ESMA Call For Evidence – Review Of The Eligible Assets Directive

On 7 May 2024, ESMA published its call for evidence ("CfE") on the review of the Commission Directive (2007/16/EC) on UCITS Eligible Assets ("EAD"). The CfE follows the formal request from the European Commission (the "Commission") in June 2023 to provide technical advice on the review of the EAD and has the potential to form the basis for significant developments in the EU's UCITS product rules.

Background

Globally UCITS have become the gold standard EU investment fund product for retail and institutional investors, with its long-standing appeal linked to clear parameters on risk and liquidity profiles and permitted asset classes enshrined in EU law.

The Commission mandated ESMA to carry out a review of market practices to ensure that the eligibility rules are being implemented in a uniform manner in all member states taking into account market and regulatory developments in the intervening period since this was considered back in 2007.

The Commission requests for ESMA's advice as reflected in the CfE include to:

• Propose clarifications on the key definitions and the criteria against which the eligibility of an asset is assessed. It should analyse whether and to what extent cross-references to other EU legal frameworks could improve legal clarity and, where appropriate, consistency between these frameworks.
• Assess the risks and benefits of UCITS gaining exposures to asset classes that are not directly investable for UCITS. ESMA seeks to gather data on the manner and the extent to which UCITS have gained direct and indirect exposures to certain asset categories that may give rise to divergent interpretations or risk for retail investors.
• Make a preliminary assessment of the impacts of the proposed regulatory adjustments, if any, taking into account the characteristics of the underlying market.

The first section of the CfE deals with convergence issues and the clarity of key concepts and definitions under the EAD while the second section considers direct and indirect exposure of UCITS to certain asset classes.

Convergence issues and clarity of key concepts

The aim of this section is to gather evidence and views from stakeholders on the clarity of key concepts and potential interpretation and convergence in the application of the EAD.

The questions generally draw on previous ESMA workstreams and issues that have previously been brought to light. For instance, the themed questions related to the presumption of liquidity reflect high-profile liquidity issues in the funds industry, as well as concerns identified by ESMA in the course of the 2020 common supervisory action on UCITS liquidity risk management (the "CSA"). In the course of that CSA competent authorities identified shortcomings with respect to the presumption of liquidity and negotiability set out in the EAD. In some cases, UCITS managers placed an overreliance on the presumption of liquidity where they invested in listed securities (e.g. instruments listed offshore with no meaningful trading volume).

Accordingly, ESMA now seeks stakeholder views on whether the presumption of liquidity and negotiability is still appropriate in light of changed market conditions since 2007.

The remaining questions on key concepts are wide ranging with a view to improving investor protection, clarity and supervisory convergence across the EU and include the following:

• Whether there are any recurring or significant issues with the interpretation or consistent application of the EAD rules with respect to:

• Financial indices;
• Money market instruments;
• The concept of "liquidity" or "liquid financial assets";
• The notion of ancillary liquid assets;
• Financial indices;
• Money market instruments;
• The concept of "liquidity" or "liquid financial assets";
• The notion of ancillary liquid assets;
• The application of the 10% limit set out in the UCITS Directive (2009/65/EC as amended) for investments in transferable securities and money market instruments
• The concept of embedded derivatives; and

The interpretation or consistent application of the rules on UCITS investments in other UCITS and alternative investments funds (and UCITS investments in both EU exchange traded funds ("ETFs") and non-EU ETFs).

• Whether a UCITS ought to be permitted to acquire or hold foreign currency also for investment purposes, taking into account the high volatility and devaluation/depreciation of some currencies?
• Whether the transferable security criteria set out in the EAD is adequate and clear enough?
• How the valuation and risk-management criteria set out in the EAD is interpreted and applied in practice and in particular, the need for (i) risks to be adequately captured by the risk management process; and (ii) having reliable valuation/prices;
• Whether the EAD provisions on financial instruments backed by, or linked to, the performance of assets other than those listed in Article 50(1) of the UCITS Directive are adequate and clear enough?
• How investor protection could be improved with respect to efficient portfolio management related issues in light of previous ESMA reports; and
• Evidence that any national regulatory frameworks go beyond what is set out in the EAD.

Direct and indirect UCITS exposures to certain asset classes

In the second section of the CfE, ESMA notes that in the intervening period since the EAD "the number, type and variety of financial instruments traded on financial markets has increased considerably, leading to uncertainty in determining whether certain categories of financial instruments are eligible for investment".

Accordingly, ESMA is seeking stakeholder analyses, data and views to assess the possible risk and merits of UCITS gaining direct or indirect exposures to asset classes on which there may be diverging views as regards the status of their eligibility as UCITS investments including:

• Real estate and real estate investment trusts;
• Crypto assets (alongside recent regulatory efforts to encourage legal certainty in digital assets including the EU Markets in Crypto Assets Regulation);
• Commodities and precious metals;
• Structured loans, which offer highly leveraged income to companies with complex financing needs;
• Catastrophe bonds, which are designed to provide financing to insurance companies in the event of a natural disasters;
• Loans, contingent convertible bonds and unrated bonds;
• Distressed securities;
• Unlisted equities;
• Exchange-traded commodities;
• Special purpose acquisition companies (known as SPACs);
• EU alternative investment funds ("AIFs") and non-EU AIFs;
• Emission allowances;
• Delta-one instruments;
• Exchange-traded notes; an
• Asset-backed securities (including mortgage-backed securities).

ESMA also asks stakeholders to consider whether a look-through approach should be required to determine the eligibility, noting that this approach would aim to ensure that the list of eligible asset classes set out in the UCITS Directive would be deemed exhaustive and reduce risk of circumvention by gaining indirect exposures to ineligible asset classes via instruments.

Timing and next steps

Respondents are requested to substantiate responses provided to the 25 questions posed by sharing as much evidence (including any available data or estimates).

ESMA's review and the advice to follow is bound to be of interest to managers and investors in UCITS and also other EU products such as the European Long-Term Investment Fund (where the portfolio is itself in part subject to the EAD restrictions), with ESMA setting a deadline of 7 August 2024 for receipt of responses to the CfE.

The Commission can be expected to not overly liberalise the EAD rules given the appeal of the UCITS brand and to seek to bring the current regime up to date for conformity with recent regulation and market practice as well as to ensure prescriptive rules apply in a harmonised manner across member states for newer asset classes.

After considering feedback, ESMA is expected to deliver its final technical advice to the Commission after which a comprehensive public consultation will take place. It remains to be seen whether ESMA's large in tray will allow it to meet the Commission's requested deadline of 31 October 2024 for receipt of its recommendations.

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