Irish Regulatory Provisions For Using Derivatives In Long/Short And 130/30 Strategies in UCITS Funds

Author:Mr Stephen Carty
Profession:Dillon Eustace
 
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1. Introduction

Under UCITS III, UCITS funds may invest in derivative

instruments for investment purposes as well as for EPM

purposes.

The Financial Regulator has, through its UCITS Notices and

Guidance Notes prescribed, in detail, the risk management

conditions that must be met by Irish UCITS funds investing in

derivatives.

The paper aims to give a brief overview of the risk

management framework and a summary of the regulatory risk

management requirements that must be met by Irish UCITS funds

investing in derivatives.

In addition, following a recent Policy Note issued by the

Financial Regulator, Irish UCITS may now invest in covered

physical short sales. This allows Irish UCITS to pursue direct

long/short and 130/30 strategies without being required to

replicate synthetically through derivatives. The paper will

look briefly at how the 130/30 strategy has been working to

date within the UCITS sphere and will give an overview of the

conditions outlined in the Policy Note that will apply to UCITS

funds seeking to engage in direct short sales.

2. UCITS III and Irish Regulatory Framework

Documentation

Prior to the introduction of UCITS III, UCITS funds could

only employ derivatives for efficient portfolio management

purposes. Regulation 45 of the Irish UCITS

Regulations1 provides that Irish UCITS funds may

invest in exchange traded or over-the-counter derivative

instruments for investment or EPM purposes, subject to certain

conditions.

Regulation 45 reflects the provisions of EU Directive

2001/10/EC (the "UCITS Product Directive) which was

introduced to widen the scope of instruments which a UCITS fund

could invest in.

The Irish UCITS Regulations have been developed and expanded

on by the Irish Financial Services Regulatory Authority (the

"Financial Regulator") in the UCITS Notices and

Guidance Notes. Specifically in relation to investing in

derivatives, the following documents are of particular

relevance:

UCITS Notice 9 outlines investment restrictions

applicable to UCITS funds including limits on counterparties

and counterparty criteria and provisions regarding index

derivatives, uncovered short sales and warrants;

UCITS Notice 10 outlines derivatives provisions including

summary of permitted derivatives, cover requirements and risk

management requirements;

UCITS Notice 12 - outlines provisions regarding permitted

use of collateral received by a UCITS in the context of stock

lending or repurchase contracts; and

Guidance Note 3/03 the outlines the provisions for the

use of derivatives by UCITS funds.

3. Conditions for the use of derivatives by UCITS

Funds

As outlined in UCITS Notice 10, Irish UCITS funds may invest

in any type of exchange traded or OTC derivative for investment

purposes or for EPM purposes, subject to the following

conditions:

the underlying asset relates to UCITS eligible assets,

i.e. transferable securities, money market instruments, CIS,

deposits, financial indices, interest rates, foreign exchange

rates or currencies, in which the UCITS fund may invest

according to its investment objectives as stated in the trust

deed, deed of constitution or memorandum and articles of

association and prospectus of the UCITS fund;

the counterparties to OTC derivative transactions are

institutions subject to prudential supervision and belong to

categories approved by the Financial Regulator (qualifying

credit institutions; ISD authorised investment firms with a

minimum credit rating of A2 or equivalent, or an implied

rating of A2 or guaranteed by an entity with a rating of

A2);

the OTC derivatives are 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 initiative of the UCITS fund.

Positions may create long or short exposure to the

underlying asset and may result in leverage to the portfolio

(under UCITS I, both short positions and leverage were not

permitted).

UCITS funds that use derivatives for investment or efficient

portfolio management purposes must prepare a Risk Management

Process and file it with the Financial Regulator. In addition,

adequate disclosure of the derivatives investment must be made

in the UCITS fund's prospectus specific provisions in this

regard are outlined in Guidance Note 3/03.

4. Guidance Note 3/03

The UCITS Directive2 was very broad in terms of

outlining how EU Member States were to implement risk

management procedures and what needed to be contained in a

UCITS fund's Risk Management Process.

The Guidance Note was produced by the Financial Regulator

following the Commission Recommendation on the use of

derivatives by UCITS funds3 in order to ensure

investor protection, by outlining the parameters for the use of

derivatives by UCITS funds and providing guidance on the

measurement and control of derivative associated risk by UCITS

funds.

Guidance Note 3/03 contains detailed requirements

regarding:

the format and content of the Risk Management

Process;

the options for measuring and controlling risk

exposure;

requirements and limits on position exposure;

counterparty exposure; and counterparty restrictions.

Risk Management Process

In order to monitor, measure and manage the risk profile of

a UCITS fund, the investment manager must construct a formal

Risk Management Process (RMP) that is adapted to the complexity

and sophistication of the derivatives used within the UCITS

fund.

Sophisticated vs. Non-sophisticated UCITS

The rules for measuring global exposure and leverage differ

depending on whether a UCITS fund is characterised as

'sophisticated' or 'non-sophisticated'.

The Commission Recommendation was unspecific on what

constitutes a 'sophisticated' or

'nonsophisticated' UCITS, acknowledging that the

distinction between the concepts and their precise definitions

required further consideration. The Financial Regulator has not

provided a formal definition of what constitutes a

'sophisticated' or 'non-sophisticated' UCITS

fund, rather requiring the UCITS fund to classify itself as

either 'sophisticated' or 'non-sophisticated'

and provide a rationale for such classification.

Factors that may cause a UCITS fund to be considered

'sophisticated' include the following:

where the use of derivatives forms a fundamental part of

the UCITS fund's investment objective and would be

expected to be used in all market conditions;

where the performance of the derivative is non-linear in

relation to the underlying assets or the performance is based

on a reasonably complex mathematical formula;

where the use of cover for the derivative position is

different from the underlying of the derivative.

The use of OTC derivatives might indicate the UCITS fund is

more sophisticated but the complexity of the transaction should

also be considered.

A 'non-sophisticated' UCITS generally will only use

a limited number of simple derivative instruments for

non-complex hedging or investment strategies.

Measurement of Global Exposure and Leverage

Non-Sophisticated UCITS

Guidance Note 3/03 provides that the global exposure and

leverage of a non-sophisticated UCITS fund should be measured

using the commitment approach. A UCITS fund's global

exposure may not exceed its net...

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