The Financial Regulator permits the use of repos by Irish UCITS solely for efficient portfolio management purposes. Previously, this meant that repos may only be used where they (a) reduce risk, (b) reduce cost, or (c) generate additional capital or income for the UCITS in circumstances where the risk profile of the UCITS is not affected by use of the repo. Repos could not, therefore, be used for investment purposes (i.e. to generate a return outside of scope noted at (a) – (c) above). In addition the Financial Regulator was of the view that the use of repos was not permissible where they were used for financing purposes or where their use resulted in leverage being introduced into the portfolio.
Furthermore the Financial Regulator’s rules surrounding the use of collateral were relatively restrictive in that while cash collateral could be placed on deposit or invested in money market instruments, non-cash collateral could not be either sold or pledged by the UCITS (rather, it had to be held within its custodian’s custodial network). This, combined with the expectation that the repo is self-funding (i.e. when entering into the repo the UCITS must be satisfied that any cash collateral invested will, at all times, enable repayment obligations to be met) means there is a practical hurdle for UCITS entering into repos. This was because the UCITS, in investing the cash collateral, would generally obtain a money market return whereas the cost of entering into the repo could be higher than this.
However, following a submission to the Financial Regulator from certain legal firms in Dublin, including William Fry, the Financial Regulator has indicated that it will shortly issue new guidance to reflect recent European consultations. It is expected that this guidance will enable an Irish UCITS to enter into repos where these result in leverage and to invest collateral for the purposes of generating an investment return (i.e. for financing purposes).
The revised guidance is expected to recognise that UCITS can (subject to adherence to the principles outlined in guidelines issued by the Committee of European Securities Regulators (“CESR”)) (i) use repos where they result in the generation of leverage, (ii) use repos for financing purposes, (iii) reinvest cash collateral in other than money market instruments, and (iv) reinvest non-cash collateral for the purposes of generating additional returns forthe UCITS.
Until such time as the Financial Regulator has issued the revised UCITS Notices proposals to enter into repos utilising the CESR guidelines are subject to receipt of prior approval of the Financial Regulator. The Financial Regulator has indicated that it will accept specific proposals from UCITS who propose to enter into repos on a leveraged basis. Any proposal submitted to the Financial Regulator must indicate (i) the purpose of the transaction, (ii) how they meet with relevant CESR guidelines and (iii) how their use will be addressed in the UCITS’ risk management process and in its calculation of global exposure.
This is a very positive development and reflects the speedy implementation at a domestic level of CESR guidelines which were only issued at the end of July 2010. The promptness with which CESR guidelines are being adopted is to be welcomed and is reflective of the Financial Regulator’s progressive and prompt approach to issues arising at both market level, where the demand for the use of repos as a material part of a UCITS investment strategy is high, and international / industry level where the Irish market is seen to react quickly to new developments.