Regulatory trends and the implications for UCITS ETFs
Based on the European regulations that have been published in the last few years, it would seem that regulators consider transparency to be the panacea to all investor concerns. Already, in this space, the European Securities and Markets Authority (ESMA) provided its guidelines on ETFs and other UCITS issues in 2012, which were completed by the ESMA Q&As of March 2013.
These rules greatly increased the information available to investors in European ETFs structured as UCITS1. Since 2012, the European regulators have continued to publish a plethora of additional European directives and regulations, placing a number of additional obligations on ETF providers.
This article will not focus on the disclosure requirements to regulators but rather seeks to give a high-level overview of the additional information that will be provided to investors in UCITS ETFs over the coming months.
At the time of going to press, the UCITS V Directive had not yet been implemented in all member states; however, its goal is to impose on UCITS management companies (UCITS ManCos) the same remuneration requirements (and disclosures) that are currently imposed on alternative investment fund managers (AIFMs).
Whilst we await final ESMA guidelines, it is clear that UCITS ManCos will need to:
• Prepare and annually review a remuneration policy;
• Put in place a remuneration committee that includes an employee representative (this is likely to be capable of disapplication on proportionality grounds);
• Carry out multi-year reviews (taking into consideration both financial and non-financial criteria);
• Refrain from granting any guaranteed bonuses (except in an employee’s first year);
• Ensure a balance between fixed and variable remuneration;
• Ensure that at least half of the variable remuneration is paid in UCITS units or linked instruments (note that UCITS can ignore this rule if the total amount of UCITS managed is less than 50% of the total amount of assets managed);
• Have a suitable retention policy (this is likely to be capable of disapplication on proportionality grounds);
• Delay payment of at least 40% of the variable remuneration for at least three years (this is likely to be capable of disapplication on proportionality grounds);
• Make any payment conditional upon the UCITS ManCo being in good financial health (this is likely to be capable of disapplication on proportionality grounds).
Importantly for investors, the directive requires additional disclosure to be added to the prospectus, key investor information document (KIID) and annual report.
Disclosure in the prospectus must include either (i) the details of the up-to-date remuneration policy, including, but not limited to, a description of how remuneration and benefits are calculated, the identities of persons responsible for awarding the remuneration and benefits including the composition of the remuneration committee, where such a committee exists; or (ii) a summary of the remuneration policy and a statement to the effect that the details of the up-to-date remuneration policy, including, but not limited to, a description of how remuneration and benefits are calculated, the identity of persons responsible for awarding the remuneration and benefits, including the composition of the remuneration committee, where such a committee exists, are available by means of a website – including a reference to that website – and that paper copies are available free of charge upon request.
The annual report must also include the total amount of remuneration for the financial year, split into fixed and variable remuneration paid by the UCITS ManCo and by the UCITS to its staff, and the number of beneficiaries, and where relevant, any amount paid directly by the UCITS itself, including any performance fee. Additionally, it will need to include the aggregate amount of remuneration broken down by categories of employees or other members of staff; a description of how the remuneration and the benefits have been calculated; the outcome of the annual reviews (including any irregularities that have occurred) and material changes to the adopted remuneration policy.
Regulation on Transparency of Securities Financing Transactions (SFTR)
This regulation entered into force and started to apply from 12 January 2016. However, there are a number of phase-in periods, so that all of the obligations imposed by the SFTR do not apply immediately.
The SFTR imposes new obligations in relation to three principal areas:
• Mandatory reporting of securities financing transactions (SFTs) to authorised or recognised trade repositories;
• Documentary and operational requirements in respect of all collateral reuse arrangements (note that these are not just limited to those relating to securities financing transactions); and
• Transparency and disclosure requirements for UCITS ManCos in respect of securities financing transactions and total return swaps.
Focusing on the transparency and disclosure requirements, please note that these rules already apply to UCITS ManCos if a fund was constituted on or after 12 January 2016 (if a fund was constituted before 12 January 2016 the UCITS ManCo has until 13 July 2017 to comply).
The transparency requirements apply to:
• Repurchase transactions;
• Securities or commodities lending or borrowing transactions;
• Buy-sell back or sell-buy back transactions;
• Margin lending transactions, which is defined broadly to capture any extension of credit “in connection with the purchase, sale, carrying or trading of securities”; and
• Total return swaps (TRS).
Moreover, there are two transparency requirements: one in relation to half-yearly and annual reports (the Report Requirement) and the other in relation to pre-investment disclosure (the Disclosure Requirement).
The report requirement
Article 13 obliges UCITS management companies, UCITS investment companies (and AIFMs) to inform investors of the use they make of SFTs and TRS.
