UCITS Investment In Financial Derivative Instruments Finance and Banking

Post on: 5 Апрель, 2015 No Comment

UCITS may invest in financial derivative instruments for investment purposes subject to a variety of conditions as outlined below relating to the nature of the exposures taken, the leverage generated through such positions, the process employed by the UCITS to manage the risks arising from derivatives investment as well as rules relating to OTC counterparty exposure and to the valuation of derivatives positions.

The Central Bank has prescribed in detail through its UCITS Notices and Guidance Notes the risk management conditions that must be met by Irish UCITS investing in derivatives.

UCITS are permitted to invest in exchange traded or over-the-counter derivative instruments for investment purposes, subject to certain conditions, in particular, those set down in:

UCITS Notice 9 which sets out investment restrictions applicable to UCITS including limits on counterparties and certain counterparty criteria;
UCITS Notice 10 which sets out high level derivatives rules including summary of permitted derivatives, cover requirements and risk management requirements; and
Guidance Note 3/03 which contains detailed provisions for the use of derivatives by UCITS.

Conditions for the use of derivatives by UCITS
As outlined in UCITS Notice 10, UCITS may invest in any type of exchange traded or OTC derivative for investment purposes, subject to the following conditions:
the underlying asset relates to UCITS eligible assets (i.e. transferable securities, money market instruments, CIS, deposits), financial instruments having one or several characteristics of these assets, financial indices, interest rates, foreign exchange rates or currencies;
the counterparties to OTC derivative transactions are institutions subject to prudential supervision and belong to categories approved by the Central Bank (qualifying credit institutions, MIFID authorised investment firms or an entity subject to regulation as a Consolidated Supervised Entity by the US Securities and Exchange Commission) with a minimum credit rating (in the case of counterparties which are not credit institutions) 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.

Positions may create long or short exposure to the underlying asset and may result in leverage to the portfolio.

UCITS that use derivatives for investment (or for EPM) purposes must prepare a Risk Management Process and file it for approval with the Central Bank. In addition, adequate disclosure of derivative investments must be made in the UCITS prospectus. Specific provisions in this regard are outlined in Guidance Note 3/03.

Guidance Note 3/03
Guidance Note 3/03 was produced by the Central Bank to outline clearly the parameters for the use of derivatives by UCITS and to provide guidance on what the Central Bank expects in relation to the measurement and control of derivatives associated risk by UCITS. It was updated as part of UCITS IV in order to reflect the ESMA Guidelines on Risk Measurement and the calculation of Global Exposure and Counterparty Risk for UCITS dated July 28, 2010.

Guidance Note 3/03 contains detailed requirements in relation to (i) measuring and controlling global exposure (by the use of the commitment approach or VaR); (ii) the use of OTC derivatives including counterparty risk and issuer concentration; (iii) the use of techniques and instruments (including repurchase and reverse repurchase agreements and stock lending) for the purpose of efficient portfolio management; (iv) cover, reporting, the UCITS annual Financial Derivative Instruments report and prospectus disclosure; and (v) the format and content of the Risk Management Process.
Risk Management Process
In order to monitor, measure and manage the risk profile of a UCITS, its investment manager must construct a formal Risk Management Process (RMP) that is adapted to the complexity of the derivatives used within the UCITS. The RMP must be prepared in accordance with Guidance Note 3/03 and submitted to the Central Bank for approval as part of the UCITS application for authorisation.

The RMP should give information on the trading process employed by the investment manager and explain in detail the responsibilities and expertise of the personnel involved in the derivative trading activity of the UCITS. It should explain clearly the types of derivative instruments used by the UCITS and their specific purpose. The RMP must cover all derivatives used.

The RMP should also explain the following:
how the various exposures (global exposure and leverage, counterparty exposure etc.) are measured;
what limits apply to each such exposure;
how these limits are monitored and enforced;
how breaches of limits are reported and escalated.

A worked example of exposure calculations should also be provided. This should incorporate examples of each type of derivative and also demonstrate how hedging is used.

Any material amendments to the RMP must be addressed in a revised RMP, which must be notified to the Central Bank in advance. Any non-material amendments or updates to the RMP (for example change of personnel or systems) should be included in the annual derivatives report.

Measurement of Global Exposure
Global exposure is understood to be a measure of incremental exposure and leverage generated by a UCITS using financial derivative instruments. UCITS 10 provides that a UCITS may calculate its global exposure by using the commitment approach, the value at risk approach or other advanced risk measurement methodologies, as may be appropriate. The UCITS must ensure that the method is appropriate taking into account the investment strategy of the UCITS, the types and complexities of the FDI used and the proportion of the UCITS portfolio which comprises FDI. The concept of sophisticated versus non-sophisticated UCITS under UCITS III has, therefore, disappeared.
Commitment Approach

A UCITS using the commitment approach must ensure that its global exposure does not exceed its net asset value. The UCITS may not, therefore, be leveraged in excess of 100% of its NAV.

