Proposed EMIR modifications to UCITS Directive

On May 22nd 2015, the European Securities and Markets Authority published its opinion to the EU institutions on the impact of Regulation 648/2012 (“EMIR”) on Directive 2009/65/EC (the “UCITS Directive”).

Currently the UCITS Directive allows UCITS to invest in both exchange traded derivatives (“ETDs”) and over the counter derivatives (“OTC Derivatives”) but only the latter are subject to counterparty risk limits.  The risk exposure to a counterparty of the UCITS in an OTC derivative transaction may not exceed 10% of its assets when the counterparty is a credit institution or 5% in other cases.

Pursuant to the EMIR Regulation certain OTC derivatives are subject to the clearing obligation.  ESMA is of the view that the UCITS Directive should be amended to take into account this clearing obligation.  They believe that instead of a distinction being made between ETDs and OTC derivatives the distinction should be made between cleared financial derivative transactions and non-cleared financial derivative transactions.

ESMA believes that cleared financial derivative transactions should not be considered automatically as free of counterparty risk and suggests, in particular, that counterparty risk limits should be calibrated to the different types of segregation arrangements that are in place.

"This approach means that a UCITS would have to calculate counterparty risk limits for ETDs, something which is currently not the case.
Higher counterparty risk limits could apply to EU Central Counterparties (“CCPs”) and non-EU CCPs that have been recognised by ESMA because of the relatively low counterparty risk of such CCPs."

With regard to clearing members (“CMs”), EMSA is of the view that where individual client segregation is in place the UCITS should not apply any counterparty risk limits to the CM.  However counterparty risk limits should apply to the CCP as mentioned above. Omnibus client segregation provides UCITS with less protection when the CM defaults therefore ESMA is of the view that UCITS should apply counterparty risk limits to CMs in this case.

In the case of alternative types of segregation arrangements ESMA believes the counterparty risk limits should be proportionate to the degree of protection offered to the UCITS.

Finally ESMA noted that the UCITS Directive currently provides that UCITS can invest in OTC financial derivative instruments provided that those instruments can be sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS’s initiative.  To comply with this provision, a clause of unilateral termination right was inserted in the ISDA standard documentation for bilateral OTC financial derivative transactions. ESMA makes the point that for the OTC transactions subject to the clearing obligation under EMIR some CCPs do not accept the unilateral termination clause.  ESMA does not intend to exclude UCITS, from the clearing obligation, nor has it the possibility to require CCPs to accept this clause. Therefore EMSA believes that there is a conflict between the operation of the UCITS Directive and the operation of EMIR.