ESMA call for evidence on the review of the UCITS Eligible Assets Directive

On 7 May 2024, ESMA published a call for evidence (CfE) as part of its review of the UCITS Eligible Assets Directive[1] (UCITS EAD).

The CfE will be of interest to Fund Management Companies (Fund Managers) and other service providers and promoters of Undertakings for Collective Investment in Transferable Securities (UCITS) who are invited to respond to ESMA’s questions on the manner and the extent to which UCITS have gained direct and indirect exposures to certain asset classes that may give rise to divergent interpretations and/or risk to retail investors.

Background to the CfE

UCITS are the key retail investment product in the EU, accounting for around 75% of all collective investments by retail investors in the EU. The success of UCITS as a global brand is based on their established reputation of being well-regulated and supervised investment products.

The UCITS Directive[2] requires that UCITS are invested in assets subject to stringent eligibility criteria, with a view to ensuring adherence to the principles underlying the UCITS Directive, such as liquidity, risk-diversification, the ability of the UCITS to redeem its units or shares at the request of the investors and to calculate its net asset value whenever units are issued or redeemed.

Since the adoption of the UCITS EAD in 2007, the number, type and variety of financial instruments traded on financial markets has increased considerably. This has lead to uncertainty in determining whether certain categories of financial instruments are eligible for investment, in turn giving rise to divergent interpretations and market practices in terms of the application of the UCITS Directive and possible investor protection concerns.

Against this background, in June 2023, the European Commission requested that ESMA carry out an assessment of the implementation of the EAD and make recommendations on how the EAD should be revised to keep it in line with market developments. The mandate includes that ESMA:

• propose clarifications on key definitions and the criteria against which the eligibility of an asset is assessed, and to what extent cross-references to other EU legal frameworks could improve legal clarify and consistency between these frameworks
• assess the risks and benefits of UCITS gaining exposures to assets that are not directly investable by UCITS e.g. through delta-one instruments, derivatives and financial indices
• gather data on the manner and extent to which UCITS have gained direct and indirect exposures to asset categories that may give rise to divergent interpretations and/or risk or retail investors (the Commission gives examples of structured/leverage loans, catastrophe bonds, emission allowances, commodities, crypto assets, unlisted securities)
• make a preliminary assessment of the impacts of the proposed regulatory adjustments, if any, taking into account the characteristics of the underlying market (e.g. the availability of valuation, liquidity, assets safekeeping etc.)

ESMA’s previous work in relation to UCITS investment related issues, includes Q&As, an ESMA Opinion on certain investment limits set out in the UCITS Directive and ESMA Guidelines on exchange-traded funds (ETFs) and other issues. ESMA also performed a peer review in 2018 and a follow-up peer review in 2023 on efficient portfolio management (EPM). In addition, ESMA’s Common Supervisory Action (CSA) on costs and fees, also assessed UCITS’ compliance with the applicable legal requirements and ETF guidelines when using EPM techniques.

Call for evidence – questions to stakeholders

The CfE is divided into separate sections which seek to collect evidence on:

• the clarity of key concepts and potential interpretation and convergence issues with the application of the UCITS EAD (drawing on previous ESMA workstreams and issues of which it is aware)
• direct and indirect UCITS exposures to certain asset classes and related data collection/analysis

Convergence issues and clarity of key concepts

The questions in this section include:

• Priority issues to address in the UCITS EAD with a view to improve investor protection, clarity, and supervisory convergence across the EU.
• Recurring or significant issues experienced with the interpretation or consistent application of the UCITS EAD rules and/or understanding with respect to:

