GUIDELINES ON ETFs AND OTHER UCITS ISSUES

Transcription

1 EFAMA RESPONSE TO ESMA s CONSULTATION PAPER ON GUIDELINES ON ETFs AND OTHER UCITS ISSUES EFAMA welcomes the opportunity to reply to ESMA s Consultation Paper on ESMA s guidelines on ETFs and other UCITS issues. EFAMA is the representative association for the European investment management industry. EFAMA represents through its 26 member associations and 58 corporate members approximately EUR 13 trillion in assets under management of which EUR 7.9 trillion was managed by approximately 54,000 funds at end For more information about EFAMA, please visit EFAMA s membership includes a very large proportion of the European investment management industry, as well as nearly the entire European ETF industry, therefore EFAMA fully supports initiatives to promote the understanding and increase the robustness of UCITS products (including UCITS ETFs). Contents General Comments... 2 I. Index tracking UCITS... 3 II. Index tracking leveraged UCITS... 5 III. UCITS Exchange Traded Funds... 6 Definition of UCITS ETFs and identifier... 6 Actively managed UCITS ETFs... 8 Secondary market investors... 8 IV. Efficient portfolio management techniques... 9 V. Total Return Swaps VI. Strategy indices VII. Transitional provisions Annex I rue Montoyer 47, B 1000 Bruxelles Fax e mail : info@efama.org

2 2 General Comments 1. EFAMA strongly welcomes ESMA s decision to broaden the scope of these proposed guidelines in such a manner as to target not only UCITS ETFs but all UCITS that engage in relevant activities (such as Efficient Portfolio Management (EPM) techniques and the use of derivatives, including swaps) or pursue the same type of investment policy (such as tracking an index). 2. Furthermore, when considering investor protection and disclosure requirements, we strongly encourage ESMA as well as other regulators and supervisors to take a horizontal approach to funds and non funds products alike in the spirit of MiFID and of the PRIPs initiative. In this context, we very much support ESMA s statements that further consideration should be given to the development of harmonized definitions at European level of all exchange traded products and that products with broadly similar characteristics should be subject to the same level of regulatory requirements and that investors in such products should be able to rely on an equivalent level of regulatory protection (Consultation Paper, p. 11, paragraph 20). 3. As further detailed in our answer to question 6 below, EFAMA considers that the proposed definition of an UCITS ETF is still inaccurate and therefore must be improved as it does not sufficiently distinguish between UCITS ETFs and non ETF UCITS which are also listed or admitted to trading on a regulated market (this issue is particularly crucial in Denmark but also raises significant problems in Germany and in Austria). 4. EFAMA supports ESMA s move towards greater transparency as it will further enhance investor s understanding and confidence in UCITS products. Transparency requirements should however be proportionate and bring real added value in particular to retail investors allowing them to take well informed investment decisions. 5. As further explained in our detailed answers below, EFAMA has significant objections in relation to the collateral requirements both in the context of EPM techniques and the use of total return swaps (TRS) or other OTC derivatives and disagrees, in particular, with the proposed diversification rules for collateral. We indeed believe that these requirements are based on a wrong perception of the role played by collateral in the mitigation of counterparty risks. In this context, EFAMA believes that it is extremely important to bear in mind that collateral diversification rules and UCITS assets diversification rules have two distinct objectives, which should not be confused: the purpose of the collateral diversification is to reduce counterparty risks while the purpose of the assets diversification is to prevent excessive concentration of investments. As collateral is taken in order to reduce counterparty risks, we firmly believe that good credit quality and liquidity of the collateral are much more important than diversification.

3 3 6. EFAMA also believes that it will be important to clarify the scope of ESMA s proposed guidelines on Strategy Indices. We consider that there is no reason to restrict the scope of application of the proposed guidelines in Box 8 only to strategy indices. To the contrary, we believe that such guidelines should apply to all indices but only to the extent that they wish to benefit from the exemption under the third paragraph of Article 51.3 of the UCITS Directive 7. Lastly, even if EFAMA largely agrees with ESMA s proposed guidelines in many respects, it is essential to recognise that the industry but also national regulators will need a reasonable period of time to put these guidelines into practice. Equally important is the fact that specific transitional provisions should be foreseen for existing products, including notably a grand fathering clause for structured UCITS which do not accept any new subscriptions from the public. I. Index tracking UCITS Q1: Do you agree with the proposed guidelines? Concerning the scope of the proposed guidelines: EFAMA strongly welcomes ESMA s proposal to broaden the scope of these guidelines to all index tracking UCITS, not just ETFs. However, EFAMA believes that it is necessary to provide a clear definition of index tracking UCITS in order to differentiate those index tracking funds from other UCITS and, therefore, to unequivocally determine the scope of these guidelines. For this purpose, and with reference to Article 53 of Directive 2009/65/EC, EFAMA suggests the following definition of index tracking UCITS : A UCITS qualifies as an index tracking UCITS if, according to its fund rules or instruments of incorporation, the aim of its investment policy is to replicate the performance of a benchmark. Concerning the contents of the proposed guidelines: EFAMA supports ESMA s policy orientations towards greater transparency for investors in index tracking funds and broadly agrees with the proposed guidelines, subject to the following comments: 1. EFAMA agrees in principle with the proposal in relation to the description of the index including details of its underlying components (Box 1, 1a). In practice, however, it will not always be possible to direct investors to a website where the exact composition of the

