (with a pre-determined maturity date) in existence before the application date are not required to comply with the Guidelines, provided they do not accept any new subscriptions after the application date.

• Existing UCITS are required to align their collateral portfolio with the Guidelines within 12 months of the application date. Any reinvestment of cash collateral after the application date must comply with the Guidelines immediately.

• Existing UCITS ETFs must comply with the Guidelines relating to identifiers on the first occasion after the application date on which the name of the fund is changed for another reason, or 12 months after the application date, whichever date is earlier.

• Existing UCITS ETFs should comply with the provisions relating to the treatment of secondary market investors from the application date.

• Requirements in respect of the contents of the fund rules, instruments of incorporation, prospectus, KIID or marketing materials that were issued prior to the application date do not come into effect until the first occasion after the application date on which the relevant document (having been revised or replaced for another purpose) is published, or 12 months after the application date, whichever date is earlier.

• Requirements to publish information in the annual report do not apply in respect of any accounting period that has ended before the application date.

In terms of when the new rules enter into force, although ESMA refers to an “applicable date” within the Guidelines, a concrete date has not been set. Rather, ESMA has simply instructed that the additional rules which will emerge from the Consultation on repos (which closes on September 25, 2012) will be incorporated into the Guidelines issued on July 25, 2012 (following appropriate consideration of feedback and finalisation); that the Guidelines as a whole will require translation into all of the official languages of the European Union; and that there will then follow a two month period after the publication of the translations on ESMA’s website, upon the expiration of which the Guidelines come into effect — this is referred to as the “application date”. We understand from ESMA that, taking these steps into account, a reasonable estimate for the Guidelines to come into force is February 2013. Having said that, now that the Guidelines have been published, it will be expected that market participants will move to prepare themselves to comply with the new requirements which they are now on notice of.

ESMA Consultation on Recallability of Repo and Reverse Repo Arrangements

In addition to the Guidelines published within the ESMA release dated July 25, 2012, ESMA launched a Consultation with proposals on the recallability of assets subject to repo and reverse repo arrangements entered into by UCITS. In contrast to the approach for securities lending arrangements, the proposed treatment for repo and reverse repo arrangements would allow a UCITS to permit a proportion of assets to be non-recallable at any time at the initiative of the UCITS.

This option leaves open the possibility for UCITS to enter into fixed term repo and reverse repo arrangements under which the assets are not recallable for a certain proportion of their assets, provided that the relevant UCITS applies certain safeguards to ensure that the counterparty risk arising from these arrangements would be limited and the ability to execute redemption requests is not compromised. The Consultation includes a request for respondents to give their views on what the appropriate percentage of non-recallable assets should be, and asks whether respondents believe that there should be a minimum number of counterparties to the arrangements pursuant to which the assets are not recallable at any time.

ESMA is seeking comments by September 25, 2012.

Comment

There has been much media comment since the publication of the new Guidelines about the impact which some of the changes will have on the funds industry (and in particular on the effect the securities lending revenue sharing rules will have on funds which use securities lending).

In relation to a number of the changes featured within the ESMA rules, it is more than fair to say that many of these had been anticipated, following on from the discussion and consultation processes which had been run in 2011 and earlier this year. In addition, from an Irish perspective, certain provisions featuring within the Guidelines which represent changes from the previous ESMA position are matters which are already familiar to Irish UCITS and applied by the Central Bank of Ireland.

With respect to the rules around the return of revenue arising from EPM to the UCITS, the framework prescribed by ESMA foresees that direct and indirect operational costs and fees will be allocated and deducted. This will be aligned with a disclosure regime with regard to the identity of the entities to which direct and indirect costs and fees are paid, including whether these entities are related parties to the management company or the depositary. The new rules do not appear to specifically require a description or itemised breakdown of the services provided in return for the corresponding consideration to be deducted from the revenue generated, nor has a proportionality measure been specifically prescribed — although this would more than likely be the expected approach in the application of the new rules.

Michael Jackson is a Partner, Elizabeth Grace is a Consultant, and Dualta Counihan is a Partner with Matheson Ormsby Prentice, Dublin. They may be contacted at michael.jackson@mop.ie, elizabeth.grace@mop.ie, and dualta.counihan@mop.ie.