The Central Bank of Ireland claimed in July that there are strong grounds for limiting the collateral diversification relaxation set out in the revised version of the European Securities and Markets Authority (ESMA) guidelines on exchange-traded funds and other UCITS issues.
The central bank invited all stakeholders to provide comments on its consultation paper, with the responses to be assessed following the 17 October deadline. The International Securities Lending Association (ISLA) obliged, with chief executive Kevin McNulty writing a letter to the central bank on deadline day.
The collateral diversification relaxation, which was initially intended to apply to UCITS money market funds (MMFs), was extended to all UCITS funds in ESMA’s final report in March, following market support for the move. But the Central Bank of Ireland is worried that the extension could result in funds holding on to sovereign collateral of deteriorating credit quality in stressed market conditions.
ESMA’s guidelines require all collateral to be of “high quality” and no UCITS fund can have exposure of more than 20 percent of its collateral basket to any single issuer. UCITS MFFs are exempt from this, as long as they receive securities from at least six different issuers, and no single issuer accounts for more than 30 percent of the collateral received.
The Central Bank of Ireland, in its 28 July consultation paper, said high quality is not adequately defined to warrant the relaxation being extended to all UCITS funds.
“UCITS MMFs are subject to quite specific requirements with regard to credit quality, which means that even where collateral is not diversified, a UCITS MMF will still be required to hold collateral, which, if rated, will have been awarded one of the two highest available short-term credit ratings by the credit rating agency that has rated the instrument, or, if the instrument is not rated, it is of an equivalent quality as determined by the management company’s internal rating process.”
“The effect of the disapplication to all UCITS is that the only protection in place with regard to the kind of sovereign debt collateral a non-UCITS MMF can take is an undefined requirement that it be of ‘high quality’.”
“The vagueness of that requirement was acceptable under the original guidelines because it was counter-balanced by the precision of the 20 percent diversification requirement.”
The Central Bank of Ireland wants a rule introduced requiring a UCITS fund to only be able to accept high quality collateral. A determination of whether the collateral is sufficiently ‘high quality’ would be made before accepting it.
Any acceptance that would mean that more than 20 percent of the UCITS fund’s total collateral comes from the specific issuer would require a more detailed assessment of credit quality. In the event of deteriorating credit quality, the UCITS fund would have to put into place and execute an action plan to deal with its exposure to the collateral, and cease holding and receiving collateral that does not have one of the two highest available ratings.
The Central Bank of Ireland stated: “We recognise that this would mean that Irish rules on UCITS collateral would be substantially different from other member states. If we can achieve a satisfactory risk mitigation effect without creating that difference we prefer to do so.”
In response, ISLA’s McNulty wrote that the ESMA derogation allows a UCITS to be fully collateralised in transferable securities issued by a member state as long as diversification levels are maintained at an issue level.
“These requirements are amongst the strictest in the world for funds and institutions participating in EPM (efficient portfolio management) techniques. There are a number of additional safeguards, alongside diversification in the guidelines that apply to all collateral (including government bonds) and therefore we do not believe that further safeguards are not required.”
Existing market practices dictate that where accepted collateral deteriorates in credit quality to less than is acceptable to the UCITS, “this will be identified immediately and the collateral issue replaced with acceptable collateral”, according to ISLA.
“It is well established practice that collateral in securities lending and repo markets is reviewed by the parties on a daily basis.”
“We therefore believe that the concerns are better addressed through the requirement that the UCITS must ensure that collateral meets the criteria in the guidelines on an ongoing basis and that arbitrarily further restricting the collateral that can be accepted is not necessary.”
The suggested collateral management framework, which the central bank acknowledged would implement a different approach for Irish UCITS than other European UCITS, will be disadvantageous to nationally domiciled funds, according to ISLA.
“With investors focusing on the cost profile of funds, securities lending can provide a low risk revenue stream. In a competitive market, having different and potentially more restrictive collateral requirements that will need additional resources to manage means that Irish UCITS may become less attractive to borrow from and therefore generate less return.”
McNulty warned in the letter: “Whilst this would not be a deciding factor, this may be a consideration when a new UCITS is deciding on jurisdiction.”
A further concern for ISLA’s members is the Central Bank of Ireland’s reliance on credit rating agencies, which goes against the grain of Financial Stability Board (FSB) proposals.
McNulty quotes the FSB publication ‘Principles for Reducing Reliance on Credit Rating Agencies’, which states: “Standard setters and authorities should assess references to credit rating agency (CRA) ratings in standards, laws and regulations and, wherever possible, remove them or replace them by suitable alternative standards of creditworthiness.”
McNulty wrote on behalf of ISLA: “We believe there are already a number of safeguards in the guidelines that apply to all collateral including government bonds and therefore further safeguards are not required.”
“For example, the requirement to stress test collateral portfolios if more than 30 percent of the fund NAV (net asset value) is exceeded in collateral value ensures that collateral portfolios are appropriately analysed and risk levels remain appropriate. This process would capture the deterioration of credit quality.”
The Central Bank of Ireland is expected to publish other comments soon, but if any of the other commentators adopted ISLA’s position, it could well have a fight on its hands.