The Central Bank has published a Consultation Paper in which it proposes the introduction of additional rules (applicable to all UCITS) in respect of the credit quality of collateral received by UCITS.

Background

On 20 December 2013, ESMA published a Consultation Paper on its proposal to grant UCITS money markets funds (MMFs) a derogation from the requirements of paragraph 43(e) of ESMA’s Guidelines on ETFs and other UCITS issues (Guidelines). Paragraph 43 (e) requires that all collateral used to reduce counterparty risk exposure should be sufficiently diversified in terms of country, markets and issuers. ESMA proposed that a UCITS MMF would be permitted to receive collateral of up to 100% of the UCITS’ net asset value in different transferable securities and money market instruments issued or guaranteed by an EU Member State, one or more of its local authorities, a third country, or a public international body to which one or more EU Member States belong, provided that:

• Such a UCITS would receive securities from at least six different issues
• Securities from any single issue would not account for more than 30% of the collateral received

ESMA subsequently published its final report which confirmed that all UCITS would be permitted to avail of the derogation set out in the initial Consultation Paper, subject to compliance with the conditions set out above. 

Central Bank Consultation Paper

On 28 July 2014 the Central Bank published a Consultation Paper outlining its concerns regarding the extension of the proposed derogation to all UCITS.  Its concerns derive mainly from the fact that, though the Guidelines require collateral received to be of “high quality”, high quality is not a defined term within the Guidelines. 

In light of this, the Central Bank believes that there are strong grounds for limiting the derogation set out in the Final Report to UCITS MMFs. However, such limitation would mean that Irish rules on UCITS collateral would be substantially different from those prevailing in other Member States. The Central Bank is therefore willing to approve the extension of the derogation to all UCITS, but, for the purpose of mitigating risk, the Central Bank is proposing the introduction of additional rules (applicable to all UCITS) in respect of the credit quality of collateral received by UCITS:

• In determining whether collateral is of high quality (as required by the Guidelines) the UCITS must conduct an assessment prior to accepting the collateral which assessment takes into account:
  • The credit quality of the instrument
  • The nature of the asset class represented by the collateral
  • Any operational risk
  • Any other significant related counterparty risk
  • The liquidity profile of the collateral
• Where the acceptance of the collateral would mean that the collateral issuer constituted more than 20% of the total collateral held by the UCITS, the UCITS must apply the additional resources which a prudent UCITS would apply to a more detailed assessment of the credit quality of that collateral.
• The credit quality of already-accepted collateral should be monitored by a UCITS on an on-going basis. Additional resources will continue to be applied to the more frequent and more detailed re-assessment of collateral issuers who constitute more than 20% of the collateral of a UCITS.
• Where there is evidence of deteriorating credit quality of collateral held, a UCITS must put into prompt action a plan to remedy its exposure to that collateral of deteriorating quality in an orderly manner and should prioritise the reduction of its exposure to any collateral counterparty representing more than 20% of the collateral held.
• Unless the board of the management company / investment company, explicitly and specifically on each occasion a decision is to be made, decides otherwise, the UCITS will not accept as new or replacement collateral, or continue without a timely remediation plan to hold, any rated collateral which has not been awarded or does not continue to hold one of the two highest available ratings by each recognised credit rating agency that has rated the instrument.

The proposed rules will be published in the UCITS Rulebook which will consolidate the existing UCITS Notices, Guidance Notes and Policy Papers into a single document.

Questions for consideration

In the Consultation Paper the Central Bank requests that stakeholders provide a response to each of the following questions in particular:

1. Do you agree that the concerns of the Central Bank outlined in the Consultation Paper are valid?
2. Do you consider that the Central Bank should implement the ESMA Guidelines but limit the derogation from the collateral diversification requirements to UCITS money market funds?
3. Do you agree with the proposed rules on the credit quality of collateral? Is there another way to achieve a satisfactory risk mitigation effect?

Consultation responses

All comments on the proposed rules and on the questions raised in 1. to 3. above should be submitted by email to [email protected] or in writing to:

Adoption of ESMAs revised guidelines on ETFs and other UCITS issues
Markets Policy Division
Central Bank of Ireland
Block D Iveagh Court
Harcourt Road
Dublin 2

The deadline for submission of comments is 17 October 2014.

It should be noted that all responses will be published on the Central Bank’s website. As a result, commercially confidential information should not be included in responses to the Consultation Paper.

Contributed by Niall Crowley