Do you want to access the full text of articles?

Please see our digital edition archive for the full text of articles.

Alternatively:

If you are a Chartered Accountants Ireland member, please visit the RIS service where Accountancy Ireland is available free of charge via the EBSCO databases.

If you are an Accountancy Ireland subscriber (i.e. you pay each year to receive your copy of Accountancy Ireland) please contact our Subscriptions Department quoting your subscription number and include details of the article you want.

All other users should enquire from their local public or college library about accessing full text Accountancy Ireland articles.

Home / ...

Introduction

In May 2006 the Financial Regulator issued its final guidance on the use of derivatives in the pan-European regulated retail fund structure, more commonly known as “UCITS”. This article discusses the history behind the European Parliament’s decision in 2001 to allow UCITS utilise derivatives for investment purposes. It also provides a brief overview of the main categories of derivative products, the primary risks associated with their use and a summary of the Financial Regulator’s requirements in this area.

Overview

The original UCITS Directive of 1985 allowed UCITS to invest in a clearly defined and relatively narrow market segment called “transferable securities”. For the purposes of UCITS, transferable securities are generally considered to be highly liquid securities, and common examples are European government issued sovereign debt, listed equities, highly rated bond issues and money market instruments. The purpose of the Directive was to develop a well-regulated retail fund product that could be sold easily throughout the European Union in order to provide European retail investors with access to the investment management sector. The rationale behind restricting investments to transferable securities was primarily investor protection, and so there was a general prohibition on the use of advanced investment techniques such as leverage (see below).

The 1990’s witnessed an explosion in the use of derivative instruments and other structured financial products with a resultant demand from consumers and industry to be allowed invest, via the UCITS brand, in such instruments. While generally acknowledged that the use of such instruments could increase financial risks, it was also recognised that these financial innovations could help boost returns on savings. On balance there seemed to be no compelling reason not to allow this activity if done in a highly regulated environment. These considerations, as well as the ongoing objective of maintaining the overall competitiveness of the European funds industry, led to the passing of the Product Directive in 2001, also known as UCITS III.

UCITS III allows fund managers more flexibility in their investment strategies, including the use of modern investment techniques and instruments such as derivatives. However, these new investment opportunities do not come without additional regulatory safeguards. One of the prime objectives of the legislators and regulatory authorities throughout Europe is to maintain a high level of retail-investor protection. This translates into a requirement for UCITS managers to implement a sound risk-management process (RMP) to monitor, manage and measure the financial and operational risks associated with derivatives. This RMP is subject to review by the Financial Regulator.

Derivatives – A Beginners Guide

It’s fair to say that there is a general lack of knowledge among retail investors on the types of derivatives that are traded in the markets today, what they are used for and the risks that they carry. Allied to this is a certain amount of confusion as to what “leverage” actually means, and indeed what are its associated financial implications. What, therefore, do derivatives actually bring to the table other than risk and confusion!

These are some of the important reasons why derivatives are important to the financial markets:

-They offer the ability to increase trading capability; -They allow leverage; -They allow customisation of requirements; -They can be used to both increase and decrease risk exposures; and -Their use can save significant transaction costs.

The key element to understanding derivatives is the effect of “leverage”. This can mean different things to different people, but it generally seen as the octane that gives derivatives their potency. The use of leverage allows traders to commit a relatively small amount of cash (generally known as premium or margin) to obtain exposure to the full returns of the associated underlying asset. If, for example, a trader wants exposure to US Treasury Bills, he could simply buy, say, $1m worth of the T-bills for cash. Or he could use a derivative and gain the same amount of exposure for only, say, $50,000. This, as you can see, gives the trader a leverage factor of 20, which means that for every 1% rise or fall in the underlying value of the T-bills, the trader will gain or lose 20% of his investment.

Derivative Product Types

Derivatives generally fall under two headings - exchange-traded derivatives and over-the-counter (OTC) products, the former type being traded on a regulated market and the latter traded on a bi-lateral basis with a single counterparty. The basic derivative product types can be categorised under the following headings:

-Forwards: These are generally OTC contracts and common examples are forward FX contracts or forward rate agreements. -Futures: These are generally exchange-traded instruments and, like forwards above, commit the buyer or seller of the futures contract to meet the specific terms of the contract, for example to buy or sell a particular bond at a specific price on a specific date. -Options (puts and calls): These contracts allow the buyer the option whether or not to meet the terms of the agreement depending on whether it is beneficial or not. They may be either OTC or exchange-traded. -Swaps: A hugely important and influential OTC instrument that allows two parties to swap cash-flows on any type of underlying asset. Common examples are interest rate, cross-currency and total-return swaps. -Contracts for Differences: These OTC instruments offer exposure to the equity markets at a small percentage of the cost of owning the underlying shares.

Derivative Risks

The more extensive use of derivatives under UCITS III (noting that the original 1985 Directive did allow the limited use of derivatives primarily for hedging) exposes UCITS to a number of specific risks that regulators and market-participants must be aware of and address. They are the same types of risks found in traditional financial products, i.e. market, credit, legal and operational risks, but with the potential for greater downside. Indeed, as OTC derivatives are customised transactions, they often assemble risks in complex ways. This can make the measurement and control of these risks more difficult and create the possibility of unexpected loss. This has been shown most dramatically in such cases as the Long Term Capital Management fiasco, the collapse of Barings Bank via the derivative trading of Nick Leeson and, closer to home, the John Rusnak scandal at AIB.