1. financial indices
2. money market instruments
3. notions of liquidity or liquid financial instruments
4. the 10% limit set out in the UCITS Directive for investments in transferable securities and money market instruments other than those referred to in Article 50(1) of the UCITS Directive (sometimes referred to as the ‘trash bucket’)
5. the ‘transferable security’ criteria
6. valuation and risk management criteria
7. financial instruments backed by, or linked to the performance of asset other than those listed in Article 50(1) of the UCITS Directive
8. embedded derivatives
9. delta-one instruments (ESMA is aware of diverging interpretations on the treatment of delta-one instruments under the EAD and requests details of their eligibility assessment per product)
10. UCITS investment in other UCITS and AIFs, including in EU ETFs and non-EU ETFs

• Appropriateness of the presumption of liquidity and negotiability in light of changed market conditions since 2007 (2020 ESMA CSA on UCITS liquidity risk management identified issues).
• Understanding of ancillary liquid assets (distinguishing between ancillary liquid assets denominated in (1) the base currency of the fund and (2) foreign currencies.Foreign currency for investment purposes (beyond liquidity).
• Proposed amendments to the UCITS EAD to improve investor protection, clarity and supervisory convergence with respect to Efficient Portfolio Management (EPM) related issues identified in ESMA reports[3].
• Merits of linking or replacing the notion of EPM techniques with the notion of securities financing transaction (SFT) set out in the SFTR[4].
• Other definitions, notions or concepts used in the UCITS EAD that may require updates, clarification or better consistency with other EU legislation (e.g., MiFID II, EMIR, Benchmark Regulation and MMFR).
• Whether any rules, guidance, definitions, or concepts in national regulatory frameworks go beyond (gold-plating), diverge or are more detailed than the UCITS EAD and if yes, whether they cause any recurring or significant practical issues or challenges.

Direct and indirect UCITS exposures to certain asset classes

Respondents are asked to complete a table on the merits of allowing direct or indirect UCITS exposures to certain asset classes on which there are divergent views as regards their eligibility. They should also assess and provide evidence on the merits of such exposures in light of their risks and benefits taking into account the characteristics of the underlying markets. This could include availability of reliable valuation information, liquidity and safekeeping. Respondents should also elaborate and provide evidence on whether indirect exposures increase or decrease the costs and/or risks borne by UCITS and their investors.

The table includes:

• loans
• catastrophe bonds (Cat bonds)
• contingent convertible bonds (CoCo bonds)
• unrated bonds
• distressed securities
• unlisted equities
• crypto assets
• commodities and precious metals
• exchange-traded commodities (ETCs), real estate
• real estate investment trusts (REITs)
• Special Purpose Acquisition Companies (SPACs)
• EU and non-EU AIFs
• emission allowances
• delta-one instruments
• exchange traded-notes (ETNs)
• asset-backed securities (ABS) including mortgage backed securities (MBS)
• other relevant asset classes

Other questions in this section seek views on:

• whether a look-through approach should be required to determine the eligibility of assets (this is aimed at delta-one instruments in practice)
• the risks and benefits of UCITS investments in securities issued by securitisation vehicles
• the risks, benefits, and current market practices of UCITS building up short positions through the use of (embedded) derivatives, delta-one instruments or other instruments/tools

Commentary

It is clear that questions around liquidity are driving a lot of the focus of the European Commission and are therefore heavily reflected in the CfE. Recent UCITS issues have focused the minds of regulators on the need to analyse the liquidity of instruments rather than treating all instruments that have the same legal terminology in the same way from a liquidity perspective. The UCITS Directive and ESMA Guidelines on liquidity stress testing already impose requirements on Fund Managers, but we can expect that changes to the EAD arising out of the Commission’s review will lead to more granular liquidity analysis requirements. This would be preferable to banning entire asset classes solely because of a concern that certain aspects of those instruments on the fringes may have questions around liquidity.

Next steps

Responses to the CfE should be submitted online to ESMA by Wednesday 7 August 2024.

ESMA will take account of feedback received from stakeholders in developing its technical advice, which is due to be delivered to the Commission by 31 October 2024.

If you would like to discuss the contents of the CfE in more detail or require assistance in preparing a CfE response, please get in touch with any member of ALG’s Asset Management and Investment Funds team.

Date published: 30 May 2024