Focus on regulation – ESMA’s Ucits and ETF guidelines pose dangers to markets, warn French lawyers

Changes necessary to comply with ETF and Ucits guidelines set out recently by Europe’s regulatory co-ordinator could impact liquidity and securities lending, according to French lawyers Gide Loyrette Nouel.

The guidelines published by the European Securities and Markets Authority in late July, spell out various matters in regards to the activities of Ucits funds including compliant ETFs.

They set out what information investors should receive; they discuss specific rules for Ucits when they enter into over-the-counter financial derivative transactions and engage in ‘efficient portfolio management techniques’; and they set out detailed criteria for financial indices in which Ucits invest.

ESMA’s guidelines Guidelines are aimed at protecting investors, but some commentators have doubted this will universally be the case

French lawyers Gide Loyrette Nouel say physically replicated ETFs will benefit from receiving the revenues generated by lending out securities, repo and reverse repo arrangements. Such revenue previously gone to the products’ providers “to subsidise their management fees”.

“The change in business model required to comply with the guidelines may mean that, while physically replicated ETFs benefit from receiving the securities lending revenues, the management fees increase,” say French lawyers Gide Loyrette Nouel.

The lawers said that over time the requirement could also lead to an increase in the proportion of synthetically replicated ETFs in Europe and, potentially have an impact on the liquidity of the securities lending market.

According to ESMA, a Ucits product should not invest in a financial index unless there is sufficient information about its calculation methodologies accessible to investors, to enable them to replicate the financial.

The rebalancing frequency of the index should not prevent investors from being able to replicate it.

There are other, wide-ranging stipulations for allowable financial indices. They must publish their constituents and weightings; have selection and rebalancing methods based on pre-determined and objective criteria; not accept payments from potential index components for inclusion; and not permit backfilling.

The Ucits prospectus must disclose various pieces of information about the index after conducting due diligence on it.

The law firm said: “Some providers already make a point of offering transparency, but a number will have intellectual property protection concerns. It will be interesting to see whether investors attempt to replicate an existing Ucits financial index in practice.”

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