EMIR versus UCITS: the clash of regulations
January 2015 | SPOTLIGHT | INVESTMENT FUNDS
Financier Worldwide Magazine
European asset managers are now facing difficulties with reconciling the longstanding Directive on Undertakings for Collective Investment in Transferable Securities (UCITS Directive) with the recent European Market Infrastructure Regulation (EMIR). In effect, the UCITS Directive and EMIR collide in specific areas by introducing conflicting obligations for asset managers. In this article, we discuss the duties of UCITS fund managers in relation to the clearing of OTC derivatives and some of the complications arising from the multiplicity of ever more constraining financial regulations.
The UCITS Directive (now UCITS IV as adopted on 23 July 2014) was originally introduced in the mid-1980s to regulate collective investment schemes at a European level and generally to offer protection to small investors. Since then, it has gone through several iterations to attempt to align itself with developments in the financial markets.
A main pillar of the protection offered by the UCITS Directive to small investors relies on its article 84(1). It provides that “a UCITS shall repurchase or redeem its units at the request of any unit-holder”. This requirement means that units must be liquid investments and that a UCITS must be able to sell any investment it holds in order to obtain the cash needed to reimburse the unit-holders.
The liquidity of a UCITS has some consequences in the investments a UCITS can hold, including OTC derivatives which are a key tool in the management of UCITS. Article 50(1)(g)(iii) of the UCITS Directive provides that to the extent a UCITS invests in OTC derivatives, such derivatives must be “subject to reliable and verifiable valuation on a daily basis and can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS’ initiative”.
The liquidity requirement means that the UCITS must be able to walk away at any time from an OTC derivative. This so-called early termination right (ETR) has created complications and delays for the UCITS fund manager when negotiating a Master Agreement governing such OTC derivatives with financial counterparties. Certain national legislations implementing the UCITS Directive contain even more constraints than the UCITS Directive require.
For example, under French law, the article R214-15-3 of the Code Monétaire et Financier requires that in addition to the condition that the OTC derivatives “can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS’ initiative”, they must also “be subject to a valuation which must be reliable and verifiable daily, shall not depend only on the prices given by the counterparty, and satisfy the criteria that the valuation is controlled by one of the following entities: (i) an independent third-party which controls such valuation on an adequate frequency and procedures that the UCITS can verify; or (ii) a service (which is independent of the operational functions and capable to proceed with such verification) of the UCITS”.
With regard to the UK, the Financial Conduct Authority’s Collective Investment Schemes sourcebook similarly provides that the UCITS “carries out, at least daily, a reliable and verifiable valuation in respect of that transaction corresponding to its fair value and which does not rely only on market quotations by the counterparty”.
The French and UK legislations aim to protect the UCITS (and therefore the small investors) against the counterparty which traditionally acts in conflicting roles as both an interested party (as a party to the OTC derivative) and as arbiter/’judge’ (when acting as the calculation agent) by not allowing the price of the early terminated transaction being only calculated by the counterparty or dependent on the counterparty’s market quotations.
To comply with the ETR requirement, most fund managers have – not without difficulty – negotiated into their master agreements some specific carve-out provisions by which the UCITS can terminate an OTC derivative early, and by which the ‘exit’ price is determined by its counterparty but can be challenged through an ad hoc dispute resolution procedure.
However, this solution may no longer work when the new clearing regime introduced by EMIR comes into force. A response to the 2008 financial crisis, EMIR is aimed at building a solid financial structure by introducing, among other things, mandatory clearing through central counterparties (CCPs) for all standardised OTC derivatives. Under the new principal-to-principal clearing model to be used in Europe, the clearing mechanism will result in the UCITS entering into an OTC derivative with the clearing member (the ‘Client Transaction’) which will enter into a back-to-back transaction (the ‘Central Counterparty Transaction’) with the CCP. Because the terms of the Central Counterparty Transaction effectively mirrors the Client Transaction, the exercise by a UCITS of its ETR in respect of the Client Transaction, as provided by the UCITS Directive, will result in the early termination by the clearing member of the Central Counterparty Transaction.
In practice, this means that in order to accommodate the ETR requirement, fund managers will have to find a way to insert into their clearing documentations (mainly the ISDA/FOA Client Cleared OTC Derivatives Addendum (the ‘Addendum’)) governing their relationship with the clearing member a provision by which the Client Transactions can be terminated early. Yet, whilst this Addendum can be negotiated, taking into account the predominant role of the CCP, this may limit the fund manager’s and the clearing member’s room to introduce such a term in the Addendum.
At present, fund managers of UCITS are pushing hard to negotiate with the clearing members the introduction of the ETR in the Addendum.
Three potential solutions are being explored. The first is to negotiate a carve-out provision in the Addendum (as it is done traditionally for the master agreement and as explained above) but taking into account the necessity of the clearing member to early terminate its back-to-back transaction with the CCP. The second is to use opportunely the mechanisms of the offsetting transactions (Section 6 of the Addendum) and the compression (Section 3(d) of the Addendum). Accordingly, the UCITS would be able to close out a Client Transaction by entering into a new Client Transaction with identical terms but in the opposite direction and compress them. The final solution is to introduce an exception in the Section 8(b) of the Addendum authorising the UCITS to rely on the ETR included in the ISDA Master Agreement for the Client Transactions (creating a bridge between the cleared and non-cleared worlds).
Marc Hétroy is a legal counsel at Amundi Asset Management, Martha Collins Rolle is a partner and Claire Morel de Westgaver is an associate at Bryan Cave LLP. Mr Hétroy can be contacted on +33 (0) 1 7632 0730 or by email: firstname.lastname@example.org. Ms Rolle can be contacted on +44 (0)20 3207 1285 or by email: email@example.com. Ms Morel de Westgaver can be contacted on +44 (0)20 3207 1253 or by email: firstname.lastname@example.org.
© Financier Worldwide
Amundi Asset Management
Martha Collins Rolle and Claire Morel de Westgaver
Bryan Cave LLP