ESMA Consultation paper on the treatment of repurchase and reverse repurchase agreements.

25 September 2012 ESMA 103 Rue de Grenelle 75007 Paris France Dear Sir/Madam ESMA Consultation paper on the treatment of repurchase and reverse repurchase agreements. IMA represents the UK-based investment management industry. Our Members include independent asset managers, the investment management arms of retail banks, life insurers and investment banks, and the managers of occupational pension schemes. They are responsible for the management of over 4.2 trillion of assets, which are invested on behalf of clients globally. In particular, they manage both UCITS and non-ucits. The use of repos and reverse repos will become much more important if and when UCITS are required to post more liquid collateral in the future under Central Clearing arrangements. However, we are concerned that the proposed guidelines will prevent UCITS from entering into repo transactions to finance variation margin requirements. Without the use of repos, UCITS might no longer be able to engage in derivative contracts to an economically reasonable extent or they might be forced to retain some cash from subscriptions in order to collateralise OTC derivative trades. Please find attached our detailed response to the questions raised. We would welcome the opportunity to discuss these points with you. Yours faithfully Perry Braithwaite Adviser Product Regulation 1

ESMA Consultation paper on the treatment of repurchase and reverse repurchase agreements. Q1: What is the average percentage of assets of UCITS that are subject to repurchase and reverse repurchase agreements? Repos are a form of borrowing and are principally used to generate cash for funding purposes or to raise cash for onward reinvestment. Reverse repos are a cash management tool and have largely replaced the unsecured deposit market. The use of repo and reverse repo arrangements in UK authorised UCITS is limited. However, these transactions will become much more important if and when UCITS are required to post more liquid collateral in the future under Central Clearing arrangements see response to question 2 below. The average percentage of assets subject to repurchase and reverse repurchase agreements will differ depending on the type of transaction. We are aware of government liquidity funds that use reverse repos to obtain the target sovereign credit risk. Such reverse repos can be as high as 80% of the portfolio, but on average are 50% with the balance in government bills. In credit funds, reverse repos may be used as an alternative to deposits, depending on yield, supply and ratings available in the two instrument types. The maximum would be around 10%, with usage ranging between 0% and 10%. We are aware that repos are used by some UCITS as a low risk means of generating additional return for investors. An example of this would be the use of repos in low risk cash benchmarked funds where the cash collateral obtained from repos is reinvested in, for example, an AAA-rated liquidity fund yielding an interest rate return in excess of what the UCITS pays on the repo leg. Reverse repos can be thought of as a collateralised deposit. Therefore, there should not be any limitations on their use, subject to compliance with other requirements such as counterparty exposure and liquidity. Further restrictions could lead to longer term deposits being placed on an un-collateralised basis, increasing the risk to the UCITS. For the purposes of this question, please have regard to arrangements covered by the provisions of Article 51(2) of the UCITS Directive and Article 11 of the Eligible Assets Directive (i.e. those arrangements which do not fall under the definitions of transferable securities and money market instruments, in accordance with recital 13 of the Eligible Assets Directive). In addition, please provide input on the following elements: i) the extent to which assets under such arrangements are not recallable at any time at the initiative of the UCITS. As stated above, use of repo and reverse repo arrangements in UK-authorised UCITS is limited. However, we are aware of that UK investment managers of UCITS authorised elsewhere enter into reverse repurchase agreements that contain put and call provisions, making them as readily recallable as normal time deposits. Such flexibility does, however, come at a cost. 2

ii) the maximum and average maturity of repo and reverse arrangements into which UCITS currently enter. Please provide a breakdown of the maturities with reference to the proportion of the assets of the UCITS. As stated above, use of repo and reverse repo arrangements in UK-authorised UCITS is limited. However, we are aware that UK investment managers of UCITS authorised elsewhere enter into reverse repurchase agreements for overnight transactions, with few exceeding maturities of one week. The wholesale repo and reverse repo markets transact up to 1 year. We recommend that there should be the same maximum duration for UCITS, as long as the appropriate liquidity management framework is put in place. Q2: Do you agree with the proposed guidelines for the treatment of repo and reverse repo agreements? If not, please justify your position. We recommend that the position of cash revenues acquired from the use of repo transactions is clarified in the guidelines in order to avoid potential confusion. Cash revenues generated from the sale of investments should not be viewed as collateral. In particular, repos involve the transfer of legal and economic ownership in the relevant securities, meaning that securities submitted to repo transactions are no longer considered portfolio assets and not accounted for in the calculation of investment limits. This means that, on the other hand, UCITS also hold genuine ownership of cash acquired from repo trades and can use it for any legitimate purpose, be it investment, collateralisation or satisfaction of redemption requests by investors. In these circumstances, it is not acceptable to submit cash proceeds from repos to the same restrictions as cash collateral from securities lending. In practical terms, such an outcome would have grave implications for the UCITS' ability to collateralise OTC derivative transactions under EMIR. In the context of EMIR, ESMA itself is currently suggesting that collateralisation of both centrally cleared and bilateral derivative trades shall be limited to "highly liquid assets", which already excludes equities from the range of eligible collateral. In addition, the variation margin required as a reaction to price movements in underlying securities shall be acceptable in cash only. In case of UCITS, however, liquidity from unit subscriptions is usually used for investment purposes in line with the defined investment strategy in order to generate returns for investors and to satisfy redemption requests. Hence, UCITS must rely on other sources of liquidity in order to obtain assets eligible for collateral. Should repos be no longer usable in this context, UCITS might no longer be able to engage in derivative contracts to an economically reasonable extent or they might be forced to retain some cash from subscriptions in order to collateralise OTC derivative trades. Either result would have negative effects on the UCITS' ability to realise its investment strategy and, consequently, would be detrimental to the interests of investors. We do not agree with paragraph 40 (i) of the ESMA Guidelines regarding the inability to pledge non-cash collateral received. If UCITS are likely to enter into reverse repo transactions to facilitate collateral management, they will need to be able to pledge the collateral received. We believe that it should be possible to re-hypothecate all received collateral and not just cash. 3