The challenge for all European regulatory authorities was and continues to be the interpretation and implementation of the provisions of the UCITS III Directive while ensuring that clear and complete guidance on the use of derivatives in UCITS and the resultant RMP is disseminated and understood by all market participants. In that regard, the Financial Regulator issued Notice UCITS 10 (Financial Derivative Instruments) and Guidance Note 3/03 in November 2004, both updated in May 2006 . The content of these documents was the subject of a lengthy consultation process with interested market participants, including the Dublin Funds Industry Association, and the result is a fine example of how the Financial Regulator and industry work together to ensure that strong, clear and practical regulatory requirements are put in place.

Irish Regulatory Requirements

The purpose of these documents is to ensure that all market participants are aware of the limitations and requirements imposed by the Financial Regulator with regard to the use of derivatives in UCITS. The requirements cover both quantitative limits and qualitative factors, with the essential requirement that these are comprehensively described in the RMP document submitted to the Financial Regulator.

Quantitative Limits

The most important quantitative limits applicable to the use of derivatives are as follows.

-Global Exposure and Leverage Limits; -Position (Issuer-Concentration) Risk Limits; and -Counterparty Risk Limits.

1. Global Exposure and Leverage Limits The purpose of these limits is to ensure that a UCITS does not expose itself to an unacceptable level of market risk through the use of derivatives. UCITS have the choice whether to use a simple but conservative method, the commitment approach, or an advanced risk-measurement methodology, primarily Value at Risk (VaR), to calculate this market risk. The former methodology is normally used by non-sophisticated and the latter by sophisticated users of derivatives. The commitment approach calculates risk exposure by determining the market value of the underlying assets to which the derivative contract refers, and this risk exposure may not represent more than 100% of the net asset value (NAV) of the UCITS. If VaR is used, the UCITS may not have an exposure greater than 5% of the NAV (known as absolute VaR), or it may not have a VaR, inclusive of its derivative positions, greater than twice the VaR of a similar non-derivative portfolio (known as relative VaR). The degree of exposure that a UCITS has may be reduced by the use of allowable position netting and hedging positions.

2. Position (Issuer-Concentration) Risk Limits These particular limits aim to ensure that a UCITS is not overly exposed to one issuer. For example a UCITS could have investments in shares and bonds issued by a particular bank. It may also have money on deposit as well as having some open derivative contracts with that same bank. Therefore it can be seen that the UCITS has an overall concentration exposure that, should the bank get into difficulties, could leave it open to substantial losses. A UCITS may therefore not have position risk greater than 20% with a single issuer.

3. Counterparty Risk Limits The purpose of these is to ensure that a UCITS does not have a receivable with a single derivative counterparty greater than either 5% or 10% of NAV (depending on the status of the counterparty). In order to take account of the risk of unexpected price movements during the time it takes to liquidate a derivative contract, the limit includes an add-on for future credit exposure, which is essentially a regulatory haircut. The exposure may be reduced, however, through the use of collateral management and counterparty netting, again subject to specific criteria.

Qualitative Factors In addition to the quantitative limits described above, there are a number of qualitative factors that the Financial Regulator takes into consideration when examining the RMP. These include:

-The expertise and experience of the personnel using derivatives and executing the RMP; -The controls that the risk-manager has in place; -The existence of strong reporting and escalation procedures, especially in the event of regulatory breaches; -The systems used; and -The policy with regard to legal risk (especially important in the case of OTC bi-lateral contracts).



Conclusion

Allowing UCITS the ability to use derivatives has been welcomed by all market participants due to the greater range of investment choices it creates. As this article explains, derivatives are complex instruments that may give rise to high levels of financial risk. They operate in a dynamic environment where new products and trading strategies continually evolve. The Financial Regulator therefore actively monitors the advances in derivative trading, notably the general increase in derivative instruments being traded (for example the massive growth in the use of credit default swaps) and the evolution of increasingly sophisticated risk-measurement techniques. The input of experienced market participants to this process has and continues to be extremely important in ensuring that the regulatory environment in this area is clear, practical, robust and comprehensive in its interpretation and application.

Review IFSRA guidance note 3/03 and also the latest CESR paper on this - ref CESR/09-489. The principle is that the global exposure amount is the amount that you would have to spend buying the underlying asset itself in order to get the same exposure as the derivative.

Hi, I am working on implementing UCITS regulation for our derivatives Compliance project. I found this article useful but having difficulty grasping everything. I need to provide the following: Global Exposure Value, Replacement Cost and future exposure. The replacement_cost I am getting it from our vlautaion system which is nothing but the mark to market value. The future_exposure I am putting in the Notional amount. It is the Global exposure where I am having difficulty to understand for Swaptions/IRS/CDS/FRA/FX FWDs, etc. We have the related data points available, Long_Short Fixed_or_Float Pay_or_receive Buy_or_Sell Leg1_n_leg2 Notional Market Value Price Currency Global_exposure_values Need to determin in each asset class as to what to fill in Long_Short and Global Exposure values I would greatly appreicate it you could explain in simple manner. We are using Sentinel prroduct for regulatory complinace. Please assist, if possible. Thanks Regards, Su