The commitment conversion methodology for standard derivatives is always the market value of the equivalent position in the underlying asset. This may be replaced by the notional value or the price of the futures contract where this is more conservative. For non-standard derivatives, where it is not possible to convert the derivative into the market value or notional value of the equivalent underlying asset, an alternative approach may be used provided that the total amount of the derivatives represent a negligible portion of the UCITS portfolio.
VaR
UCITS 10 now expressly 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.

VaR is defined as a measure of the maximum expected loss at a given confidence level over a specific time period. The Central Bank requires that the VaR model employed by the UCITS meets certain quantitative and qualitative criteria and be calculated using an acceptable proprietary or commercially available model. Further, following initial development, the model should undergo a validation by a party independent of the building process for ensuring that the model is conceptually sound and captures adequately all material risks.

Absolute VaR or relative VaR may be applied. The UCITS is responsible for deciding which VaR approach is the most appropriate methodology given the risk profile and investment strategy of the UCITS.

The absolute VaR approach limits the maximum VaR that a UCITS can have relative to its net asset value. The absolute VaR of a UCITS cannot be greater than 20% of its NAV.

Under the relative VaR approach, the global exposure of the UCITS is calculated as follows: (i) calculate the VaR of the UCITS current portfolio (which includes derivatives); (ii) calculate the VaR of a reference portfolio (which reference portfolio should, except in limited circumstances, be unleveraged and not contain any FDI or embedded FDI); (iii) check that the VaR of the UCITS portfolio is not greater than twice the VaR of the reference portfolio.

The VaR model used must adhere to the following requirements:

one-tailed confidence interval of 99%;
holding period equivalent to one month (20 business days);
minimum historical observation period of one year (250 business days) unless a shorter 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;
stress testing at least monthly (to measure any potential major depreciation of a UCITS value as a result of unexpected changes in the relevant market parameters and correlation factors);

back testing (a formal statistical process to compare actual portfolio returns to the VaR predicted) at least monthly and any overshootings (a one-day change in the portfolios value that exceeds the related one-day value-at-risk measure calculated by the model) to be determined and monitored on the basis of such back testing program.

A confidence interval and/or a holding period differing from the default parameters above may be used by a UCITS provided the confidence interval is not below 95% and the holding period does not exceed 1 month (20 days).

Netting

Netting arrangements are defined in UCITS Notice 10.6 as combinations of trades on financial derivative instruments and/or security positions which refer to the same underlying asset, irrespective in the case of financial derivative instruments of the contracts due date; and where the trades on financial derivative instruments and/or security positions are concluded with the sole aim of eliminating the risks linked to positions taken through the other financial derivative instruments and/or security positions.

Netting is permitted in the following situations:

between financial derivative instruments, provided they refer to the same underlying asset, even if the maturity date of the financial derivative instruments is different;

between a financial derivative instrument (whose underlying asset is a transferable security, money market instrument or a collective investment undertaking) and that same corresponding underlying asset;

a UCITS that invests primarily in interest rate derivatives may make use of specific duration-netting rules in order to take into account the correlation between the maturity segments of the interest rate curve.

Hedging arrangements are defined in UCITS Notice 10.6 as combinations of trades on financial derivative instruments and/or security positions which do not necessarily refer to the same underlying asset and where the trades on financial derivative instruments and/or security positions are concluded with the sole aim of offsetting risks linked to positions taken through the other financial derivative instruments and/or security positions.

Hedging arrangements may be taken into account when calculating global exposure if they offset the risks linked to some assets and, in particular, if they comply with all of the following criteria:

investment strategies that aim to generate a return should not be considered as hedging arrangements;

there should be a verifiable reduction of risk at the UCITS level;

the risks linked to financial derivative instruments, i.e. general and specific if any, should be offset;

they should relate to the same asset class; and

they should be efficient in stressed market conditions.

Notwithstanding the above criteria, financial derivative instruments used for currency hedging purposes (i.e. that do not add any incremental exposure, leverage and/or other market risks) may be netted when calculating a Funds global exposure. Market neutral or long/short investment strategies will not comply with all the criteria laid down above.

Position Exposure

Position exposure to the underlying assets of derivatives, including embedded derivatives in transferable securities, money market instruments or collective investment schemes, when combined where relevant with positions from direct investments, may not exceed the general investment limits. This exposure must be calculated using the commitment approach when appropriate or the maximum potential loss as a result of default by the issuer if more conservative.

A combination of the following issued by, or made or undertaken with the same body may not exceed 20% of a UCITS net asset value:

transferable securities or money market instruments;

deposits; and/or

counterparty risk exposures from OTC derivative transactions; and/or

position exposure to the underlying assets of derivatives.

