EUROPE: CESR clarifies prohibition of physical short selling by UCITS

Thursday October 2 2008

CESR has published a revised version of its Guidance on Eligible Assets for UCITS. This is in response to a request from the European Commission to remove the reference in Point 24 to the fact that “…UCITS are authorised to use … securities borrowing … to generate leverage.”

The request from the European Commission comes in a detailed letter outlining the Commission’s view as to why UCITS should not be allowed to physically short sell.

The background to this is that a for a year now there has been uncertainty as regards the ability of UCITS to physically short sell in the same way that they can synthetically short sell subject to there being adequate cover arrangements in place. This uncertainty arose following the publication of a Policy Change by the Irish Regulator confirming its view that UCITS should be able to physically short sell subject to there being adequate cover in place in the form of a stock borrow.

See the following article:

* IFSRA Policy Change on UCITS and Physical Short Selling.

The European Commission cited a number of key reasons for their view that UCITS should not be able to physically short sell. Funds-Axis do not agree with this view so we set out our thoughts below against each of the points made by the European Commission. We would welcome any thoughts or feedback on this:

Point 1

* EC: The UCITS Directive has no explicit provisions regarding the exposures that can be created through the use of physical short selling;

* Funds-Axis: However, a UCITS can synthetically short sell and therefore should be able to physically sell under the efficient portfolio management arrangements so long as that transaction meets the requirements set out in the UCITS Directive and Eligible Assets Directive in terms of being for reduction of risk, reduction of cost etc. Physical short selling is often more efficient than synthetic short-selling.

Point 2

* EC: The UCITS Directive does not contain any provisions governing risk management controls for physical short selling;

* Funds-Axis: However, the Eligible Assets Directive does require that the risk management processes of the UCITS must cover all the asset classes of the UCITS, not just derivatives, and so it would be up to Managers engaging in physical short selling to be able to demonstrate the adequacy of their risk management arrangements.

Point 3

* EC: the mere fact of borrowing the security to accompany the potential obligation to cover the short sale does not mean that the transaction can be equated with a “covered sale”.

* Funds-Axis: we agree with this, but it is bit of a “red-herring” which stems from the Irish Regulator’s requirements that the short sell be accompanied by a stock borrow. Other cover in the form of liquid assets and cash may represent more adequate cover for the physical short sell – in the same way as required for synthetic short sales through physically settled derivative instruments.

10% Borrowing Limit

There is another important aspect in the European Commission letter as it states clearly that the 10% borrowing limit for UCITS covers both cash borrowing and stock borrowing.

Finally, although not explicit, it is not a big leap from the requesting wording change to take the view that cash borrowing, in the same way as confirmed for physical borrowing, can not be used to generate leverage within the portfolio – a position taken in some but not all Member States.