EUROPE: CESR Consultation on UCITS and Derivatives

Monday June 15 2009

The Committee of European Securities Regulators (CESR) has today published its Consultation Paper on Risk Measurement Calculations for UCITS Market Risk. This is an informative Paper which deserves consideration and response.

Coming on the back of much hype and discussion as regards the future acceptability of VaR methodologies, we had been awaiting the publication of this paper with much concern and anticipation. However, on first reading, it is the proposals in respect of Counterparty Exposure which in our view deserve most attention.

Counterparty Risk

Funds-axis recently held four sessions on Counterparty Risk attended by 120 people from over 50 Companies. Having spent much time addressing all the scenarios where counterparty risk can arise, it is disappointing that CESR `s consultation focuses only on Counterparty Risk in OTC Derivatives.

Of more concern is CESR`s proposal in respect of how Counterparty Risk should be calculated.

Currently UCITS are recommended (UK UCITS are required) to use the Banking Consolidation Directive (BCD) approach to calculating Counterparty Risk.

The BCD envisages a three-step approach:

a) The current MtM value / replacement cost of the contract

b) An add-on for potential future credit-exposure

c) The sum of a) plus b) is multiplied by a risk weighting dependent upon the counterparty and which has the effect of reducing the calculation of exposure.

UK, Dublin and Luxembourg currently apply the above entirely differently. The UK uses steps a) and b); Dublin uses steps a) and b) but in step b) uses the market value rather than the notional value of the contract; and, Luxembourg uses steps a), b) and c).

Funds-Axis has spent much time arguing that the UK approach is both the most appropriate and most prudent approach. However, now CESR are proposing getting rid of both steps b) and c), the impact of which will be enable UCITS to take greater exposure to any one counterparty. Funds-Axis will be making the case to CESR for retention of step b). based on notional value of the contracts.

CESR `s argument seems to be based on the simplicity of applying only the step a) MtM calculation, which reflects how counterparty risk would typically have been calculated before UCITS III. This is hardly compelling given the complexity of derivatives exposure calculations in any case and the much greater scope for assumption of counterparty risk under UCITS III.

The Consultation Paper also makes proposals in respect of the recognition of netting and collateral. Much of this is familiar from the EC Recommendations on Derivatives usage by UCITS, 2004 and from Lux CCSF Circular 07/308. There is a Consultation question on whether there should be eligibility criteria and diversification requirements for collateral received.

Also, interestingly, the Consultation seeks to address the issue of whether a UCITS can deliver scheme assets to a Counterparty as collateral and how this should be included within the 5% and 10% OTC Counterparty exposure limits / 20% issuer-concentration exposure limit.

Market Risk and VaR

Coming on the back of much hype and discussion as regards the future acceptability of VaR methodologies as regards Market Risk / Global Exposure, this part of CESR `s Consultation is a bit of a (welcomed) anti-climax as it largely appears to be a restatement of the Luxembourg CSSF `s, albeit excellent, Circular 07/308 on Derivatives and Risk Management Processes and proposes the same limits as regards Absolute and Relative VaR as set out in that document. Hence, this is also consistent with IFSRA Guidance 3/03 and will be of most import in the UK, where there is no equivalent Regulatory publication but instead the IMA/DATA/FOA Industry Guidance.

Some additional safeguards are proposed by CESR and respondents can of course make the case that these methodologies are not appropriate.

Also, noteworthy:

* A proposal to dispense with “Sophisticated” / “Non-Sophisticated” terminology;

* The Consultation contains some detailed proposals as regards Interest Rate risk;

* As regards hedging, the Consultation raises the question of what quantitative threshold to apply when assessing the correlation between the derivatives and other holdings when assessing whether to allow recognition of netting; and

* There is no proposal to also require UCITS using VaR to comply with the Commitment approach 100% global exposure / 200% total exposure limits.

Sophisticated vs. Non-Sophisticated

There is a proposal to dispense with the terminology of sophisticated and non-sophisticated UCITS. Whilst accepting that these are ill-defined and inconsistently applied terms, Funds-Axis view is that they are a useful line of demarcation in addressing with Managers which funds that have chosen to apply advanced risk measurement techniques (e.g. VaR) to, rather than using commitment approach calculations for Market Risk.

Funds-Axis Support

Funds-Axis provides extensive consultancy and training services in respect of Derivatives and UCITS III.

Training: As well as our public courses, we have provided in depth in-house training on UCITS III and Derivatives to leading Asset Managers, law firms and regulators in UK, Dublin and Luxembourg.

Consulting: Our consulting activities have included:

* Product development support including for UCITS III credit derivatives strategies and long/short funds;

* Preparation of Derivatives Risk Management Processes (DRMP) documentation;

* Implementation of automated compliance monitoring systems to automate calculation of derivatives exposures;

* Performance of specialist compliance monitoring reviews;

* Work with a leading derivatives Exchange to document the UCITS eligibility of their credit derivative products;

* Extensive work on Counterparty Risk;

* OTC derivatives: independent valuation, in association with OTC Valuations Limited;

Funds-Axis GRC:

Funds-Axis GRC includes a comprehensive framework for derivatives risk management under UCITS III including. For a demo contact info@funds-axis.com

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