On July 20, EU legislators reached agreement to review the Alternative Investment Fund Management Directive (AIFMD).
But hang on, the title of this blog refers to UCITS, why does AIFMD matter? Well, it matters a lot because one of the main themes underpinning the AIFMD review was a plan to harmonize it and the UCITS framework to a greater degree.
Through the agreement, EU lawmakers have confirmed the value of the delegation model for investors, with no further restrictions placed on delegation within or outside the EU. However, additional regulatory reporting and additional due diligence of third country delegates will be required.
The perpetual review and recalibration of UCITS is a feature of the framework to reflect prevailing investor and regulator expectations. The latest political resolution from the EU lawmakers now sets in train another period of renewal for the UCITS framework.
To keep pace with evolutions in the market, UCITS rules have been revised several times since their introduction in 1985, most recently via UCITS V which focused primarily on depositary liability and asset manager remuneration in a post-Madoff world.
What to expect
Now, with two revisions of so called “Level 1” provisions, the industry can expect the delivery of UCITS 6 to be followed soon after by UCITS 7. Given the scale of the UCITS market, these revisions are considered a big deal.
Let’s look briefly at the respective proposals and what they might mean for UCITS asset managers and management companies:
In November 2021, the European Commission (EC) published proposed amendments to both the AIFMD & UCITS directives. Recognizing that many managers were subject to both regimes and many investors invested in both fund types, harmonization of the rulesets was one noted ambition.
The main areas of proposed change are:
- Delegation: The addition of delegation reporting and more demanding due diligence of third country delegates will require some additional work and cost, however, most will see it as a price worth paying for retention of the current delegation model.
- Liquidity Risk Management (LRM): Regulators’ focus on open-ended funds as a source of systemic risk has been clear to see in the past year. A sub-set of that focus relates to liquidity transformation, and the fact that daily dealing funds often invest in assets that cannot be liquidated fast enough to pay investors back the next day. The UCITS revisions accordingly prescribe eight Liquidity Management Tools (LMT) and a harmonized set of rules around access to and use of LMTs across the UCITS landscape:
1. Temporary fund suspensions
3. Notice periods
4. Apply redemption fees
5. Swing pricing
6. Anti-dilution levy
7. Redemption in kind
8. Side pockets
In addition to a general power to suspend funds, UCITS will also be required to provide for at least one of these prescribed LRM tools. One contentious area of the LRM proposals still under review is to grant National Competent Authorities (NCA) power to instruct a UCITS to activate a LRM tool in the best interest of investors. The industry believes that competency best resides within the discretion of the portfolio manager and/or UCITS management company instead.
- Regulatory Reporting: To align with the “Annex IV” reporting of AIFMD, it is proposed that UCITS management companies be required to regularly report details of the markets and instruments in which it trades to its NCA.
- Depositaries: Depositaries will be exempt from the requirement to perform ex-ante due diligence over central securities depositaries (CSDs) – even where they are considered “delegates” (e.g., “investor CSDs”) - on the basis that those that have been authorized are considered already sufficiently vetted. However, issuer CSDs will continue to not be considered “delegates” of depositaries in the first place.
The European Commission (EC) is proposing a two-year implementation for the new UCITS rules. Taken together, this means that, realistically, the rules are unlikely to be effective until 2025.
Interestingly, the EC has also formally requested ESMA to review the UCITS Eligible Asset Directive. This is hardly surprising in view of the passage of time since the last major changes to eligible assets rules were made in 2007 as part of the UCITS 3 refresh.
In the intervening years there have been many clarifying guidelines, Q&As, and direct correspondence from national regulators to UCITS management companies regarding the asset eligibility rules. However, what is envisaged now are direct revisions to the core Directive to ensure a consistent ruleset is applied across all EU member states. Uniform clarity on asset eligibility will be welcomed to offset slight differences among these rules.
Also, the Commission noted areas of review are evolutionary rather than revolutionary, resulting in the foundational UCITS criteria requiring strong levels of diversification, liquidity, price discovery, and asset safety remaining unchanged. This confirms that the Eligible Assets Directive (EAD) review doesn’t represent a widespread shift in investor protection parameters for UCITS. Asset eligibility criteria will likely continue to include only liquid assets with high degrees of price discovery and liquidity. A loosening of standards to allow more illiquid assets into UCITS portfolios is unlikely.
The asset classes referenced in the ESMA letter include bank loans, structured notes, catastrophe bonds, emission allowances, and crypto assets. However, there is no indication that the EC or anyone else wishes to fundamentally change the rules governing which assets a UCITS may, or may not, invest in. Rather, the consultation is likely to unify the approach in the industry and encourage a more harmonious approach to supervision of the UCITS rules across all member states.
Many areas of review that will form the basis of the EAD review have already largely been clarified by national regulators through various regulatory or industry body publications. However, the review and revision of primary legislation will allow for consistently applied rules and removal of the fragmentation of supervisory approach across the various EU NCAs.
The EC’s request to ESMA does not suggest a broad opening to new asset classes or a shift of risk or liquidity profiles. The focus is rather on harmonization and formally addressing certain asset classes that either didn’t exist or were in their infancy since the last UCITS review, 16 years ago.
The EC will push ESMA to primarily consider the removal of any eligible asset rule ambiguities as well as ironing out all national level fragmentation through primary legislation (Level 1 revisions) rather than by way of non-binding guidelines and Q&A publications. The next evolution of the UCITS regime is already under way. It will be critical for managers to stay attentive to what is a big deal in the funds industry.