4 4 index is published. Indeed, index providers may not be willing to publish the exact index composition on a real time basis in order to protect their proprietary information (for which their clients usually pay). One way to circumvent this difficulty would be to foresee the possibility to delay the publication of information about the composition of the index. 2. EFAMA has objections towards the suggestion requiring index tracking UCITS to adopt and disclose an ex ante tracking error policy, including in particular its target level (Box 1, 1c) for the following reasons: the tracking error may vary from time to time depending on a range of circumstances (liquidity in the market, taxes applied on the underlying securities, etc) and the ex ante tracking error may therefore significantly deviate from ex post figures. This may create confusion for investors and potentially mislead their investment decisions. Moreover, the inclusion of a target tracking error level in the prospectus could be interpreted by investors (but also in the audit policy) as a hard limit which would apply under any circumstances (even under extreme market conditions) therefore raising liability related issues for fund providers/distributors. EFAMA therefore considers that it would be more appropriate to disclose an indicative or anticipated tracking error which would provide an indicative range in normal market conditions, together with appropriate risk disclosures. Furthermore, in relation to paragraph 2 in Box 1, EFAMA wishes to point out that, in practice, it would be difficult to explain any divergence between any target and actual tracking error given the very broad range of variables which affect tracking error. Q2: Do you see merit in ESMA developing further guidelines on the way that tracking error should be calculated? If yes, please provide your views on the criteria which should be used, indicating whether different criteria should apply to physical and synthetic UCITS ETFs. EFAMA members would indeed see merit in ESMA developing further guidelines on a standardised calculation method of tracking error to allow for greater comparability between different funds. We wish to stress, however, that, regardless of the replication method being used, any standard measurement methodology should be very carefully considered and should be applied on a level playing field method to all index tracking funds in order to produce a result that is meaningful and consistent for investors.

5 5 Q3: Do you consider that the disclosures on tracking error should be complemented by information on the actual evolution of the fund compared to its benchmark index over a given time period? EFAMA understands that the reference made in this question to the actual evolution of the fund relates to the fund s performance (i.e. the tracking difference as defined in the IOSCO Consultation Report on Principles for the Regulation of Exchange Traded Funds 1 ) and would welcome ESMA s clarification in that respect. Subject to that clarification, EFAMA considers that such graphical comparison is useful, in particular to retail investors, in order to assess the quality of the index tracking strategy and to better understand and compare the respective merits of different fund offerings, regardless of the replication method being used EFAMA also wishes to point out that this comparison between the past performance of a UCITS and the performance of its benchmark is already included in the KIID (under Article 18 of UCITS Level 2, COM Regulation 583/2012 ( Use of a benchmark alongside the fund performance ). II. Index tracking leveraged UCITS Q4: Do you agree with the proposed guidelines for index tracking leveraged UCITS? Concerning the scope of the proposed guidelines: EFAMA strongly welcomes ESMA s proposal to broaden the scope of these guidelines to all index tracking leveraged UCITS, not just ETFs. It is worth noting, however, that not all index tracking leveraged UCITS are necessarily index tracking as, over time, their cumulative performance would diverge from that of the index. EFAMA therefore believes that all UCITS that employ leverage should be required to make similar disclosures. Concerning the contents of the proposed guidelines: Yes, EFAMA agrees with the proposed guidelines. Q5: Do you believe that additional guidelines should be introduced requiring index tracking leveraged UCITS to disclose the way the fund achieves leverage? 1 page 9, Box 3

