On March 15th, 2013 the European Securities and Markets Authority (ESMA) issued a Q&A document to give further clarity to certain aspects of its guideline document published on December 18th, 2012 in relation to ETFs and other UCITS issues (the "Guidelines"). The Guidelines became effective on February 18th, 2013.
The Q&A document provided clarity mainly on the aspects of the Sections of the Guidelines specified below.
UCITS ETF Label (Section III)
Application at umbrella/sub-fund level - in the case of an umbrella UCITS, the 'UCITS ETF' labeling requirement is applicable to all subfunds which are UCITS ETFs and the UCITS may also apply it at the umbrella level. The requirement does not apply to sub-funds which are not UCITS ETFs.
Secondary Market (Section V)
Redemption Price - with regards to the redemption price where secondary market investors are given the possibility to redeem directly at the level of the UCITS ETF, the redemption price should be the NAV from which costs may be deducted (such cost not to be excessive).
EPM Techniques (Section VI)
Fees to Securities Lending Agents - the Guidelines do not prohibit the deduction of fees paid to securities lending agents from gross revenues arising from EPM techniques, as a normal compensation for its services. However, the annual report of the UCITS should contain details on the revenues arising from EPM techniques for the entire reporting period together with direct and indirect operational costs and fees incurred.
UCITS management company also acting as a securities lending agent - in jurisdictions where a UCITS management company may also act as a securities lending agent, the investor should be informed of this pursuant to Paragraph 28 of the Guidelines. The investors should also be provided with details of the amount of fees paid to the UCITS management company that may be deducted from the gross revenues arising from EPM techniques (see Paragraph 35).
FDIs (Section VII)
Unfunded swap - in circumstances where a UCITS enters into an unfunded swap, where it swaps the performance of its assets against the performance of another portfolio of assets, the UCITS should not combine both the assets swapped out and the exposure swapped into the UCITS when assessing the investment limits laid down in Article 52 of the UCITS Directive. The reasoning behind this is that the ultimate exposure of the UCITS is not a combination of the two portfolios. Total Return Swaps/Other FDIs - in response to a query on the meaning of total return swaps "and other financial derivative instruments with similar characteristics", ESMA outlined firstly that total return swaps should be treated like any other FDI and secondly that ESMA's intention was to make sure that the Guidelines are not circumvented by using other FDIs which are not total return swaps but have similar characteristics.
Collateral Management (Section VIII)
Application of collateral requirements - the collateral requirements apply to all assets received in the context of OTC financial derivative transactions and EPM techniques to cover counterparty risk, not just fraction of assets that reduce counterparty risk of UCITS to the limit imposed by the UCITS Directive. This requires that assets received in excess (after the application of haircuts) should comply with the same requirements.
Diversification - reinvested cash collateral should be diversified in accordance with the diversification requirements applicable to non-cash collateral (20% per issuer limit - Paragraph 43 (e) of Guidelines). The diversification requirement refers to the NAV of the UCITS. The 20% limit applies to the issuers not to the issue. When assessing the diversification of the collateral received by a UCITS, re-invested cash collateral should be aggregated with non-cash collateral.
Correlation - collateral received by the UCITS should be issued by any entity that is independent from the counterparty and is expected not to display a high correlation with the performance of the counterparty. Therefore, collateral issued or guaranteed by the counterparty of an OTC FDI or EPM technique or by one of its subsidiaries or by a parent company should not be considered compliant with the Guidelines.
Title transfer - where a transfer of title is to a custodian that is not the depository of the UCITS, it is possible to do so only where the UCITS' depository has delegated the custody of the collateral to a sub-custodian and the depositary remains liable if the collateral is lost by the sub-custodian. Tripartite agreements are possible as long as there is no title transfer and the collateral is held by a third party custodian subject to prudential supervision and that is unrelated to the provider of the collateral.
Counterparty Risk Limit - the Guidelines require that counterparty risk exposures are aggregated across both financial derivative instruments and EPM techniques, these should both be combined when calculating the counterparty risk limits of Article 52 of the UCITS Directive.
Financial Indices (Section IX)
Application of Guidelines - the Guidelines on financial indices apply only to UCITS that are using financial indices for investment purposes and to any UCITS investing in financial indices and not only to index-tracking UCITS.
Transparency Requirements - if a financial index is comprised of other indices, the transparency requirements under Paragraph 56 of the Guidelines will be applicable to the underlying indices. Timing of Publication of index weightings - this can be done retrospectively and should be published before the next rebalancing of the index. So if an index rebalances on a monthly basis, information on the weightings of the index components should be provided as soon as possible after the rebalancing but within one month of the rebalancing.
Technical adjustments - Paragraph 54 of the Guidelines prohibits investment in financial indices which re-balance on an intra-day basis but notes "technical adjustments" made to such indices should not be considered as re-balancing. Technical adjustments in the context of the Guidelines are adjustments which:-
(i) are based solely on algorithmic non-subjective frameworks;
(ii) are generally published on an ex-ante basis;
(iii) draw on publicly available criteria;
(iv) do not rely on the judgement of the index-provider.
Transitional Provisions (Section X)
Application of Paragraphs 43-45 and 46 of Guidelines (Section VIII Collateral Management) - UCITS existing before the Guidelines should comply with Paragraphs 43-45 and 46 within 12 months of the date of application of the Guidelines. However, as per Paragraph 65 (alignment of collateral portfolio), any new reinvestment of cash collateral made by such existing UCITS after the application date of the Guidelines should comply with the Guidelines immediately.
Tracking Error - where a tracking error occurs for a UCITS with an accounting period that ends within 12 months of the date of the application of the Guidelines and the UCITS has not amended its Prospectus in line with the Guidelines, the existing UCITS need only provide information on the realised tracking error. Information on the anticipated tracking error and any difference between the two can be reported from the next accounting period.
EPM techniques - UCITS that exist before the date of application of the Guidelines should amend the agreements governing EPM techniques in accordance with Sections X and XII of the Guidelines as soon as possible. This should be done 12 months after the date of application of the Guidelines at the latest.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.