The following information must be included in the half-yearly and annual reports:
• Global data: the amount of securities/commodities on loan as a proportion of total lendable assets; the amount of assets engaged in each type of SFT/TRS, expressed in the fund base currency and as a proportion of the fund assets under management (AUM);
• Concentration data: the 10 largest collateral issuers across all SFTs/TRS, with volume breakdown per issuer name; top 10 counterparties of each type of SFT/TRS, with counterparty name and gross volume of outstanding transaction;
• Aggregate transaction data for each type of SFT/TRS: type and quantity of collateral; maturity tenor of collateral broken down by seven maturity buckets; currency of collateral; maturity tenor of SFTs/TRS broken down by seven maturity buckets; country of domicile of counterparties; settlement and clearing of trades (eg, bilateral, tri-party, CCP);
• Data on reuse of collateral: amount of collateral reused, compared to maximum amount disclosed to investors; cash collateral reinvestment returns to the fund;
• Safekeeping of collateral received or granted by the fund as part of SFTs/TRS;
• Number and names of custodians and the amount of collateral safe-kept by each;
• Proportion of collateral held in segregated, pooled or in other accounts;
• Data on the return and cost for each type of SFT/TRS, broken down between fund, fund manager and third parties (eg, agent lenders) in absolute terms and as percentage of overall returns generated by relevant type of SFT/TRS.
Pursuant to Article 14 of the SFTR, the UCITS prospectus must specify the SFTs and TRS which the fund is permitted to use and include a clear statement that SFTs and TRS are used.
The following information must also be included:
• General description of the SFTs/TRS used, including the rationale for their use;
• Overall data for each type of SFT/TRS: type of assets; maximum and expected proportion of AUM that will be subject to each type of SFT/TRS;
• Counterparty selection criteria (including legal status, country of origin, minimum credit rating);
• Description of acceptable collateral with regard to asset types, issuer, maturity, liquidity, diversification and correlation;
• Collateral valuation methodology, including rationale and whether daily mark-to-market and daily variation margin is used;
• Description of risks of SFTs/TRS and collateral management, including operational, liquidity, counterparty, custody, legal and reuse;
• Specification of how assets and collateral are safe-kept;
• Description of any restrictions (whether regulatory or self-imposed) on re-use of collateral; and
• Disclosure of policy on profit sharing, including proportion of revenue on SFTs/TRS paid to the fund, costs and fees assigned to third parties (eg, agent lenders).
Where all this information will assist investors in making their investment decisions remains to be seen.
Other rules imposing additional disclosure obligations
In addition to the two major sources of new investor information cited above, a number of other requirements are imposed on UCITS ETFs. Set out below are brief summaries of some of the more important developments on the horizon.
While few are unhappy with the delayed implementation of the Markets in Financial Instruments Directive II (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR), ETF issuers were probably one of a small group of people who were looking forward to the implementation of the new post-trade disclosure rules. In effect, much of the trading in ETFs is currently carried out over-the-counter and thus such trades do not hit the consolidated tape – thereby giving an incomplete picture of the demand/liquidity in European ETFs. Once MiFID II is implemented, and noting that ETFs will be in scope of the new reporting obligations, it was anticipated that investors would be able to see the true depth of liquidity in European ETFs, which, based on current publicly available information, looks less liquid than their US counterparts.
The regulation on key information documents for packaged retail and insurance-based investment products (PRIIPs – Regulation 2014/1286/EU) will become effective at the end of this year. Whilst UCITS ETFs still benefit from the five-year exemption period provided for by the PRIIPs Regulation, it is worth remembering that the KIID will be replaced by the three-page key investor document in December 2019.
This proposed regulation seeks to prohibit the use in the EU of unauthorised benchmarks. Whilst the text has not yet been finalised, investors should not that the draft regulation defines “use of a benchmark” in a manner that could impact ETFs, and thus investors will need to pay attention to the possible impact of this regulation
Finally, given the impending UK referendum, it would be remiss of me to refrain from referencing Brexit and its impact on investors.
Most UCITS ETFs are based in Ireland, Luxembourg or France, so it will still be possible to rely on the UCITS fund passport to market in other EU countries (thus there should not be an amputation of non-UK based investors). As to whether or not the UK FCA will still allow UCITS ETFs to be sold in the UK, my instinct would suggest that if the UK left the EU, the FCA would probably grandfather the marketing authorisation of such funds (at the very least).
In relation to the management of the UCITS, there could be a licensing risk, as it is likely that it will become impossible for a UK manager to passport its collective management services into the EU. However, UCITS ETFs typically have a local management company, which will shield the investment manager from any Brexit risk as the local management company should still be allowed to delegate investment management activities to a London-based manager.
Ian Rogers, Head of Asset Management, Simmons & Simmons, Paris
1 See our article ‘Legal and regulatory developments at European level’ in the IPE Exchange-Traded Funds Guide 2013