The Commission of European Securities Regulators (CESR) has issued a finalised set of guidelines on risk management and the calculation of global exposure and counterparty risk for UCITS .
Background – UCITS IV
The Guidelines form part of a range of technical advices being provided by CESR following a 2007 European Commission initiative to update the UCITS legal and regulatory framework (UCITS IV). The Guidelines support and supplement the Level 2 measures on risk management contained in section IV of CESR’s technical advice on the UCITS management company passport .
These new measures will be applicable from 1 July, 2011.
The release of the Guidelines follows a consultation process between CESR and industry participants. This involved the publication of proposed guidelines and questions by CESR and responses from industry representative bodies and direct industry participants.
The Guidelines set out detailed methodologies to be used by UCITS when applying either the commitment approach or the value at risk (VaR) approach to calculate global exposure.
The first part of this paper gives a summary of the changes that have been made to the Guidelines from the initial draft (issued by CESR in April, 2010) following the industry consultation process.
The second part of this paper gives an overview of the essential elements of the now finalised CESR Guidelines that will impact on existing UCITS following implementation of UCITS IV from July, 2011.
PART ONE – OUTCOME OF THE CONSULTATION PROCESS
Below is an overview of some of the key elements adapted by CESR in the finalised Guidelines as part of the consultation process:
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The requirement for all UCITS to measure global exposure on a daily basis has been retained as it is considered a critical element by CESR.
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CESR added a third element to consider when determining if a UCITS should employ VaR to measure global exposure. This is “where the commitment approach does not adequately capture the market risk of the portfolio”. This supplements the existing criteria of: (a) where the UCITS engages in complex investment strategies which represent more than a negligible part of its investment policy; or (b) where the UCITS has more than a negligible exposure to exotic derivatives.
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The conversion methodology for single name credit default swaps, used when measuring global exposure using the commitment approach, has been amended to account for specific elements dependent on whether the UCITS is selling or buying protection.
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It has been clarified that where a conservative calculation of commitment is used, rather than an exact calculation, netting will not be permitted if the result is an underestimation of global exposure.
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Regarding the re-investment of collateral, it has been clarified that risk free returns based on short-dated “government bonds” should instead refer to “high quality government bonds”.
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The sensitivity approach (option 2) for the netting of derivatives on interest rates of variable maturity has been retained - under “duration-netting rules”.
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Regarding the choice of a UCITS to use either relative VaR or absolute VaR, provision is made to require that one or the other is used consistently – preventing a UCITS from switching between the two, from time to time.
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Industry submissions were divided in their response on whether an absolute VaR limit of 20% was appropriate. The 20% limit has been retained in the Guidelines.
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The requirement to report back-testing breaches above a certain level to the national regulator on a quarterly basis has been change to semi-annually.
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The requirement for each UCITS using VaR to disclose an expected level of leverage and the possibility of higher levels of leverage in the prospectus was strongly opposed by industry submissions. However, CESR considers this to be information investors should be given and has retained this in the Guidelines. The corresponding requirement regarding annual report disclosure has also been retained.
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CESR did not amend its provisions in the Guidelines regarding re-investing collateral – i.e. that cash collateral can be invested in “risk-free” assets but that non-cash collateral cannot be sold, re-invested or pledged.
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There was strong industry resistance to the proposal to include clearing houses in counterparty exposure. CESR has therefore removed this and instead will require the UCITS to determine if its exposure is to an OTC counterparty, a clearing house or a broker.
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Counterparty exposure generated through stock-lending or repos will not be considered when calculating counterparty exposure, but will be considered for issuer limits.
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Further work will be undertaken by CESR to determine if other methodologies may be more appropriate for the calculation of global exposure by structured UCITS.
PART TWO – OVERVIEW OF THE CESR GUIDELINES
Measurement of global exposure
Below is a high level overview of some key points contained in the Guidelines on the measurement of global exposure:
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Fund classification. VaR (or an equivalent advanced risk measurement methodology) should be used where UCITS “engage in complex investment strategies which represent more than a negligible part of their investment policy; or have more than a negligible exposure to exotic derivatives; or where the commitment approach does not adequately capture the market risk of the portfolio.” Otherwise the commitment approach will be adequate.
