ESMA call for evidence on reviewing the EAD

UCITS eligible assets – ESMA call for evidence on reviewing the EAD

On 7 May 2024, ESMA published the long awaited Call for Evidence (CfE) on the review of the UCITS Eligible Assets Directive (EAD), seeking views from stakeholders in order to assess the possible risks and benefits of UCITS gaining exposure to various asset classes as well as insights on some key notions and definitions used in the UCITS EAD and their consistency with other pieces of legislation in the EU Single Rulebook.

Background to the Call for Evidence

The assets in which a UCITS can invest are subject to stringent eligibility criteria to ensure adherence to the investor protection principles which underlie the UCITS Directive.

The EAD dates back to March 2007. Since its adoption, financial instruments traded on financial markets have increased considerably, both in the number and variety. This has led to both (a) uncertainty when determining whether certain categories of assets are eligible for investment and (b) divergent interpretations and market practices across the EU as to how the UCITS Directive applies.

Questions on interpretation have arisen, in particular, in relation to the eligibility of direct or indirect exposures to asset classes such as structured/leveraged loans, catastrophe bonds, commodities, crypto assets and emission allowances.

In particular there are divergent views in relation to the eligibility of delta-one instruments and exchange-traded products, which can provide UCITS with exposures to asset classes that are not eligible for direct investment.

As a result, in June 2023, the European Commission (the Commission mandated ESMA to carry out a review of the EAD’s implementation to (among other things):

• carry out an assessment of how Member States have diverged in their implementation of the EAD

• provide the Commission with recommendations on how to amend the EAD to keep it in line with market developments.

Our summary of the Commission’s mandate can be found here.

The CfE is divided into separate sections which seek to collect evidence on the main aspects of the ESMA mandate:

• Section 3.1, which contains 19 questions, deals with convergence issues and the clarity of key concept and definitions

• Section 3.2 looks at direct and indirect UCITS exposures to certain asset classes and related data collection/analysis. This sets out six questions on which ESMA is seeking views.

Taking these in turn:

Convergence issues and clarity of key concepts

This section poses, among other things, the following questions for consideration:

• what is the most pressing issue to be addressed in the EAD with a view to “improving investor protection, clarity and supervisory convergence across the EU”?

• what recurring or significant issues are there with the interpretation or consistent application of the EAD rules on:

  • criteria for transferable securities.
  • financial indices
  • money market instruments
  • the notions of “liquidity” or “liquid financial assets”
  • the 10% limit for investments in transferable securities and money market instruments other than those referred to in Article 50(1) of the UCITS Directive
  • the interpretation or consistent application of the valuation and risk management-related criteria
  • the concept of embedded derivatives
  • the treatment of delta-one instruments
  • UCITS investments in other UCITS and AIFs (including EU ETFs and non-EU ETFs)?

• given the changed market conditions since 2007, are the EAD’s presumption of liquidity and negotiability still appropriate?

• should a UCITS be able to acquire or hold foreign currency for investment purposes, bearing in mind high volatility and devaluation/depreciation of some currencies?

• are the EAD provisions on investments in financial instruments backed by, or linked to the performance of assets other than those listed in Article 50(1) of the UCITS Directive adequate and clear enough?

• how could the rules on Efficient Portfolio Management (EPM)-related issues be improved in terms of investor protection, clarity and supervisory convergence?

• should the notion of EPM techniques in the UCITS Directive and EAD be linked with / replaced by the notion of securities financing transaction set out in the SFTR?

• what other definitions, notions or concepts of the EAD should be updated, clarified or made more consistent with those used in other pieces of EU financial legislation, such as MiFID / MiFIR, EMIR, the BMR and the MMFR?

• are there national regulatory rules, guidance, definitions or concepts going beyond the EAD that cause recurring or significant practical issues or challenges?

Direct and indirect exposures to certain asset classes

The CfE sets out a list of asset classes and asks stakeholders to complete a table with their views on the merits of allowing (a) direct or (b) indirect UCITS exposures to these, along with evidence on the merits in light of the risks and benefits “taking into account the characteristics of the underlying markets (e.g. availability of reliable valuation information, liquidity, safekeeping)”.

The CfE also asks respondents to provide evidence on how indirect exposures to the listed asset classes would increase or decrease costs and/or risks compared to direct investments.

The asset classes listed include:

• Loans

• Catastrophe (‘Cat’) bonds, Contingent Convertible (‘CoCo’) bonds and unrated bonds

• Distressed securities

• Unlisted equities

• Crypto assets

• Commodities and precious metals

• Exchange-traded commodities (‘ETCs’) and Exchange-traded notes (‘ETNs’)

• Real estate and Real Estate Investment Trusts (‘REITs’)

• Special Purpose Acquisition Companies (‘SPACs’)

• AIFs – EU and/or non-EU

• Emission allowances

• Delta-one instruments

• Asset-backed securities (‘ABS’) including mortgage-backed securities (‘MBS’)

• Other relevant asset classes (please specify)

The EAD distinguishes between (i) financial instruments backed by or linked to the performance of other assets and (ii) financial instruments embedding a derivative, leading to differing views as to whether (and, if so, when) a look-through approach is required to determine the eligibility of the asset and the distinction between the two concepts.

Given the difference in views, the CfE seeks feedback as to whether a look-through approach should be required where the aim of such an approach would be to ensure that the list of eligible asset classes set out in Level 1 of the UCITS Directive would be exhaustive. The purpose of introducing such a look-through approach would be to reduce the ability for UCITS to gain indirect exposure to otherwise ineligible asset classes via instruments such as delta-one instruments, exchange-traded products or derivatives.

The CfE also seeks views on the perceived the risks and benefits of a UCITS:

• investing in securities issued by securitisation vehicles and/or

• building up short positions through the use of (embedded) derivatives, delta-one instruments or other instruments or tools

Next steps

The CfE is open until 7 August 2024. If you want to respond, you must use the form available here.

ESMA will then consider feedback received and submit its technical advice to the European Commission by 31 October 2024.