EU: ESMA technical advice on UCITS eligible assets

Why should I read this?

The Final report “Technical advice to the European Commission on the review of the UCITS Eligible Assets Directive”, sets out ESMA’s views on direct and indirect investments by UCITS, the consistent application of look through to the underlying assets and UCITS exposure to alternative assets, including structured/leveraged loans, catastrophe bonds, commodities, crypto assets, and emission allowances.  These include recommendations for the reform of the UCITS Eligible Assets Directive (EAD).

See our previous client briefings:

• EU: One month left to respond to ESMA Call for Evidence on review of the UCITS Eligible Assets Directive
• ESMA Call for Evidence on UCITS Eligible Assets Directive

Eligible assets

The UCITS I Directive provided a rather narrow list of assets eligible for investments, mainly limited to the broad category of ‘transferable securities’.  Over the past decades, however, the variety of financial instruments traded on financial markets has increased significantly, and with this diversification uncertainties and differing views on the eligibility of these asset classes have emerged.

ESMA’s mandate for the report on the EAD included:

• gathering insights 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 for retail investors
• analysing the risks and benefits of UCITS gaining exposures to asset classes that are not directly investable for UCITS

ESMA discovered divergence between Member States in respect UCITS eligibility of direct exposure asset classes.  ESMA further found that Member States making inconsistent distinctions between different types of indirect exposures (such as delta-one instruments, derivatives, index replication, ETNs, AIFs) relating to the same underlying asset, means that such exposures might be permitted or forbidden, depending on the legal form of the instrument used.  These inconsistencies included whether and to what extent it was required to look through from the investment asset to the asset(s) underlying that investment asset, in particular different treatments of investment assets comprising:

• financial indices
• index tracking UCITS
• units/shares in collective investment undertakings

ESMA is concerned that the divergence in Member State supervisory practices and policy preferences relating to the application of look-through is such that there is no longer a level playing field within the EU.

ESMA recommends the Commission uses directly applicable EU regulations to promote greater harmonisation and convergence than now, as it has done in relation to other aspects of financial services law, in order to create a more level playing field.

Liquidity assessment

ESMA is of the view that the liquidity assessment to determine the eligibility of an individual assets is to be distinguished from the broader liquidity risk management at portfolio level.  The liquidity assessment of an asset is to determine whether it has the necessary qualities or satisfies the necessary conditions to be deemed investible for UCITS.  The portfolio level liquidity assessment is of the overall system put in place by the UCITS management company to ensure an ongoing ability to redeem investors on request.

ESMA recommends the Commission amends the text of EAD to reflect this.

Exposure to alternative assets and look through

The UCITS Directive sets out that UCITS have the “sole object” of investing in transferable securities or “other liquid financial assets” and provides an exhaustive list of traditional asset classes, in particular transferable securities and money market instruments.

Investments in precious metals or certificates representing precious metals and derivatives are prohibited under the UCITS Directive. 

The initial prohibition on investment in derivatives was subsequently loosened to permit derivatives on eligible asset classes, a concept that has been subject to varying interpretations at Member State level.

Look through

Since the UCITS EAD were adopted in 2007 the markets have developed financial instruments that wrap ineligible assets in such a way that they can be actively traded on regulated markets and thus are eligible for UCITS, providing indirect exposure to assets that were meant to be excluded from eligibility for UCITS. 

The most radical element of the proposals is to amend the EAD so that asset classes are not eligible for UCITS investments if they are  backed by, or linked to the performance of, other assets which do not fall within those set out in Article 50(1) of the UCITS Directive.  This would effectively reinstate the position as it was when the UCITS Directive was introduced:

• UCITS may invest in transferable securities, provided that they are not backed by ineligible assets
• UCITS may invest up to 10% of their assets in other collective investment schemes, including AIFs which are eligible transferable securities, again provided that they are not backed by ineligible assets
• UCITS may invest up to 10% of their assets in transferable securities or money market instruments other than those set out in Article 50(1) of the UCITS Directive, which would include investments in securities or instruments which are backed by ineligible assets, such as certain forms of derivatives, financial indices, investments in AIFs which are not eligible transferable securities, securitisations etc. The 10% limit is commonly referred to as “UCITS trash ratio”, a term which ESMA does not endorse.  The look through provisions would not apply to the trash ratio assets
• UCITS may not acquire precious metals or certificates representing them

To prevent circumvention by layering of instruments or schemes, ESMA proposes that the look-through approach is performed to the level of the final underlying investment.

ESMA believes that if its proposals for look through were enacted, fewer than 10% of UCITS would be affected, but suggests that the affected UCITS should be given the benefit of a transitional period in which to unwind their positions.

While ESMA’s proposal will leave some room for limited exposure to alternative assets to improve risk diversification and fund performance, the new approach to look-through would prevent significant indirect UCITS exposures to alternative assets.  Those funds which are indirectly invested in assets that are not UCITS eligible by using wrappers, may have to substantially restructure and reallocate their investments. 

Potential consequences for UK funds

Any reforms to the EAD will not directly affect the UK, if manufacturers run mirror funds in the UK and EU they will have to consider whether they will implement a restructuring of investment holdings of their UK funds in the event that the EU adopts a radical approach to look through.

AIF reforms

ESMA recognises that there is a demand for exposure to alternative assets through collective investment schemes.  Noting the limitations of the current AIFMD framework, under which marketing to retail investors is left to national discretion, ESMA suggests two possible future workstreams:

• reforming the rules on marketing AIFs to permit adoption of an ELTIF style retail passport
• creation of a new EU harmonised AIF product for investments in alternatives

Next steps

While the European commission will take careful note of any ESMA report, that does not mean that it will accept ESMA’s recommendations in full or even, in extremis, at all.  Member States which have adopted permissive interpretations of look through may seek to reshape the suggestions to avoid such potentially radical changes and their national fund industries may push them hard on this issue.  The legislative journey will take many months yet and it is proposed that there will be a transitional period, which will likely be longer the greater the impact of the reforms. 

How Eversheds Sutherland can help

Our team have been advising on regulatory interpretation and product development for the fund management industry since the 1980s and we have been at the forefront of new products under European and UK regulation since then. Our in-depth understanding of the sector and experience with the practical implementation of new product categories means that we are very well placed to guide you in complying with the changing product and regulatory environment.