For every action, there is an equal and opposite reaction

ESMA recently published its Guidelines on ETFs and other UCITS issues. As their Chair, Steve Maiijoor, puts it “these comprehensive guidelines are aimed at strengthening investor protection and harmonising regulatory practices across this important EU fund sector”.

At a high level here are the key provisions (plus some of my own comments):
1. UCITS ETFs must by identified as “UCITS ETF” (imagine that!)
2. UCITS ETF units traded on a secondary market are allowed direct redemption when secondary market liquidity is unavailable (lucky!)
3. UCITS must disclose the calculation method of financial indices invested in (who is going read this?)
4. Efficient Portfolio Management (EPM) must have adequate disclosure language of risks (can you really fool-proof these things by adding more language?)
5. UCITS engaged in EPM should be able to recall lent securities at any time or terminate any agreement in relation to securities lending (so UCITS good, Counterparty bad?)
6. Collateral received for OTC financial derivative transactions or EPM techniques must comply with qualitative requirements and diversification requirements related to counterparties (makes sense, consistency of application)
7. Revenue from EPM activities, net of costs, should go to the UCITS (get your hand out of my pocket!)

The most disruptive of these provisions is the new position on EPM revenue (7) which tries to balance the risk/reward inherent in the securities lending business. But does it swing the pendulum too far in the other direction? Historically, the management company has taken a large portion of the revenue for supplying the mechanism to the UCITS for entering into these agreements, but the risk is disproportionately borne not by the management company but by the UCITS. Maybe it’s time to put things right, but will this have negative consequences?

UCITS: there is an obvious monetary implication since they won’t have to share the revenue.

Management Company: give up money to UCITS (remember Newton’s 3rd Law of Motion) – will they continue to offer security lending?

Counterparty: where will the positions come from if the management companies scale back?

Food for thought …

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