EUROPE: CESR- Final guidelines on risk measurement, calculation of global exposure and counterparty risk for UCITS

Wednesday July 28 2010

Following its earlier Consultation, CESR has now published its Level 3 Guidelines on risk measurement and the calculation of global exposure and counterparty risk for UCITS.

In summary, these Guidelines deal with a range of issues including calculations for the commitment approach, procedures in respect of VaR calculations, stress testing, back testing and regulatory reporting, together with guidelines on hedging, collateral and netting.

These Guidelines need to be considered by Management Companies together with:

CESR `s Level 2 Advice to the European Commission in October 2009 on the UCITS Management Company Passport –

http://www.cesr-eu.org/index.php?page=home_details &id=448

This advice included Risk Management Principles and Level 2 measures for the calculation of UCITS global exposure and counterparty exposure (including a change to how counterparty exposure needs to be calculated).

The implications of these Guidelines and the changes that Managers will need to make to their investment compliance monitoring systems, operating environments and reporting arrangements will be fully considered at the Funds-Axis training course on UCITS, Derivatives and Eligible Assets on 20th and 21st September; click here for details.

An overview of the contents of the CESR Guidelines is set out below. One point to be welcomed is that CESR has removed the Guidance that OTC counterparty exposure needs to be calculated in the case where OTC transactions are novated to central clearing. Less welcome in our view, is that CESR has decided to proceed with the requirements for VaR disclosure in the prospectus and report and accounts, without further advance consultation on this issue.

OVERVIEW

Commitment Approach Calculations

For the commitment approach, CESR sets out guidelines on:

* The conversion of financial derivatives into the equivalent position in the underlying assets of those derivatives;

* Acceptable hedging strategies

* The methodologies for netting and hedging arrangements and the principles to be respected when calculating global exposure; and

* The calculation of global exposure when using efficient portfolio management techniques.

VaR

CESR sets out guidelines on:

* The principles to be applied for the choice between relative and absolute VaR;

* The methodology for the computation of the global exposure when using Relative and absolute VaR with a set of quantitative and qualitative requirements to be respected;

* Quantitative and Qualitative standards for stress testing

* Requirements for back testing

* A requirement for reporting to the UCITS competent authority on a semi-annual basis, if there is greater than 4 overshootings revealed by the back-testing.

Var Disclosures

As regards the Prospectus:

1. UCITS will need to disclose in its prospectus the method used to calculate of the global exposure

(i.e. commitment approach, relative VaR or absolute VaR).

2. UCITS using VaR approaches will have to disclose the expected level of leverage and the possibility of higher leverage levels in the prospectus.

As regards the Annual Report:

1. The UCITS should disclose in its annual report the method used to calculate the global exposure (i.e. commitment approach, relative VaR or absolute VaR)

2. When using the relative VaR approach, information on the reference portfolio should be disclosed in the annual report.

3. The VaR measure of the UCITS should be published in the annual report. In this respect, the information provided should at least include the lowest, the highest and the average utilization of the VaR limit calculated during the financial year. The model and inputs used for calculation (calculation model, confidence level, holding period, length of data history) should be displayed.

4. UCITS using VaR approaches should disclose the level of leverage employed during the relevant Period

Counterparty Risk

CESR has not proceeded with the proposal that OTC counterparty exposure needs to be calculated in the case where OTC transactions are novated to central clearing.

Collateral & Cover

CESR has defines a set of high level principles relating to assets that may be used as collateral and cover rules for transactions in financial derivative instruments.

The guidelines set out. For UCITS using the VaR approach, CESR guidelines also provide additional safeguards which these UCITS should put in place when calculating the global exposure (stress testing and back testing obligations of the VaR model, validation of the model etc.).

Structured Products

In the consultation paper, the Committee also consulted on its initial views on specific guidelines for structured UCITS for the calculation of the global exposure. In light of the feedback on this issue, CESR is expected to carry out further work to assess whether it might be appropriate for certain types of structured UCITS to use other methodologies than those published in these Level 3 Guidelines.

The implications of these Guidelines and the changes that Managers will need to make to their investment compliance monitoring systems, operating environments and reporting arrangements will be fully considered at the Funds-Axis training course on UCITS, Derivatives and Eligible Assets on 20-21September.