ESMA Tightens the Reigns on UCITS Efficient Portfolio Management Oversight

ESMA recently published its findings after inspecting UCITS Efficient Portfolio Management and the report is likely to trigger higher standards of oversight and governance of UCITS EPM programs. Here’s what asset managers need to know.

On 30 July 2018, the European Securities and Markets Authority (ESMA) published a report outlining its findings of a peer review of six national competent authorities (NCAs) with regards to UCITS Efficient Portfolio Management (EPM). ESMA inspected the NCAs of Ireland, UK, Luxembourg, Germany, France, and Estonia based on elements of its 2014 Guidelines on ETFs and other UCITS issues.

As we have explored before, ESMA has shown a desire to take a stronger hand in regulating certain sectors of the market. This has been most notable in it views on delegation permissions to non-EU third countries, but in many ways ESMA already acts as a “regulator of regulators.” This EPM exercise shows how ESMA can use its current toolkit to drive regulatory harmonization across EU member states. Overall, ESMA found NCA practices to be compliant, however it did note some areas in need of enhancement. ESMA flagged specific NCAs that could do more to ensure harmony of approach across all member states and formally requested revisions to current supervisory practices.

Whilst the report addresses the NCAs directly, UCITS asset managers will feel its impact directly. The NCAs will likely act to ensure UCITS EPM rulesets are executed in line with the requirements which in turn is likely to heighten scrutiny of asset managers and UCITS management companies alike.

Here are three key impacts to UCITS managers stemming from the ESMA report:

  1. UCITS Operations

The most interesting theme arising from the ESMA report is the suggestion that there remains opaqueness around revenue splits from UCITS EPM programs. UCITS rules require that all revenue generated net of direct and indirect operational costs of activities such as securities lending must be directly returned to the fund to the benefit of the UCITS and its investors. Any costs and fees cannot include hidden revenues to service providers involved in the securities lending program or other EPM activities. ESMA suggested there are elements of the market which are not meeting transparency standards in terms of fee splits and program costs. ESMA noted divergent practices across the various NCAs and recommend it would take further policy action to achieve greater supervisory convergence and clarity.

It is also worth noting that ESMA identified several best practices within their review. These are items asset managers and fund boards can review their own current practices against, including:

  • A data driven approach to identify areas where resources should be best deployed. As relevant for fund boards as it is for regulators, transparent and understandable data is critical to adhering to ever-increasing corporate governance requirements
  • Bespoke reporting tools to best support oversight of UCITS guidelines

The ESMA report is likely to spur the various European regulators to review their policies and oversight procedures in relation to framing more explicit industry guidance on fees, costs, and revenue transparency accruing from EPM activities on UCITS funds. We also expect that all UCITS documentation, such as prospectus and risk management process documents, will be reviewed by boards to ensure they are operating in accordance with regulatory expectations. It is also likely that NCAs will conduct thematic reviews or spot checking of actual EPM practices within their industry inspections in late 2018 or early 2019.

Interestingly, the regulators of the two largest UCITS domiciles, the CSSF in Luxembourg and CBI in Ireland, have both previously conducted their own reviews of securities lending revenue arrangements and splits but did not report anything untoward.

  1. Collateral Management – Regulating the Regulators

ESMA’s UCITS guidelines contain detailed requirements for counterparties to provide the ongoing management, monitoring, and eligibility of collateral to a UCITS within their EPM trading programs. These rules set out specific parameters for collateral liquidity, valuation, credit quality, correlation, and diversification.

However, the ESMA report notes that whilst NCAs generally have compliant supervisory practices, two NCAs, the FCA in the UK and BaFIN in Germany, are currently in breach of UCITS guidelines. Both the UK and Germany currently grant exemptions from the collateral management requirements where the UCITS engages in a securities lending program with central securities depositories (CSDs). Going forward, we expect ESMA to more explicitly disallow such programs going forward. This crack down highlights that ESMA has powers to step in and demand compliance and consistency of approach where it sees regulatory divergence or even arbitrage, which is also a large focus of the Brexit regulatory debate.

  1. Increased Diligence on Disclosure Reviews

UCITS that engage in efficient portfolio management techniques are required to provide investors with associated risks, any conflicts of interest, and the fund’s policy on costs, fees, and revenues arising from its EPM program in its prospectus. This must be part of UCITS annual reports and may include financial derivative trading, repos, securities lending, and detailed disclosures of any collateral management program in place to support the EPM trading strategy.

ESMA indicated NCAs should be more vigilance in checking these mandatory disclosures in UCITS annual reports. ESMA suggested NCAs should scrutinize the disclosures independently and query them as required, instead of relying on self-reporting. This increased scrutiny puts a greater onus on UCITS and their boards to ensure that disclosures are adequate, accurate, and transparent. To adhere to the increased expectations, boards require timely, transparent, and easily digestible reporting from the providers of their securities lending and collateral management programs. This is something not all securities lending providers currently deliver.

Next Steps

The ESMA report outlines several best practices for all NCAs under its authority to consider, including enhancements to existing practices. ESMA also indicated it would take further policy action in the future but we expect the largest UCITS regulators, like the CSSF and CBI, may choose to take their own action in the meantime.

Asset managers and UCITS boards should confirm that their current securities lending and collateral management processes adhere to the detailed and stringent transparency requirements as set out in the UCITS Guidance.

ESMA review