ISLA and the CBI tackle UCITS collateral rules
17 November 2017 Dublin
Image: Shutterstock
The Central Bank of Ireland’s (CBI) director of policy and risk has confronted industry concerns around stringent collateral re-use and “arbitrary” fee splits for UCITS funds at a roundtable discussion.
Gerry Cross spoke to members of the International Securities Lending Association (ISLA) in Dublin on 14 November to address the challenge of allowing UCITS funds to interact fully with the securities lending market while remaining compliant.
“It appears that there may be an impression amongst some market participants of a regulatory preference for title transfer arrangements to apply to securities lending collateral arrangements,” said Cross.
“Title transfer arrangements are of course optimal from the perspective of collateral receivers to protect against counterparty failure and the Central Bank requires that collateral received should be capable of being fully enforced by the UCITS at any time without reference to or approval from the counterparty.”
Cross added: “However, title transfer arrangements are not mandated by the European Securities and Markets Authority (ESMA) guidelines or indeed by the central bank. Rather, the guidelines (and the CBI UCITS Regulations) provide for the possibility of pledge arrangements with the proviso that the collateral be held by a third party custodian who is unrelated to the collateral provider and is subject to prudential supervision.”
“As this pledge model is already being used in the context of derivatives clearing through central counterparties, it is not clear from where this uncertainty originates.”
Cross also used his speech to dispel latent theories around the need for UCITS funds to conduct credit ratings on received collateral.
In order to move away from “arbitrary” fee splits between UCITS funds and their agent lenders the CBI has changed the rules to ensure investors are “are appropriately remunerated for lending their assets”.
Cross said: “In short, all revenues arising from securities lending transactions, net of direct and indirect operational costs should be returned to the UCITS, and these costs and fees should not include hidden revenue.”
“This rule was designed in order to move away from the traditional revenue sharing or fee split model to a more transparent and fairer arrangement where the UCITS (and investors) are appropriately remunerated for lending their assets.”
“Fee splits were deemed to be arbitrary arrangements where irrespective of costs the UCITS earned a pre-defined proportion of revenues and the proportion often favoured the service providers to the potential disadvantage of investors.”
The issue of investors historically being left out of pocket as a result of aggressive fee structures with their agents has been forced into the spotlight recently after several US pension funds filed class action law suits against several major banks for lost earnings as a result of alleged misconduct in the securities lending market.
It was clarified that Ireland’s domestic requirements for eligible collateral are consistent with ESMA guidelines and require that collateral is of a high quality.
“High quality is not defined and, as such, that determination is made by the UCITS, although where issuers are rated by an external credit rating agency (CRA), that rating must be taken into account in the credit assessment process,” Cross said.
“Moreover, if an issuer is downgraded below the two highest short-term credit ratings of a CRA, the UCITS must immediately carry out a new credit assessment.”
Cross acknowledged ISLA’s concerns regarding collateral re-use and term trade rules which had caused a significant gap between securities held by UCITS, which are available for lending and the amount of securities, which they have on loan.
In ISLA’s latest market report it was highlighted that investment funds including UCITS account for 45 percent of all securities available for lending only 15 percent of available assets on loan.
Cross added: “Proportionately funds lend less than other market participants and moreover ISLA has observed that lending by funds has declined over the last number of years. Indeed ISLA observed that less than 20 percent of Irish UCITS participate in this activity.”
Gerry Cross spoke to members of the International Securities Lending Association (ISLA) in Dublin on 14 November to address the challenge of allowing UCITS funds to interact fully with the securities lending market while remaining compliant.
“It appears that there may be an impression amongst some market participants of a regulatory preference for title transfer arrangements to apply to securities lending collateral arrangements,” said Cross.
“Title transfer arrangements are of course optimal from the perspective of collateral receivers to protect against counterparty failure and the Central Bank requires that collateral received should be capable of being fully enforced by the UCITS at any time without reference to or approval from the counterparty.”
Cross added: “However, title transfer arrangements are not mandated by the European Securities and Markets Authority (ESMA) guidelines or indeed by the central bank. Rather, the guidelines (and the CBI UCITS Regulations) provide for the possibility of pledge arrangements with the proviso that the collateral be held by a third party custodian who is unrelated to the collateral provider and is subject to prudential supervision.”
“As this pledge model is already being used in the context of derivatives clearing through central counterparties, it is not clear from where this uncertainty originates.”
Cross also used his speech to dispel latent theories around the need for UCITS funds to conduct credit ratings on received collateral.
In order to move away from “arbitrary” fee splits between UCITS funds and their agent lenders the CBI has changed the rules to ensure investors are “are appropriately remunerated for lending their assets”.
Cross said: “In short, all revenues arising from securities lending transactions, net of direct and indirect operational costs should be returned to the UCITS, and these costs and fees should not include hidden revenue.”
“This rule was designed in order to move away from the traditional revenue sharing or fee split model to a more transparent and fairer arrangement where the UCITS (and investors) are appropriately remunerated for lending their assets.”
“Fee splits were deemed to be arbitrary arrangements where irrespective of costs the UCITS earned a pre-defined proportion of revenues and the proportion often favoured the service providers to the potential disadvantage of investors.”
The issue of investors historically being left out of pocket as a result of aggressive fee structures with their agents has been forced into the spotlight recently after several US pension funds filed class action law suits against several major banks for lost earnings as a result of alleged misconduct in the securities lending market.
It was clarified that Ireland’s domestic requirements for eligible collateral are consistent with ESMA guidelines and require that collateral is of a high quality.
“High quality is not defined and, as such, that determination is made by the UCITS, although where issuers are rated by an external credit rating agency (CRA), that rating must be taken into account in the credit assessment process,” Cross said.
“Moreover, if an issuer is downgraded below the two highest short-term credit ratings of a CRA, the UCITS must immediately carry out a new credit assessment.”
Cross acknowledged ISLA’s concerns regarding collateral re-use and term trade rules which had caused a significant gap between securities held by UCITS, which are available for lending and the amount of securities, which they have on loan.
In ISLA’s latest market report it was highlighted that investment funds including UCITS account for 45 percent of all securities available for lending only 15 percent of available assets on loan.
Cross added: “Proportionately funds lend less than other market participants and moreover ISLA has observed that lending by funds has declined over the last number of years. Indeed ISLA observed that less than 20 percent of Irish UCITS participate in this activity.”
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