UCITS

Under the UCITS framework, funds have strict rules on investment and eligible assets, eligible markets and exposure limits, counterparty risk, diversification and leverage. They must be open-ended fund structures, and units must be redeemable out of the fund’s assets upon request of the unit holder. UCITS must have liquidity management processes in place and can only suspend redemptions in the interests of investors in exceptional circumstances. UCITS cannot engage in leverage including by borrowing securities or cash.

The UCITS comprises the fund itself (which holds the pooled assets), the fund manager or management company which is responsible for the investment strategy and managing the portfolio; the depositary which acts as the fund’s custodian, must safeguard all the assets of the fund,  and verify the accuracy of the fund’s valuation; the fund administrators who are responsible for fund accounting, regulatory reporting and investor services. The depositary must be a credit institution and is liable to the unit holders and management company for failure to properly perform its obligations including for loss of financial instruments or to fulfil its oversight duties. It cannot discharge its liability to any third party.

In addition to investments, the UCITS may employ Efficient Portfolio Management Techniques  which are techniques and transactions that are economically appropriate, entered into for the reduction of risk and/or reduction of cost and /or generation of additional capital or income for the UCITS consistent with its risk profile and diversification rules and adequately captured by its risk management process. Securities lending/ repo and reverse repo for UCITS fall under EPM which generates additional income. These are set out under the 2014 revised ESMA guidelines on ETFs and other UCITS issues.

The UCITS Directive revisions pursuant to AIFMD 2 prescribe 8 liquidity management tools to counter redemption pressure in open-ended funds and UCITs are required to provide for at least one of these tools. UCITS list of ancillary services is also extended to include reception and transmission of orders, administration of benchmarks and any other non-core services already provided by the management company in relation to a UCITS it manages.

With their large holdings of listed securities and bonds, UCITS are an important source of securities liquidity for the capital markets. UCITS are permitted to engage in securities lending, repo and reverse repo transactions as part of Efficient Portfolio Management techniques.  UCITS which permit securities lending under their investment strategy are key participants in the securities lending market, most often through a securities lending agent. Collateral assets received as collateral from securities lending or reverse repurchase will fall under the safeguarding and oversight regime of the depositary.

On 30 July 2018 ESMA published its final report following its peer review of the compliance and supervisory framework of the UCITS framework for Efficient Portfolio Management Techniques (EPM) and included an assessment of inconsistencies regarding collateral reuse between Art 22(7) of the UCITS Directive and the 2014 ESMA Guidelines on ETFs and other UCITS issues. It found that the Guidelines permit ‘title transfer’ and ‘other types of collateral arrangement’ (such as pledging arrangements to be received by the UCITS for its EPM, the text of Art. 22(7) permits reuse of assets held in custody by the depositary only ‘where the transaction is covered by high-quality and liquid collateral received by the UCITS under a title transfer arrangement.’

The EU Commission has mandated ESMA to provide recommendations as to how to amend the [UCITS] Eligible Assets Directive and advise on clarifications to EPM. ISLA is responding to the ESMA Call for Evidence on the review of Eligible Assets Directive (7 May 2024) and has asked ESMA to confirm that pledge arrangements are an acceptable type of collateral arrangement, on the basis that this increases the possibilities for UCITS securities lending without reducing levels of investor protection or introducing additional risk.

Use of pledge arrangements by UCITS could also facilitate UCITS participation in CCP-cleared securities lending. ISLA notes that UCITS are permitted to accept collateral subject to security interest arrangements such as pledges, to meet their obligations under the Margin RTS for uncleared OTC derivatives and proposes that there should be consistency between EPM for OTC derivatives collateral and securities lending /reverse repo collateral.

ISLA also monitors developments in UCITS through its Regulatory Steering and Market Practice Steering groups and reports on any proposals which may impact securities lending and borrowing markets.