6 6 No. EFAMA believes that the proposed disclosures in Box 2 are sufficient. III. UCITS Exchange Traded Funds Definition of UCITS ETFs and identifier Q6: Do you agree with the proposed definition of UCITS ETFs? In particular, do you consider that the proposed definition allows the proper distinction between Exchange Traded UCITS versus other listed UCITS that exist in some EU jurisdictions and that may be subject to additional requirements (e.g. restrictions on the role of the market maker)? EFAMA is of the opinion that the proposed definition is still inaccurate as it does not sufficiently distinguish between UCITS ETFs and non ETF UCITS which are also listed or admitted to trading on a regulated market. This issue is crucial in particular in Denmark as almost all UCITS aimed at the retail market in that country are traded on a tailor made market place called IFX (see on Nasdaq OMX. Those Danish listed UCITS would be caught by the definition proposed by ESMA, despite the fact that they cannot be considered as ETFs for a number of reasons described in Annex 1 to this document. The proposed definition also creates a significant problem in Austria and in Germany where fund units are often traded or in the so called open market section of the German Stock Exchanges ( Freiverkehr ) without consent, or even knowledge, of the responsible management companies. This is possible because UCITS distribution partners can order large blocks of units and then pass them through to other distributors, including market makers, who make on their own account the necessary arrangements for secondary trading. This scenario applies to many traditional UCITS offered for sale in the German and Austrian Markets. In order to take into account these specific situations, EFAMA therefore suggests the following alternative definition (changes to the definition proposed by ESMA are highlighted in bold): A UCITS exchange traded fund (UCITS ETF) is a UCITS at least one unit or share class of which is continuously tradable on at least one regulated market or multilateral trading facility (MTF) at the initiative or with the consent of the UCITS or its management company with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from its indicative net asset value without being restricted by the UCITS in this action.

7 7 Q7: Do you agree with the proposed guidelines in relation to the identifier? Yes. EFAMA supports the proposed guidelines in relation to the identifier. Q8: Do you think that the identifier should further distinguish between synthetic and physical ETFs? Almost all EFAMA members disagree that the identifier should distinguish between synthetic and physical ETFs for various reasons, including the following: 1. Funds are usually classified according to their strategy, not according to the type of instruments they use to implement their strategy. 2. The right place for such distinction is the KIID, not the fund name There is not enough space in the fund s name: the name of the ETF generally already include ETF, the name of the provider and the name of the index. The appropriate place for such information is the KIID, the prospectus or both. 3. Synthetic or physical replication are difficult concepts that cannot be understood without explanations (the same applies to actively managed ). The KIID and/or the prospectus have enough space to explain these concepts. 4. This distinction would not accommodate mixed situations, which often occur in practice: a. ETFs can use several techniques and switch from one replication to another, or use a combination of them, in order to optimize the return of the fund. For example, an ETF could own physically 90% of the shares of the index, proportionally to the weighting of the index, but use synthetic replication only for the remaining 10% of the index by purchasing some other shares and swapping them with the rest of the index. A threshold would be necessary to allocate a mixed ETF in one category or another. b. Physical ETFs sometimes invest in futures or in certificates on single stocks, instead of investing in the underlying stocks. One EFAMA member, however, believes that such a distinction would benefit end investors understanding of the fund policy and allow them to assess the associated risks and rewards with a particular ETF investment strategy. This member suggests that the identifier could be ascribed based on the principal replication methodology of the fund.

8 8 Q9: Do you think that the use of the words Exchange Traded Fund should be allowed as an alternative identifier for UCITS ETFs? EFAMA considers that UCITS management companies should be given the flexibility to use interchangeably the words ETF or Exchange Traded Fund in the identifier of the UCITS ETF. Q10: Do you think that there should be stricter requirements on the minimum number of market makers, particularly when one of them is an affiliated entity of the ETF promoter? EFAMA does not see the need for stricter requirements on the minimum number of market makers in case of affiliated entities but recognises that end investors would benefit from multiple market makers in a fund and are therefore one element of good practice in the ETF industry. We are indeed of the opinion that a market maker, affiliated or not, shall be equally under the obligation to ensure correlation between the bid and offer prices and the net asset value of the ETF units, particularly as the activities of market makers are regulated through their exchange membership agreements. Actively managed UCITS ETFs Q11: Do you agree with the proposed guidelines in relation to actively managed UCITS ETFs? Are there any other matters that should be disclosed in the prospectus, the KIID or any marketing communications of the UCITS ETF? EFAMA agrees with the proposed guidelines in relation to actively managed UCITS ETFs. Secondary market investors Q12: Which is your preferred option for the proposed guidelines for secondary market investors? Do you have any alternative proposals? EFAMA members concur in the desirability of ensuring the availability of liquidity for ETF investors and fully recognise that the right for UCITS unit holders to redeem their shares at any time is a fundamental tenet of UCITS products. Against this background, EFAMA is of the opinion that both options presented by ESMA represent equally suitable and valid redemption models which are recognised under the UCITS Level 1 Directive Indeed, according to the definition of UCITS in Article 1 para. 2(b), action taken by a UCITS to ensure that the stock exchange value of its units does not significantly vary from their net asset value shall be regarded as equivalent to such repurchase or redemption.

