In September 2017, the European Securities and Markets Authority ("ESMA") launched a peer review on its Guidelines on ETFs and other UCITS issues (the "Guidelines"). The aim of the peer review, conducted by an independent group of experts, was to assess compliance by 6 jurisdictions, including Ireland, with a subsection of the Guideline's requirements relating to efficient portfolio management techniques ("EPM"), including securities lending. On 30 July 2018, following completion of the peer review, ESMA published its report setting out findings regarding compliance, identifying good practices and policy considerations for follow-up by ESMA.
The peer review was positive in relation to Ireland and found it to have a "well-structured and robust process around the use of EPM by UCITS". Ireland was also highlighted as having in place a number of good practices including the issuance by the Central Bank of Ireland (the "Central Bank") of guidance and Q&As to assist UCITS in addressing the EPM requirements in the Guidelines. However, certain breaches by other jurisdictions of the Guidelines were specified in ESMA's report including of the requirement that all revenues arising from EPM should be returned to the UCITS, net of direct and indirect operational costs and that these costs should not include hidden revenues. The peer review also found that, notwithstanding the absence of any exemption in the Guidelines, certain other jurisdictions had granted permission to market participants to diverge from the collateral management requirements for EPM.
The peer review group identified a number of policy follow-ups for ESMA which may well be indicative of areas of focus for future guidance from ESMA.
Potentially the most significant of these was in the context of collateral management and specifically a possible inconsistency between the Guidelines and the requirements under the UCITS Directive. ESMA's report notes that "While the Guidelines refer to 'title transfer' and 'other types of collateral management' (such as pledging arrangements) to be permissible for collateral received by the UCITS for its EPM, the text of Art. 22(7) stipulates that the assets held in custody by the depositary are allowed to be reused only where the transaction is covered by high-quality and liquid collateral received by the UCITS under a title transfer arrangement." There has been some uncertainty in the market, potentially due in part to this inconsistency, as to the ability of UCITS to lend out assets under transactions covered by more flexible collateral arrangements than title transfer. In November 2017, the Central Bank outlined its view that title transfer arrangements for securities lending transactions were not mandated by the Guidelines or the Central Bank "Rather, the Guidelines (and the Central Bank UCITS Regulations) provide for the possibility of pledge arrangements".
The level of regulation in the area of securities lending by UCITS has increased over recent years following the introduction of requirements such as those set out in the Guidelines and also the Securities Financing Transactions Regulation. The International Securities Lending Association, in its latest Market Report dated December 2016, concludes that the gap between lendable supply of mutual/retail funds including UCITS (45% of global lendable securities) and their share of on loan balances (15% of the total on loan balance globally) is "for the most part due to the restrictive regulatory environment that UCITS face in Europe".
It is unlikely therefore, that the market will welcome the clarification in ESMA's report that the UCITS Directive requires collateral for UCITS securities lending transactions to be by way of title transfer. As regards next steps, the peer review group has recommended that any policy follow-up by ESMA "regarding the Guidelines should give consideration to addressing the potential inconsistency of para. 43(g) of the Guidelines with the Art. 22(7) (d) of the UCITS Directive regarding the aforementioned collateral arrangement requirements". It is also likely that the Central Bank will look to update its UCITS Regulations to address this inconsistency.
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