Regulation: Ucits III has managers scratching their heads

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By:
Mark Brown
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Funds are still unsure what use they can make of derivatives.

With just over 12 months to go until EU-based Undertakings for Collective Investment of Transferable Securities funds need to be compliant with the new Ucits III regulations, the fund industry is still unsure what use it can make of derivatives and structured products.

Ucits funds can be marketed to investors in EU countries other than those in which they are domiciled. Ucits III aims to give Ucits funds more flexibility by letting them use instruments like bank deposits, units of other funds and derivatives. It says that fund managers “must employ a process for accurate and independent assessment of the value of OTC derivative instruments” and tell their regulator how they calculate the risks associated with derivatives transactions in each managed Ucits. Back in April 2004, the European Commission recommended that the total exposure of a Ucits to derivatives, calculated according to the value of underlying assets, counterparty risk, liquidity and future market movements, should not exceed its net asset value.

“It is clear that under Ucits III you can use derivatives not just for efficient portfolio management but for your investment strategy,” says Jonathan Herbst, a partner in the financial services group at law firm Norton Rose.

But Ucits III doesn’t go into detail on precisely how investment funds can use derivatives. “Ucits III is a high-level regulation and, at that level, regulators try not to be too prescriptive,” says Stephen Ashworth, senior vice-president at derivative portfolio valuation and risk management firm SunGard Reech. “That leaves room for some uncertainty.”

Relaxed

What regulated funds definitely couldn’t do under Ucits I was pursue classic hedge fund-style strategies. “Effectively, you could not sell short under Ucits I, because of its requirement that funds had specific securities available for delivery,” says Herbst. “It appears that Ucits III has more relaxed cover requirements.”

So, while the European Commission thrashes out the final Ucits III wording, managers in London, Dublin and elsewhere are trying to get approval from their regulators for funds that take hedge fund-style exposures synthetically by using derivatives and indices. “That’s where people are getting more creative,” says Herbst. The asset management industry has been pushing for Ucits funds to be allowed exposure to derivatives written on indices that contain non-eligible assets, such as commodities.

Meanwhile, the Committee of European Securities Regulators published the results of its second consultation on Ucits III at the end of November last year. If these find their way into Ucits III, investing in structured products could be easier, since CESR recommends that Ucits III’s liquidity requirements should be clarified so that each Ucits is liquid enough to meet redemptions. This would be an advance on the current blanket ban on investing in illiquid securities. At the time of writing, CESR was due to submit final advice to the European Commission by mid-January.