9 9 In order to account for this flexibility enshrined in the UCITS Level 1 provisions, EFAMA believes that both options should be available to ETF providers at their own choice. The relevant redemption procedure (secondary or primary market) and its implications in terms of costs should clearly be disclosed to the investors in the KIID and the fund prospectus. Q13: With respect to paragraph 2 of option 1 in Box 5, do you think there should be further specific investor protection measures to ensure the possibility of direct redemption during the period of disruption? If yes, please elaborate. EFAMA does not see the need for further guidelines in this respect given that paragraph 2 of option 1 already provides that UCITS ETFs shall also consider admitting direct repurchase of fund units by the ETF or its management company in order to cater for possible disruptions on the secondary market. Q14: Do you believe that additional guidelines should be provided as regards the situation existing in certain jurisdictions where certificates representing the UCITS ETF units are traded in the secondary markets? If yes, please provide details on the main issues related to such certificates. EFAMA is not aware of any specific concerns regarding this practice and does not believe it is detrimental to investors. Q15: Can you provide further details on the relationship between the ETF s register of unitholders, the sub register held by the central securities depositaries and any other subregisters held, for example by a broker or an intermediary? No comment. IV. Efficient portfolio management techniques Q16: Do you agree with the proposed guidelines in Box 6? In particular, are you in favour of requiring collateral received in the context of EPM techniques to comply with CESR s guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS? As a general remark on the proposed guidelines, EFAMA believes that is extremely important to bear in mind that collateral diversification rules and UCITS assets diversification rules have two distinct objectives, which should not be confused: the purpose of collateral diversification is to reduce counterparty risks while the purpose of the assets diversification is to prevent excessive concentration of investments. We firmly believe that good credit quality and liquidity of the collateral are much more important than diversification.

10 10 EFAMA therefore strongly disagrees with the proposed guidelines on collateral diversification (Paragraph 7 in Box 6) for a number of reasons further detailed below and in our answer to Question 20. Apart from that, EFAMA supports the move towards greater transparency in relation to the use of EPM techniques as it will help to further enhance investors confidence in UCITS products and broadly agrees with the proposed guidelines in Box 6, subject to the following remarks: Paragraph 2 (collateral policy): EFAMA is of the opinion that the required information on the UCITS collateral policy should not be too detailed in order to avoid frequent updates to the prospectus in case of minor amendments or periodic updates to the collateral policy. We therefore consider that the prospectus should provide a description of the collateral policy in relatively generic terms and include a reference to an external source (e.g. provider s website) where the relevant policy would be disclosed in more details. This detailed information should also be available on a durable medium to be sent free of charge upon request from investors. Paragraph 3 (transparency of fees): EFAMA agrees with the principle that fees arising from EPM techniques should be disclosed to investors. We wish to point out however that fees arising from EPM techniques, particularly from securities lending, typically are expressed as a percentage of the total securities lending revenues which depend on the amount of assets lent and the fees received of the assets lent. As both factors vary across time and are unknown in advance, it is difficult to disclose these fees in the prospectus like e.g. the management fee of the fund. EFAMA therefore suggests that it would be preferable that the prospectus disclose the criteria used to calculate the fees whereas disclosure of the actual amount of fees arising from EPM techniques over a certain period of time should be performed reasonably ex post in the annual reports of the fund rather than in its prospectus. In relation to the guideline proposed by ESMA following which fees arising from EPM techniques should, as a general rule, be returned to the UCITS, we wish to underline that securities lending is rightly recognised by ESMA as a legitimate activity which benefits investors by reducing costs and contributing to the performance of the fund. However, in order to provide securities lending services and to generate incremental returns, significant investments are required (including in research and technology infrastructure, administration and risk management capabilities to constantly review counterparties and collateral parameters). Those fixed and variable costs will usually not only be borne by the securities lending agent but also by the UCITS management company. In order to cover these costs, it is very important that fee sharing agreements remain admissible not only with external agents involved in the lending activities but also between the UCITS and its management company. We therefore disagree with the implicit assumption in paragraph 44 of ESMA s Consultation

11 11 Paper that fee sharing agreements are authorized only in relation to the securities lending agent. Paragraph 5: EFAMA strongly disagrees with the proposal that a UCITS should be able to recall any security that has been lent at any time or terminate any securities lending or repo agreement it has entered into. This would effectively restrict UCITS from entering into fixedterm securities lending or repo contracts, both of which require securities that are lent to be returned at a specific point in time and as such would restrict the return available from this technique ( daily term repos are available but the repo rate would be higher and the counterparty is under no obligation to renew). This would have a damaging effect on the returns from such activities with little benefit from a risk mitigation perspective. Paragraph 6: EFAMA broadly agrees with the fact that collateral received in the context of EPM techniques should comply with the criteria for the collateral received in the case of OTC derivatives set out in Box 26 of CESR s guidelines on Risk Measurement, except for the requirement that cash collateral should be invested only in risk free assets (please refer to our answer to Question 17 below for further details). Paragraph 7: EFAMA agrees with the principle that collateral should be sufficiently diversified, as highlighted in Box 26 of CESR s guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty risks for UCITS but fundamentally disagrees with the requirement that the combination of the collateral received by the UCITS and the assets of the UCITS not on loan should comply with the UCITS diversification rule (please refer to our answer to question 20 for further details). Furthermore, EFAMA objects with ESMA s statement (in footnote 7 on page 20 of the Consultation Paper, following which collateral received (excluding cash collateral) has to be held by the depositary. This question is currently being discussed in the context of the adoption of the AIFMD Level 2 implementing measures and is only expected to be tabled at a later stage in the context of the UCITS V review. We therefore urge ESMA not to anticipate on the outcome of these legislative debates. We also note that, in the context of OTC derivative transactions, Box 26 of CESR s guidelines on Risk Measurement explicitly allows for collateral to be held with a third party custodian (thus, not necessarily with the depositary). Q17: Do you think that the proposed guidelines set standards that will ensure that the collateral received in the context of EPM techniques is of good quality? If not, please explain. Generally speaking, EFAMA believes that the guidelines on collateral in Box 26 of CESR s guidelines on risk measurement set good standards in terms of quality of the collateral provided to reduce the counterparty risk exposure in the management of OTC derivatives and therefore welcomes the application of a coordinated and consistent approach to the collateral received in the context of EPM techniques.