A general observation is that there would benefits to clearing both repo and securities lending transactions centrally as this would increase transparency and reduce risk. We disagree with the proposal that collateral should agree with the criteria set out in paragraph 40 of ESMA s Guidelines. The 20% cap on single issuer exposure for collateral received will cause certain UCITS (e.g. those offering 100% sovereign exposure) to diverge from their objective by creating a conflict between the two primary objectives of the fund, namely provision of 100% sovereign credit exposure and provision of high liquidity. In times of increased market volatility, sovereign liquidity funds will adopt the defensive strategy of increasing their short-dated liquidity to levels of up to 50% of net asset value. The 20% cap on single issuer exposure will limit readily available short-dated liquidity to 20% and force the funds to invest the remaining 80% in direct issues of the sovereign issuer. When needing a further 30% of short-dated liquidity to adopt a defensive strategy, the funds will have to compete for expensive short-dated treasury bills, which are subject to restricted supply. If such supply is inadequate, they will be forced to take longer-dated sovereign issues which, if redemption levels force funds to sell those issues before their maturity, could give rise to realised duration risk and dealing spreads. Such limiting of holdings of shortdated cash runs counter to the objectives of these funds. ESMA s Guidelines appear to rule out the use of reverse repos involving a wider range of collateral e.g. non-investment grade fixed income securities, equities, and money market securities. The guidelines state that all assets received by the UCITS in the context of efficient portfolio management techniques should be considered as collateral. There should be a distinction between securities that may be purchased under a reverse repurchase agreement and securities that may serve as a guarantee and that reduce counterparty exposure. In economic terms, collateral aside, a reverse repurchase agreement with a credit institution would be equivalent to a time deposit. It is anomalous that a UCITS could have a 20% counterparty exposure to a credit institution through a totally uncollateralised time deposit, but could have no exposure to the same counterparty through a reverse repurchase agreement with identical size and maturity simply because the assets purchased did not qualify as a guarantee. Receiving equity as collateral in a reverse repo transaction does not expose the UCITS to equity market risk and, therefore, does not breach paragraph 24 of the Guidelines on Eligible Assets for Investment by UCITS [or paragraph 27 of ESMA s Guidelines on ETFs and other UCITS issues]. Reverse repo transactions are markedto-market daily and subject to margining requirements. If the value of the equities received drops, the fund s counterparty must give the UCITS either more equities or more cash to make up the valuation differential. After this margin exchange, the UCITS possesses collateral that has the same cash value as on the prior day. The UCITS would be exposed to equity market risk only if the fund s counterparty defaulted, which argues for robust counterparty exposure management. We strongly believe that it is better to have a collateralised exposure to a counterparty via a reverse repo transaction than an uncollateralised exposure to a bank via a time deposit. 4

