Summarised below are the provisions of draft UCITS Notice 10 and draft Guidance Note 3_03 which may necessitate a revision of the RMP of an existing UCITS.
It should be noted that while some of the changes would amount to straightforward updates of the text of an RMP, it may also be necessary to carry out a re-appraisal of the methodology used by a UCITS to calculate global exposure. This may result in a fundamental revamp of the RMP to reflect the fact that, for example, the use of the commitment approach in respect of the relevant UCITS is no longer permitted by UCITS Notice 10, due to the investment strategies of the UCITS or the extent of its use of exotic derivatives.
Finally, existing RMPs will contain a worked example of the manner in which global exposure is calculated. The calculations which make up such worked example must be carefully reviewed to determine how the worked example will need to be re-worked to reflect the provisions of the Notice and Guidance Note.
A UCITS must calculate counterparty risk exposure using the positive mark-to-market value of the OTC derivative contract(s) entered into with that counterparty. It is no longer necessary to supplement that value with an add-on calculation for future credit exposure.
Netting of OTC FDIs with the same Counterparty
The Notice specifies that netting is only permissible with respect to OTC FDIs with the same counterparty and not in relation to any other exposures the UCITS may have with the same counterparty.
Collateral received from a Counterparty to an OTC FDI
The criteria applicable to the collateral received from a counterparty to an OTC FDI have been significantly revised. In addition, UCITS Notice 12 no longer contains a restrictive list of the types of securities which the Central Bank regards as acceptable collateral.
Calculation of Issuer Concentration Risk
Net Exposure generated through a Stock Lending or Repurchase Agreement
The calculation of the issuer concentration limits laid down in the UCITS Regulations must take account of any net exposure to a counterparty generated through a stock lending or repurchase agreement (net exposure refers to the amount receivable by a UCITS less any collateral provided to the UCITS).
Exposures created through the reinvestment of collateral must also be taken into account in the issuer concentration calculations. In this context it should be noted that paragraph 5.4 of the draft Guidance Note 3/03 states that UCITS may not engage in stock lending if the objective in so doing is to generate leverage through the reinvestment of collateral.
The draft Notice requires that position exposure to FDIs embedded in collective investment schemes must also be taken into account when determining whether the investment limits set out in Articles 52 and 55 of the UCITS Directive are being complied with.
In addition, the draft Notice provides that though the position exposure resulting from FDIs can be calculated on the basis of the commitment approach, the maximum potential loss as a result of default by the issuer must be used if to do so would be more conservative.
The conversion methodologies set out in the CESR Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk have been inserted into Appendix 1 of draft UCITS Notice 10 (paragraph 2.1 of Guidance Note 3/03 contains illustrative numeric examples of those methodologies). It would be advisable to insert this Appendix 1, either in full or in part, into an RMP so that the conversion methodology to be used in respect of each type of derivative that may be invested in by the relevant UCITS is clear.
Use of Netting and Hedging to reduce a UCITS global exposure
UCITS Notice 10 defines “netting arrangements” as combinations of trades on FDIs and/or security positions which refer to the same underlying asset, irrespective in the case of FDIs, of the contracts’ due date; and where the trades on FDIs and/or security positions are concluded with the sole aim of eliminating the risks linked to positions taken through the other FDIs and/or security positions. “Hedging arrangements” are defined as combinations of trades on FDIs and/or security positions which do not necessarily refer to the same underlying asset and where the trades on FDIs and/or security positions are concluded with the sole aim of offsetting risks linked to positions taken through the other FDIs and/or security positions.
The criteria to be used to determine whether a combinations of trades can be regarded as a netting or hedging arrangement is set out in Guidance Note 3/03. The latter also contains worked examples of valid netting and hedging arrangements and details of hedging strategies which comply with the criteria in the draft Notice and those which do not.
It must be clear from the RMP of each UCITS that the netting and hedging arrangements which may be engaged in by the UCITS will be valid in the context of the criteria imposed by the UCITS Notice and Guidance Note.
FDIs which need not be included in the Commitment Calculation
Where the use of an FDI does not generate incremental exposure for a UCITS, the underlying exposure need not be included in the commitment calculation.
Draft UCITS Notice 10 also makes it clear that an FDI need not be taken into account when calculating the commitment if it fulfils certain characteristics, e.g. it swaps the performance of financial assets held in the UCITS portfolios for the performance of other reference financial assets. However, paragraph 35 of the UCITS Notice 10 imposes the following additional conditions:
- The combined holding by the UCITS of a FDI relating to a financial asset and cash which is invested in risk free assets is equivalent to holding a cash position in the given financial asset; and
- The FDI is not considered to generate any incremental exposure and leverage or market risk.
Calculation of Global Exposure
Techniques and Instruments employed to generate additional Leverage or Exposure to Market Risk
Where a UCITS employs techniques and instruments, including repurchase agreements, in order to generate additional leverage or exposure to market risk the UCITS must take these transactions into consideration when calculating global exposure.
Where UCITS are permitted to undertake repo transactions to generate additional leverage through the reinvestment of collateral, any global exposure generated, along with the global exposure created through the use of FDI, must not be greater than 100% of the net asset value of the UCITS.
Calculation of Global Exposure Intra-Day
The draft UCITS Notice 10 requires that, depending on the investment strategy, it may be necessary to calculate global exposure intra-day.
