On 25 July, ESMA published its final guidelines on ETFs and Other UCITS issues, Consultation on Recallability of Repo and Reverse Repo Arrangements (the “Guidelines”).

The aim of the Guidelines is to protect investors by providing guidance on the information to be provided to investors, detailing rules to be adhered to when entering into OTC or EPM techniques and the use of FDI and specifying criteria in relation to the use of financial indices.
 
The Guidelines impose a number of operational considerations on funds as well as prospectus disclosure requirements. 

UCITS ETFs

The Guidelines require that the identifier “UCITS ETF” must be used in the name, fund rules or instrument of incorporation, prospectus, KIID and marketing communications of the UCITS ETF.  Additional obligations directed at the secondary market include the requirement that the prospectus disclose the process to be followed should circumstances arise which entitle secondary market investors to redeem directly from the fund, together with potential costs involved. 

Index Tracking UCITS

The prospectus should include a clear description of the index, information on the underlying components and how the index will be tracked (whether a full/sample based physical replication model or synthetic replication model will be used), information on tracking error and details of those factors likely to affect tracking. 

Financial Indices

In relation to assessing compliance of financial indices, the Guidelines require that the index should have a clear, single objective in order to represent an adequate benchmark for the relevant market but will not be considered as being an adequate benchmark if it has been created and calculated on the request of one, or a very limited number of, market participants according to their specifications. Appropriate documented due diligence should be undertaken on the quality of the index.

EPM Techniques, Use of FDI and Management of Collateral

The prospectus should clearly disclose the intention to use EPM techniques and instruments together with a detailed description of the risks involved.  Significantly, the Prospectus should also disclose:

• The policy regarding direct and indirect operational costs/fees arising from EPM techniques that may be deducted from the revenue delivered to the UCITS (which should not include hidden revenue)
• The identity of the entity(ies) to which the direct and indirect costs and fees are paid
• Whether these entities are related parties to the UCITS management company or the depositary

In relation to the use of total return swaps or other FDI, additional disclosure is also required, including regarding:

• Information on the counterparty(ies) to the transactions
• The extent to which the counterparty assumes any discretion over the composition or management of the investment portfolio or over the asset(s) underlying the FDI and whether their approval is required in relation to any investment portfolio transaction
• Where this is the case, the identification of the counterparty as an investment manager

In addition to disclosure of the permitted types of collateral, the prospectus must disclose the level of collateral required, the haircut policy (which should be in place and documented) and in the case of cash collateral, the re-investment policy (including any risks arising therefrom).  The Guidelines set out qualitative and quantitative criteria to be respected by collateral received in the context of OTC financial derivative transactions and EPM techniques and amend Boxes 26 and 9 of the existing ESMA Guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS by providing clarity on the types of assets in which cash collateral arising from both EPM and OTC transactions can be reinvested. Where a UCITS receives collateral for at least 30% of its assets, an appropriate stress testing policy should be in place to ensure regular stress tests are carried out under normal and exceptional liquidity conditions to enable the UCITS to assess the liquidity risk attached to the collateral. 

Compliance

Compliance with the Guidelines will require a review of:

• Current disclosure documents (prospectus, KIID, financials) to ensure appropriate disclosure requirements are met, as additional disclosures will be required
• Operational procedures and policies to ensure that the new requirements in relation to various matters are attended to in the management of the fund
• Contractual arrangements to ensure that the arrangements or commitments currently in place will permit the fund to meet the new requirements
• Board processes to ensure proper oversight of the new requirements and on-going management of them is in place

The Guidelines will be effective two months after their official publication. We are currently awaiting clarification of the date of publication from ESMA and clarification from the Central Bank concerning the process for the issue of updated Central Bank Notices (to take the Guidelines into account).

For further information, please contact one of the key contacts listed above or your usual contact in our Asset Management and Investment Funds Team.