Evidence suggests that counterparties do not provide funds with the flexibility to unwind the reverse repos on an accrual basis. The fund will receive the accrued interest but also pay a cost to achieve this. However, there is no legal requirement to be able to unwind a repo or a reverse repo transaction before the end of the fixed term of the contract. The legal agreement concerning these transactions in the UK (Global Master Repurchase Agreement - GMRA) does not contain a break clause. Being able to exit a repo or reverse repo transaction at fair market value is entirely dependent upon a) the relationship between the UCITS manager and the repo / reverse repo counterparty and b) the willingness of the repo / reverse repo counterparty to execute such a transaction at a given moment in time. Recalling reverse repo assets without a cost of unwinding the transaction will be difficult because the counterparty must price the reverse repo arrangements with the collateral profile, FX rates, funding cost and the maturity date in mind. The market price of unwinding a reverse repo ( unwind cost ) will be the price the counterparty will quote for entering into an equal and opposite repo transaction. The fund will pay the counterparty the fair value price (i.e. the marked-to-market price) of unwinding the hedges they executed in order to enter into the reverse repo with the fund. The settlement figure will be equal to the accrued interest plus unwind cost, which may be positive or negative. The objective of the ESMA guidelines should be to ensure that the UCITS does not incur significant cost or experience liquidity issues in unwinding EPM techniques when required to meet redemptions. Steps that can be taken to limit this cost include: - Limiting the maturity date of the reverse repo arrangement to [X] months. The longer the maturity date, the higher the potential unwind cost (or profit). This should be determined by the UCITS or its management company based upon the liquidity profile of the UCITS and its redemption obligations. For example, we are aware of UCITS that use a target to limit the longest maturity in reverse repo arrangements to 3 months. - The liquidity profile of the reverse repo arrangement could be between [0-10] business days for [X%] of the fund s net asset value, where X% is level that is sufficient to meet large redemption requests. This should be determined by the UCITS or its management company based upon the liquidity profile of the UCITS and its redemption obligations. For example, we are aware of UCITS where the aim is to have between 15% and 20% of the reverse repo portfolio maturing within the next 7 business days. The fund can allocate up to 85% to reverse repos so 15% represents 12.75% of the fund s net asset value. Q3: What are your views on the appropriate percentage of assets of the UCITS that could be subject to repurchase and reverse repurchase agreements on terms that do not allow the assets to be recalled by the UCITS at any time and that would not compromise the ability of the UCITS to execute redemption requests? Given the wide range of UCITS, we disagree with a set percentage limit. A limit that is appropriate to one fund will likely be inappropriate for another. 5

It is sufficient that there be a guideline to the effect that a UCITS should ensure that an arrangement does not compromise its ability to meet its redemption obligations in accordance with Article 84. Proposed guideline 1a meets this need. It is then for the UCITS, when making an investment decision as regards a repo and reverse repo transaction, to consider the potential impact upon the UCITS redemption obligations. It is no different to other investment decisions that a UCITS takes. Taking an analogous example, transferable securities, it is worth noting the approach taken in the Eligible Assets Directive (2007/16/EC). One of the criteria to be considered in determining whether a transferable security can be purchased is whether its liquidity does not compromise the ability of the UCITS to comply with Article 37 (now Article 84). The EAD does not place percentage limits on the holding of potentially less liquid securities. The accompanying CESR guidelines (CESR/07-44) likewise do not put in place such limits. Rather, the guidelines specify that if a security is assessed as insufficiently liquid to meet foreseeable redemption requests, the security must be bought or held only if there are sufficiently liquid securities in the portfolio so as to be able to meet the requirements of Article 84. A similar approach should be taken for repos and reverse repos. It enables the UCITS to take into account its specificities in the way that a set limit cannot achieve. The ability to recall assets would be bilateral, so not only would the UCITS be able to recall a reverse repurchase agreement, but the counterparty would be able to do so, too. A recall by the counterparty could be disruptive for the orderly cash management of a UCITS. Therefore, we suggest a structure of gross counterparty limits on all reverse repurchase agreements, irrespective of whether they are recallable or not, similar to the 25% gross counterparty limit that Moody s require for awarding a triple A rating to a liquidity fund. See also response to question 2 above. Q4: Do you consider that UCITS should be prohibited from entering into repo and reverse repo arrangements on terms that do not allow the assets to be recalled by the UCITS at any time? If not, please indicate possible mitigating measures that could be envisaged in order to permit UCITS to use repo and reverse repo arrangements on terms that do not allow the assets to be recalled by the UCITS at any time. We disagree that a UCITS should be prohibited from entering into repo and reverse repo arrangements on terms that do not allow the assets to be recalled by the UCITS at any time. This would effectively restrict UCITS from entering into fixed-term contracts, which 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. If a UCITS was to rely on a repo to hedge a position and this were to be withdrawn by the counterparty, the UCITS would be exposed to the greater risk of an un-hedged position. This would have a damaging effect on the returns from such activities but have little benefit from a risk perspective. As mentioned in response to question 3 above, it should be sufficient that UCITS are required to be liquid enough to be able to meet redemptions. It has long been recognised (as reflected in the abovementioned CESR guidelines) that a UCITS can hold less liquid securities provided that the portfolio as a whole is such that a UCITS can meet its redemption obligations. Similarly, repo and reverse repo arrangements 6

on terms that do not allow the assets to be recalled by the UCITS at any time should continue to be permitted, provided that the portfolio as a whole is such that the UCITS can meet its redemption obligations. Q5: Do you think that there should be a minimum number of counterparties of arrangements under which the assets are not recallable at any time? If yes, what should be the minimum number? To answer this question, you are invited to take into account your response to question 2 See our response to question 3 above. We suggest a structure of gross counterparty limits on all reverse repurchase agreements irrespective of whether they are recallable or not, similar to the 25% gross counterparty limit that Moody s require for awarding a triple A rating to a liquidity fund. 7