There is no look through to underlying assets in respect of index derivatives, provided the index meets certain criteria.

Position Cover Requirements

A transaction in FDI which gives rise, or may give rise, to a future commitment on behalf of a UCITS must be covered as follows:

in the case of FDI which automatically, or at the discretion of the UCITS, are cash settled, the UCITS must hold, at all times, liquid assets which are sufficient to cover the exposure (exposure valued on mark to market basis and defined as the net liability to the counterparty).

in the case of FDI which require physical delivery of the underlying asset, the asset must be held at all times by the UCITS. However, the UCITS may alternatively cover the exposure with sufficient liquid assets where: (i) the underlying asset consists of a highly liquid fixed income security; and/or (ii) the investment manager considers that the exposure can be adequately covered without the need to hold the underlying asset where the specific FDI are addressed in the risk management statement and details are provided in the prospectus.

Counterparty Exposure Limits

The counterparty exposure must include all exposures to the counterparty (i.e. exposure related to OTC derivatives and any other exposure to the counterparty). Exposure is limited to 5% of net asset value or 10% in the case of certain credit institutions as follows:

a credit institution authorised in the EEA;

a credit institution authorised within a signatory state (other than an EEA Member State) to the Basle Capital Convergence Agreement of July 1998; Or

a credit institution authorised in Jersey, Guernsey, the Isle of Man, Australia or New Zealand.

Netting may be applied as appropriate before counterparty exposure is calculated. In addition, risk will be reduced where a counterparty provides acceptable collateral to the UCITS, in accordance with the Central Bank requirements.

Any exposure arising from initial margin posted to and variation margin receivable from a broker relating to exchange-traded or OTC derivatives, which is not protected by client money rules or other similar arrangements to protect the UCITS against the insolvency of the broker, must be calculated within the OTC counterparty limit as referred to above.

Embedded Derivatives

Care also needs to be taken to examine the true nature of particular instruments to determine whether they embed derivatives. If a transferable security or money market instrument embeds a financial derivative instrument (FDI), then the global exposure, issuer-concentration and leverage calculation rules referred to above apply to the embedded FDI element of the transferable security or money market instrument.

UCITS 10 provides that transferable security and money market instrument will be considered to embed a FDI where it contains a component which fulfils the following criteria:

by virtue of that component some or all of the cash flows that otherwise would be required by the transferable security or money market instrument which functions as host contract can be modified according to a specified interest rate, financial instrument price, FX rate, index of prices or rates, credit rating or credit index, or other variable, and therefore vary in a way similar to a stand-alone FDI;

its economic characteristics and risks are not closely related to the economic characteristics and risks of the host contract; and

it has a significant impact on the risk profile and pricing of the transferable security or money market instrument in question.

The Central Banks Guidance Note 3/03 sets out examples of structured financial instruments that may be assumed to embed a FDI as follows:

credit linked notes;
convertible or exchangeable bonds;
structured financial instruments whose performance is linked to the performance of, for example, a basket of shares or a bond index, or structured financial instruments with a nominal fully guaranteed whose performance is linked to the performance of a basket of shares with or without active management;
collateralised debt obligations and asset backed securities that create leverage, i.e. the CDO is not a limited recourse vehicle and the investors loss can be higher than their initial investment or are not sufficiently diversified.

UCITS using UCITS structured financial instruments embedding FDI must respect the principles of the UCITS Regulations.

It is the responsibility of the UCITS to check that investment in hybrid instruments embedding derivatives complies with these requirements. The nature, frequency and scope of checks performed will depend on the characteristics of the embedded derivatives and on their impact on the UCITS, taking into account its stated investment objective and risk profile.

Annual Derivatives Report

UCITS Notice 10 requires that a UCITS must submit an annual report to the Central Bank on its derivative positions (an Annual FDI Report) so that the Central Bank may review the use of derivatives and any breaches of risk.

The Annual FDI Report should include details of the following:

summary review on the use of derivatives by the UCITS during the year;
instances of any breaches of global exposure during the year, with an explanation of remedial action taken and duration of the breaches;
instances of any breaches of counterparty risk exposure during the year, with an explanation of remedial action taken and duration of the breaches;
where relevant, a summary of non-material updates to the RMP. In this instance a revised RMP should be attached.

In the case of UCITS using VaR:

year-end VaR number expressed as a percentage of net asset value (where applicable);
instances of any breaches in VaR limits during the year, with an explanation of remedial action and duration of breach;
confirmation as to whether back-testing has been successful in accordance with the requirements and, if not, what actions the UCITS has taken to address the situation;
confirmation that the UCITS does have a stress testing regime, an overview of the broad assumptions behind such testing and a commentary on the results of the stress testing and its applicability to the day to day use of the model.

To read A Guide to UCITS in Ireland in full, please click here.

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