12 12 However, in the context of securities lending, EFAMA disagrees with the requirement in Box 26 that cash collateral can only be invested in risk free assets. Within conservative reinvestment parameters, cash can be a useful collateral type for investors, but requiring risk free reinvestment will reduce the viability of cash as collateral. Please also refer to our answers to questions 19 and 20 with respect to collateral diversification. Q18: Do you see merit in the development of further guidelines in respect of the reinvestment of cash collateral received in the context of EPM techniques (the same question is relevant to Box 7 below)? Please refer to our answer to question 17 above. Q19: Would you be in favour of requiring a high correlation between the collateral provided and the composition of the UCITS underlying portfolio? Please explain your view. EFAMA fundamentally disagrees with the principle following which there should be a high correlation between the collateral received and the composition of the UCITS portfolio. We believe that this approach is based on a wrong perception of the role of collateral in the context of EPM techniques. Indeed, it seems to assume that the collateral should be a suitable substitute to the portfolio assets on loan which, in case of default of the counterparty would be directly transferred to the UCITS portfolio. In the prevailing market practice, however, the collateral is provided as means of secondary recourse with respect to the entitlement to retransfer of portfolio assets. In case of default, the collateral is being immediately liquidated and the proceeds used to acquire new securities matching with the UCITS investment strategy. For these reasons, the first objective of regulatory requirements should be to ensure that the collateral received by the UCITS is both of a good credit quality and sufficiently liquid so as to warrant the possibility of smooth disposal and adequate pricing. In this context, we do not believe that high correlation of the collateral with the portfolio is necessary to protect the investors. On the contrary, requiring such correlation would even be detrimental to investors in a number of cases (e.g. a UCITS investing in equities would be prevented from accepting triple A rated bonds in order to secure claims from EPM transactions). Q20: Do you agree that the combination of the collateral received by the UCITS and the assets of the UCITS not on loan should comply with the UCITS diversification rules? EFAMA agrees that collateral should be sufficiently diversified, as foreseen in Box 26 of CESR s guidelines on Risk Measurement and the Calculation of Global Exposure and

13 13 Counterparty risks for UCITS. However, EFAMA strongly disagrees with the principle that the collateral received by the UCITS and the UCITS assets not on loan should on aggregate comply with the UCITS diversification rules. Such a proposal would indeed raise major practical difficulties, essentially for the following reasons: The NAV calculation of a fund is based on its retained portfolio and its lent portfolio where securities lending is used. The investment portfolio does not include the collateral received. In the investment portfolio risk diversification applies to spread the investment risk across assets. While liquid assets have to be held to meet on going redemption requests, the focus is primarily on finding an asset mix which meets the long term investment objectives of the fund The key driver for collateral is the speed at which collateral can be liquidated in order to buy back lent assets on a failure of redelivery. This favours the inclusion of very liquid or short term instruments. If collateral is included in the overall UCITS diversification rules, funds would have to run two parallel calculations one for the standard NAV calculation without collateral and then one including collateral with no obvious benefit Typically collateral programmes are not managed by the portfolio management teams but by specialised collateral management and risk teams which emphasises that collateral management is primarily a risk mitigation tool rather than an investment tool. Combining the two risks blurs the boundary between the two rules which runs contrary to recent developments in UCITS and AIFMD regulations which encourage separate risk functions. Collateral is generally required to be of the highest quality under existing guidance if collateral is added into the UCITS investment diversification restrictions collateral would be subject to diversification in accordance with the fund s investment policy. Many funds would be in breach of their investment policies if they hold significant holdings of high quality government bonds and cash which typically make up collateral schedules. Holding lower quality assets but diversified assets would lead to greater potential exposure to unit holders in the event of counterparty default. Again, we strongly believe that good credit quality and liquidity of the collateral are much more important than diversification. Q21: With regards to eligibility of assets to be used as collateral, do you have a preference for a list of qualitative criteria (as set out in CESR s guidelines on risk measurement) only or should this be complemented by an indicative list of eligible assets? EFAMA has a clear preference for qualitative criteria as set out in CESR s guidelines on risk measurement.