Value at Risk (VaR) Approach
Investment Strategies which necessitate the Use of an Advanced Risk Measurement Methodology
Draft UCITS Notice 10 now provides that a UCITS must use an advanced risk measurement methodology (supported by a stress testing program) such as the Value-at-Risk (VaR) approach to calculate global exposure where:
- The UCITS engages in complex investment strategies which represent more than a negligible part of the UCITS investment policy; and/or
- The UCITS has more than a negligible exposure to exotic derivatives; and/or
- The commitment approach does not adequately capture the market risk of the UCITS portfolio.
The Guidance Notes lists the investment strategies for which the commitment approach does not adequately capture the related risks. These are: (a) option strategies (e.g. delta-neutral or volatility strategies); (b) arbitrage strategies (e.g. arbitrage on the interest rate curve, convertible bond arbitrage etc.); and (c) complex long/short and/or market neutral strategies.
Material Market Risks to be taken into account by each VaR Model
The Guidance Note requires that all the risk factors which have more than a non-negligible influence on the fluctuation of the portfolio’s value must be covered by the VaR model.
Quantitative and Qualitative Minimum Requirements
The quantitative and qualitative minimum requirements which must be complied with by a UCITS when assessing global exposure by means of a relative or absolute VaR approach have been significantly amended.
A number of the amendments deserve a special mention:
- Currently, the Central Bank permits the absolute VaR of a UCITS to exceed the 20% limit where it is satisfied that such an increase will not increase the overall risk profile of the draft UCITS to an unacceptable degree. Under UCITS Notice 10 the Central Bank will no longer have this discretion.
- The existing parameters applicable to the calculation of absolute and relative VaR have been refined by UCITS Notice 10 and the latter has also added additional parameters. The parameters set out in UCITS Notice 10 are as follows:
- Oone-tailed confidence interval of 99%
- Holding period equivalent to 1 month (20 business days)
- Effective observation period (history) of risk factors of at least 1 year (250 business days) unless a shorter observation period is justified by a significant increase in price volatility (for instance extreme market conditions)
- Quarterly data set updates, or more frequent when market prices are subject to material changes
- At least daily calculation.
Independent Validation of the VaR Model
The VaR Model used by a UCITS will be required to undergo validation by a party independent of the “building process” so as to ensure that the model is conceptually sound and captures adequately all material risks.
Draft UCITS Notice 10 contains detailed requirements in respect of the back testing program which must be conducted by a UCITS to monitor the accuracy and performance of its VaR Model. Such a UCITS will be required to carry out a back testing program at least on a monthly basis and the UCITS Notice contains a comprehensive description of the required characteristics and mechanics of a UCITS back testing program. Clearly, the back testing carried out on the VaR model utilised by an existing UCITS will have to be re-structured in accordance with these requirements.
Draft UCITS Notice 10 also now contains more stringent provisions surrounding the nature of the stress tests that must be carried out by a UCITS which utilises a VaR model. However, the Guidance Note does state that the complexity of the stress tests should be in line with the risk profile of the UCITS.
It will be necessary to revise the RMP of an existing UCITS to incorporate the additional steps and procedures required by the Notice and Guidance Note.
VaR: Additional safeguards and disclosure
Appendix 3 also contains the following general requirements:
- A UCITS which calculates global exposure using a VaR methodology must regularly monitor its leverage.
- A UCITS must supplement the VaR/Stress Testing framework, where appropriate, by taking into account the risk profile and the investment strategy being pursued, with other risk measurement methods.
Strategies that are not suited to the Relative VaR Approach
An existing UCITS should determine whether the relative VaR model used by it is appropriate, as the Guidance Note states that investment strategies suited to the relative VaR approach are those where a leverage free benchmark is defined for the UCITS, reflecting the investment strategy which the UCITS is pursuing. In contrast, UCITS investing in multi-asset classes and that do not define the investment target in relation to a benchmark but rather as an absolute return target, are suited to the absolute VaR approach.
Criteria applicable to the reference Portfolio
The Guidance Note has introduced a number of additional criteria applicable to the selection of a reference portfolio. These criteria include a requirement that the reference portfolio should not contain financial derivatives or embedded derivatives, so as to avoid any leverage inside the reference portfolio itself except for UCITS engaging in long/short strategies.
Clearly the reference portfolio of any UCITS that uses relative VaR must be revisited to ensure that it complies with the criteria outlined in the Guidance Note.
Repurchase/Reverse Repurchase and Stock Lending Agreements
Collateral obtained under a Repo or Stock Lending Agreement
Draft UCITS Notice 12 no longer prescribes acceptable forms of collateral. However, the Guidance Note does contain the following criteria that such collateral must comply with at all times:
- Liquidity: Collateral should normally trade in a highly liquid marketplace with transparent pricing.
- Valuation: Collateral should never be valued on the basis of a stale price and the value must be capable of independent verification.
- Issuer credit quality: As collateral provides secondary recourse, the credit quality of the collateral issuer is important. Accordingly issuers below an A1 credit rating (or equivalent rating) must be subject to appropriate haircuts.
Tasks to be carried out by the Risk Management Function
Draft UCITS Notice 2_5 provides that the risk management function for a UCITS management company or self-managed investment company is responsible, inter alia, for ensuring compliance with the UCITS risk limit system, including statutory limits concerning global exposure. The RMP in respect of a UCITS which utilises the VaR model will thus need to be updated to demonstrate compliance with the requirements imposed by draft UCITS Notice 2.5.