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Where now for UCITS?

Published by Charles Gubert

UCITS has evolved markedly since its inception in the 1980s, and continues to do so. It remains a truly global brand with particular interest from Latin American and Asia-Pacific allocators. UCITS V, which must be transposed into national law by EU member states by March 18, 2016, is going to bring about a number of changes around remuneration, depositary appointments and harmonisation of sanctions – i.e. fines for administrative breaches. The first two provisions are likely to have the biggest impact on managers.

Remuneration

The remuneration provisions contained within UCITS V broadly mirror those imposed on managers under the Alternative Investment Fund Managers Directive (AIFMD), and it is part of the regulatory effort to ensure that investor/manager interests are aligned. The rules will apply to individuals within UCITS funds whose roles have a material impact on the risk profiles of their firms.

Approximately 40% to 60% of variable remuneration must be deferred over at least three years, while at least 50% must be paid in non-cash instruments such as units in the UCITS fund itself or other approved financial instruments. This is designed to dis-incentivise excessive risk-taking. As with AIFMD, proportionality principles will apply to any restrictions around remuneration. In other words, firms below a certain Assets under Management (AuM) threshold will be excused from implementing restrictions around employee pay.

The UK’s Financial Conduct Authority (FCA) confirmed in 2014 that Alternative Investment Fund Managers (AIFMs) would be exempted from AIFMD remuneration rules if they managed less than £1 billion leveraged or £5 billion unleveraged. As such, this will therefore exempt a number of smaller UCITS managers from the provisions.

Depositary

A more pressing challenge for UCITS managers surrounds the new rules around depositaries. UCITS V will broadly align depositary rules with those of AIFMD. However, there are differences around the principles towards discharging liability for lost financial instruments under UCITS V versus AIFMD.

AIFMD permits depositaries to discharge liability for loss of financial instruments to sub-custodians (agent banks, central securities depositories [CSDs]) in extreme circumstances which are beyond the control of the depositary. UCITS V explicitly prohibits depositaries from discharging any liability for lost financial instruments to sub-custodian entities.

There are reports that some UCITS managers are facing fee hikes from their depositary banks because of the increased risk they are now underwriting. This is particularly true for UCITS managers if they invest in slightly esoteric markets or instruments. One expert at a depositary bank acknowledged fee increases would be inevitable but said they were likely to be in the low single digit basis points.

The big fear is whether this ban on depositaries discharging liability under UCITS V is rewritten into AIFMD or introduced via an AIFMD II. Regulators have said there are no plans for this. Industry experts argue extending the prohibition on discharging liability to AIFMs would be unlikely given the risk profile of AIFMs and the institutional nature of their underlying investors. However, AIFMD is broad and applies to nearly any manager that is not a UCITS. It is therefore possible that non-UCITS retail AIFMs could be impacted by any extension of the ban on depositaries discharging liability.

UCITS VI

While national competent authorities talk of a regulatory hiatus or temporary reprieve for fund managers, there is already speculation as to what UCITS VI may look like. Some hypothesise a pan-EU depositary passport could be introduced. This would allow managers to appoint a depositary located anywhere within the 28 EU member states, instead of having to appoint a provider in their fund’s jurisdiction. This would certainly increase competition and provide an opportunity for emerging EU fund domiciles such as Malta. Simultaneously, it would also imply the rules and regulations governing depositaries would need to be harmonised. Again, this could facilitate a pan-EU prohibition on the discharge of liability.

The most probable outcome of UCITS VI is likely to be a clampdown on the eligibility of assets permitted within a UCITS wrapper. There has been intense criticism that some UCITS managers are shoehorning illiquid or esoteric products into UCITS, raising concerns that there could be a liquidity shortfall in the event of mass redemptions. Such fears have already prompted the European Securities and Markets Authority (ESMA) to restrict UCITS’ exposure to commodity products in 2012. As such, regulators could further restrict UCITS from investing into certain asset classes or derivative products.

Regulators have made it abundantly clear that talk of UCITS VI is premature. While a consultation was issued in 2012, very little has been heard since. As such, regulators are probably focusing their attention on other areas such as the Capital Markets Union (CMU) with UCITS VI likely to be put on the backburner.

What next?

Regulators have made it no secret they want alignment of UCITS and AIFMD. Regulators are keen to push more esoteric products into AIFMD from UCITS, thereby making UCITS a strictly retail orientated product and AIFMD a purely institutional one. While the obligations under UCITS V could add to the costs of running a UCITS product, the asset class shows no sign of losing its appeal to investors globally.