14 14 Q22: Alternatively, do you see merit in prescribing an exhaustive list of assets eligible for use as collateral? If so, please provide comments on whether the list of assets in paragraph 52 is appropriate. No. An exhaustive list would be inflexible in case of market changes and therefore runs the risk of not adequately reflecting the market conditions in terms of liquidity at a given point in time. Q23: Do you believe that the counterparty risk created by EPM techniques should be added to the counterparty risk linked to OTC derivative transactions when calculating the maximum exposure under Article 52(1) of the UCITS Directive? A clear majority of EFAMA members disagree with the suggestion to account a counterparty risk for EPM techniques in calculating the maximum counterparty limits for OTC transactions under Art. 52 (1) of the UCITS Directive. In their opinion, it should be sufficient to include the counterparty risk created by securities lending and repo transactions in the calculation of the 20% limit for risk exposure to a single entity under Art. 52(2)2 nd subparagraph, letter c. Some EFAMA members believe however that it makes sense to cumulate those risks. In their view, all counterparty risks should be aggregated and regulated globally and EPM techniques should have a counterparty risk limit of max 5% for a normal counterparty and 10% for banks, just like in OTC derivatives. They consider, indeed, that it would make sense when calculating the maximum exposure under Article 52(1) for a given counterparty, to add the counterparty net exposure created by the EPM techniques (net of haircuts and collateral) to the total counterparty exposure of the UCITS linked to OTC transactions (net of haircuts and collateral). Q24: Do you agree that entities to which cash collateral is deposited should comply with Article 50(f) of the UCITS Directive? Yes. EFAMA agrees. Q25: Do you believe that the proportion of the UCITS portfolio that can be subject to securities lending activity should be limited? If so, what would be an appropriate percentage threshold? No, EFAMA believes that it would not be in the best interest of investors to prescribe such a limit at the level of the UCITS portfolio as a whole. Limiting the proportion of the portfolio that can be lent would limit the opportunities for UCITS to engage in securities lending transactions and would therefore lead to reduced competitiveness. Provided the risk management techniques are robust and CESR s guidelines on Calculation of Global Exposure and Counterparty Risks are applied, establishing a limit at the UCITS

15 15 portfolio level will be detrimental to the UCITS ability to ensure best pricing and to maximize returns without further mitigating counterparty risks. Q26: What is the current market practice regarding the proportion of assets that are typically lent? It is very difficult to give an answer to that question as it depends to a great extent on prevailing market conditions, dividend season, quality of assets and clients demands. Q27: For the purposes of Q25 above, should specific elements be taken into account in determining the proportion of assets (e.g. the use made by the counterparty of the lent securities)? Please refer to our answer to question 25. Q28: Do you consider that the information to be disclosed in the prospectus in line with paragraphs 1 and 2 of Box 6 should be included in the fund rules? Provided the information is already disclosed in the prospectus, EFAMA does not see the need to repeat it in the fund rules. It may be useful to include in the fund rules a general provision with regard to the intention to engage in EPM techniques but more specific information should only form part of the prospectus. Q29: Do you see the merit in prescribing the identification of EPM counterparties more frequently than on a yearly basis? If yes, what would be the appropriate frequency and medium? No, EFAMA does not think that prescribing the identification of EPM counterparties on a more frequent than yearly basis would provide an added value for investors. Q30: In relation to the valuation of the collateral by the depositary of the UCITS, are there situations (such as when the depositary is an affiliated entity of the bank that provides the collateral to the UCITS) which may raise risks of conflict of interest? If yes, please explain how these risks could be mitigated? The question is also valid for collateral received by the UCITS in the context of total return swaps. First of all, EFAMA would like to clarify that the depositary is not necessarily the entity in charge of the valuation of the collateral. We also wish to underline that, the collateral being in principle composed of highly liquid assets, its valuation process will, in most instances, be relatively straightforward and objective. In practice, the potential for conflicts of interests in relation to the valuation of the collateral is therefore relatively limited in our opinion.