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Methods of conversion. CESR outlines methods of conversion of derivatives in order to measure global exposure and types of instruments that may be excluded from the calculation of global exposure.
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Netting and hedging. The Guidelines set out parameters for the use of netting and hedging to reduce global exposure.
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Additional leverage. CESR proposes that any leverage generated by the reinvestment of collateral through repos or securities lending, in addition to leverage generated through derivatives, is taken into account when measuring global exposure.
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Proportionate VaR limits. The Guidelines require that each UCITS sets its own VaR limit (within the maximum permitted limits) appropriate to its risk profile – so a UCITS with a lower risk profile should apply a lower VaR limit.
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Relative VaR or absolute VaR. Each UCITS must determine whether to use relative VaR or absolute VaR dependent on which method is most appropriate to the risk profile and investment strategy of the UCITS and must apply the chosen methodology consistently.
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Relative VaR measurement guidelines. In relation to relative VaR, CESR considers that the reference portfolio should be relevant and unleveraged. CESR sets a limit of twice the benchmark.
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Absolute VaR measurement guidelines. The Guidelines outline the parameters and means of calculation of absolute VaR. CESR sets a limit of 20% of net asset value.
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Additional VaR elements. The Guidelines set out provisions regarding back testing and stress testing. CESR requires that the VaR model takes account of general market risk, specific market risk, idiosyncratic risk and event risk. This macro level review is a new requirement. CESR also requires that a UCITS using VaR to measure global exposure should carry out additional monitoring of leverage where VaR does not adequately cover the monitoring of risk.
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Prospectus and annual report disclosure. The Guidelines include details regarding required prospectus and annual report disclosure, summarised as follows:
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the prospectus and annual report should each disclose whether the commitment approach, relative VaR or absolute VaR is employed by the UCITS to measure global exposure.
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where a UCITS employs VaR to measure global exposure, the prospectus should also disclose the expected level of leverage and the possibility that there may be higher leverage.
The annual report should also contain details of the VaR limits and calculation criteria. Also, where a UCITS uses relative VaR, the annual report should disclose details of the reference benchmark.
Use of collateral, counterparty risk and cover rules
Collateral
The Guidelines set out criteria for acceptable collateral that may be received by a UCITS, as follows:
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collateral must be sufficiently liquid so as to be capable of being sold quickly and at a price close to pre-sale valuation;
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collateral must be capable of daily and independent valuation;
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lower rated assets should be subject to conservative haircuts;
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assets must be uncorrelated to the counterparty;
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asset diversification is required;
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assets must be in third party custody and available to the UCITS at any time;
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assets cannot be sold, pledged or re-invested.
Provisions are also outlined regarding how/when such collateral can be applied to reduce counterparty exposure risk.
Counterparty exposure
The Guidelines provide that initial and variation margin passed to a broker without the protection of client money rules should be included when calculating counterparty exposure.
Position cover
The Guidelines set out monitoring requirements relating to position cover.
Conclusion
To date, EU member state regulators have applied varying interpretations on the scope of the rules regarding the measurement of global exposure. These Guidelines, by imposing more specific parameters at EU level, should serve to eliminate this inconsistency and meet the aim of CESR to develop a “level playing field” for UCITS across the EU in the area of risk measurement.
However, as the Guidelines prescribe measures more detailed and more far-reaching than under the current regime, adapting to the changes and ensuring compliance on an ongoing basis will be a challenge for many UCITS.
UCITS should now start to consider the implications of this new risk management regime on their operations, examine where the Guidelines will require their risk operations are changed and consider closely what steps they will need to take to come into line with these new requirements by July, 2011. This is certainly an area that will need some focus over the next eleven months, from managers across all sectors in the UCITS space.
Relevant Links:
CESR’s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS – CESR/10-788
For further information, please contact your usual Eversheds O’Donnell Sweeney contact or:
Stephen Carty
T +353 1 6644 202
F +353 1 6644 300
E scarty@eversheds.ie
This briefing is correct as at 30 July 2010.
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