16 16 Moreover, we believe that the existing regulation applicable to conflicts of interests is appropriate to efficiently manage (and, as the case may be, disclose to investors) potential conflicts of interest in relation to valuation of the collateral. Q31: Do you think that the automation of portfolio management can conflict with the duties of the UCITS management company to provide effective safeguards against potential conflicts of interest and ensure the existence of collateral of appropriate quality and quantity? This question is also relevant to Box 7 below. No. Automation of portfolio management techniques does not relieve UCITS management companies of their usual duties of risk measurement, including monitoring of the collateral (both in terms of quality and quantity). Provided the automation of the portfolio management operates under the guidelines, supervision and control of the risk management department of the UCITS management company, we do not believe it raises specific issues. V. Total Return Swaps Q32: Do you agree with the proposed guidelines? EFAMA supports the move towards greater transparency in relation to the use of Total Return Swaps as it will help to further enhance investors confidence in UCITS products and broadly agrees with the proposed guidelines in Box 7, subject to the following remarks: Paragraph 1: EFAMA does not consider that UCITS diversification rules should apply to the swap underlying. Instead, Box 26 of CESR s guidelines should apply. TRS are financial instruments in the sense of MiFID and should be treated as such for the purpose of measuring market risk. It is essential, but also sufficient to adhere to the diversification rules with regard to the UCITS portfolio net of exposure through derivatives, as risks taken by investors are the real exposure of the fund, after the effect of derivatives. UCITS diversification rules are meant to avoid the possibility that exposure to a given issuer would have too significant an impact on the performance of the fund. However, the portfolio swapped in a TRS has no impact on the performance of the UCITS, since it is swapped. Instead, the UCITS has counterparty risk on the counterparty to the TRS, and the risk is subject to a 10% limit. Furthermore, ESMA s proposed guideline in Box 7, paragraph 1 seems to be based on the assumption that each UCITS portfolio and the underlying to the swap to which the UCITS obtains exposure must in itself comply with the UCITS diversification rules. However, this approach completely disregards the fact that UCITS may conclude swap agreements only in relation to a fraction of the fund portfolio. If, for instance, a UCITS enters into five different swap agreements, each of which ensures participation rates rating from 10 to 20%, then

17 17 there is no reason why each of these baskets should comply with the UCITS diversification requirements. We therefore strongly advocate not considering the underlying baskets in isolation, but allowing for delta adjustment of the relevant swap underlyings in the assessment of compliance with UCITS diversification rules. Paragraph 2: EFAMA agrees that the collateral should be sufficiently diversified as foreseen in Box 26 of CESR s guidelines on Risk Measurement. However, EFAMA would like to reiterate its position that due to its purpose to provide secondary recourse in case of a counterparty s default, the collateral should not be treated as part of the fund portfolio and thus not be subject to the UCITS diversification rules in combination with other assets (please refer to our answer to question 20 above and 37 below for further explanations). Paragraph 5: EFAMA considers that the information to be provided further to this paragraph is too specific in order to be fully included in the prospectus. In particular, details of counterparties and type of collateral may change very frequently. EFAMA therefore suggests that criteria for choice of counterparties and determination of eligible criteria should only be described in the prospectus in a generic manner, with further details being provided in the annual report (in accordance with paragraph 6 of Box 7). Moreover, EFAMA disagrees with the principle in paragraph 5d) of Box 7, following which the counterparty to the TRS should, under certain conditions, be treated and disclosed as an investment manager. Indeed, as a matter of principle, the counterparty should not have discretion on investments that have an impact on the performance/portfolio of a UCITS. As for any swap, the investment manager of the UCITS sets guidelines for acceptable collateral and the counterparty retains some discretion within these guidelines to choose the securities it gives as collateral. In other words, the only flexibility/discretion the counterparty can have is within the strict guidelines given by the manager of the collateral of the TRS (i.e. the investment portfolio that is swapped). The decisions of the counterparty have no impact on the performance of the fund. Such rudimentary discretion should not be treated as any other discretionary decision related to the UCITS portfolio as it appears inappropriate in these circumstances to consider the swap counterparty as an investment manager. Finally, we note that paragraph 58 of the Explanatory text indicates, in relation to the use of TRS, that ( )This investment can represent up to 100% of the assets, in which case the UCITS can be qualified as a structured UCITS. We believe that this statement is creating a lot of confusion and therefore request ESMA to clarify that a UCITS can be qualified as a Structured UCITS only when it complies with the definition set forth in Article 36(1a) of Commission Regulation 583/2010 (KIID): Structured UCITS shall be understood as UCITS which provide investors, at certain predetermined dates, with algorithm based payoffs that are linked to the performance, or to the realization of price changes or other conditions, of financial assets, indices or reference portfolios or UCITS with similar features.

18 18 Q33: Do you think that the proposed guidelines set standards that ensure that the collateral received in the context of total return swaps is of good quality? If not, please explain your view. Generally speaking, yes. However, see our remarks under Question 32 above. Q34: Do you consider that the information to be disclosed in the prospectus in line with paragraph 5 of Box 7 should be included in the fund rules? No, EFAMA does not see the need for including this information in the fund rules, for the same reasons as under Question 28 above. Q35: With regards to eligibility of assets to be used as collateral, do you have a preference for a list of qualitative criteria (as set out in CESR s guidelines on risk measurement) only or should this be complemented by an indicative list of eligible assets? EFAMA has a clear preference for qualitative criteria as set out in CESR s guidelines on risk measurement. Q36: Alternatively, do you see merit in prescribing an exhaustive list of assets eligible for use as collateral? If so, please provide comments on whether the list of assets in paragraph 73 is appropriate. No. An exhaustive list would be inflexible in case of market changes and therefore runs the risk of not adequately reflecting the market conditions in terms of liquidity at a given point in time. Q37: Do you agree that the combination of the collateral received by the UCITS and the assets of the UCITS not on loan should comply with the UCITS diversification rules? EFAMA agrees that collateral should be sufficiently diversified. However, for the reasons already explained under Question 20 above, EFAMA members strongly disagree with the principle that the collateral received by the UCITS and the UCITS investments should, on aggregate, comply with the UCITS diversification rules. Please note the reference to assets not on loan is inappropriate in the context of TRS transactions. Q38: Do you consider that the guidelines in Box 7 and in particular provisions on the diversification of the collateral and the haircut policies should apply to all OTC derivative transactions and not be limited to TRS? In principle, EFAMA considers that there is no reason not to apply the same standards in terms of collateral requirements to all OTC derivatives transactions. However, we would like to reiterate here our strong reservations concerning some of the contents of the proposed guidelines in Box 7, in particular concerning provisions on diversification of the swap

19 19 underlying and the collateral received by the UCITS (please refer to our answer to Question 32 above). VI. Strategy indices Q39: Do you consider the proposed guidelines on strategy indices appropriate? Please explain your view. Concerning the scope of the proposed guidelines: EFAMA broadly agrees with the objectives of the proposed guidelines towards greater transparency. However, EFAMA considers that it is of utmost importance to clarify the scope of application of the proposed guidelines in order to remove any uncertainty as to the type of indices to which they would apply and to be able to assess their potential impact. In particular, it would be essential to determine without any ambiguity whether the guidelines proposed in Box 8 apply solely to strategy indices or pertain also to other financial indices eligible for UCITS. In this regard, EFAMA believes that there is no reason to restrict the scope of application of the proposed guidelines in Box 8 only to strategy indices. To the contrary, we believe that such guidelines should apply to all indices but only to the extent that they wish to benefit from the exemption of Article 51.3, third paragraph of the UCITS Directive, following which: Members States may provide that, when a UCITS invests in index based financial derivative instruments, those investments are not required to be combined for the purposes of the limits laid down in Article 52. Concerning the contents of the proposed guidelines: Subject to our request for clarification of their scope, we also have the following remarks regarding the contents of the proposed guidelines: Paragraph 4: Clarifications are required as to the conditions that a strategy index needs to fulfill to demonstrate that it satisfies the index criteria, including in relation to the following queries: how can a strategy index represent a benchmark forthe market to which it refers? what is the meaning of single objective?

20 20 Paragraph 5: costs of rebalancing are in certain instances very difficult to estimate (e.g. if a strategy index replicates a trading or quantitative strategy which might have ad hoc rebalances to bring the index portfolio back in line). Paragraph 6: While agreeing that intra day rebalancing may prevent investors from being able to replicate the index, this conclusion is not necessarily justifiable in the case of daily rebalancing. It is important to note that risk controls in an index, such as measurement and management of target volatility, are vital and daily rebalancing in such cases must be considered in the best interest of investors. Furthermore, it seems highly unlikely that the majority of investors can replicate a financial index (even a relatively static index), therefore it seems arbitrary to suggest that index re balancing frequency is the characteristic that limits their ability to replicate. More generally, the key issue for investors is to be able to take well informed investment decisions, i.e. to have sufficient and appropriate information to understand their investment (including information on how the index is designed and what the fund consists of, as opposed to information on how to replicate the index). Paragraphs 7 and 8: Further clarification is required as to what is exactly meant by disclosing full calculation methodology. More generally, it is important to protect intellectual property; the implementation of such guidelines will threaten proprietary indices and undermine the incentives to develop strategy indices. Providing all of the components, constituents and calculation methodologies mean that all indices are freely available for those who are in a position to replicate. This also raises the issue of how this information can be made available in a retail format. The calculation of indices often involves mathematical formulae which are too complex for retail investors to understand. Therefore, a reasonable level of disclosure of the re balancing methodology (such as timing factors and potential limits) and of the index constituents along with an appropriate time lag would, in our opinion, be more appropriate. Paragraph 13: The level of independence required should be further specified, i.e. whether the assessment could be carried by an independent entity within the same organisation/group. Does ESMA suggest that there should be another layer of valuation which is independent from the independent valuation of the index as such? What would be the frequency of this assessment? Q40: Do you think that further consideration should be given to potential risks of conflict of interest when the index provider is an affiliate of the management company? No, so long as the index methodology is transparent as suggested by point 7, in Box 8, and the relationship between the index provider and the management company is appropriately