October 8, 2018

Monday Morning Memo: The pitfalls of the UCITS regulation

by Detlef Glow.

Undertakings for Collective Investments in Transferable Securities (UCITS) is a well-known brand for mutual funds and ETFs, and investors all over the world appreciate the regulation scheme. Investors from inside and outside the E.U. expect that all funds under the UCITS regulation are treated the same. But are all UCITS funds really treated equally? Obviously not, since the UCITS regulation was created to leave room for the needs of local markets in the E.U. The UCITS regulation creates a minimum standard, and local regulators can extend this basis with stricter rules or adopt local rules if they don’t interfere with the UCITS guidelines. In addition, there are some parts of the fund business not explicitly regulated within the UCITS framework that can be a topic of interest for local regulators.

From my perspective this is in general a good tradeoff, since there are real differences between markets and investors in the E.U. Therefore, I wonder why the Central Bank of Ireland backs a materially increased role for the European Securities and Markets Authority (ESMA), as reported by Ignites Europe. This would mean local authorities will have to give up some power for local regulation to ESMA. But, this was not the intention of the Irish watchdog; it wants ESMA to take control of interpreting the UCITS regulation in the single European markets in order to avoid regulatory arbitrage, as has happened with the efforts to attract U.K. asset managers who want to relocate parts of their fund business in preparation for the hard “Brexit.” This might be interpreted as an attempt to reduce competition between fund domiciles in Europe. I personally think this was one reason for the statement. But, looking at local regulations with regard to UCITS funds, the major reason might be a real concern for investors, especially those from outside the E.U. It is noteworthy that this call by the Central Bank of Ireland was the second call for more action from regulators at ESMA after they urged a probe of fund fees in 2017.

But, are there really big differences in how local regulators interpret the UCITS guidelines in the local laws? Unfortunately, there are numerous differences just because of local requirements such as tax regimes. On the other hand, because there is competition between fund domiciles, some countries desperately try to attract asset managers to domicile their funds in the country by using weak interpretations of the UCITS guidelines and easygoing local standards. But this is also the reason some investors especially avoid those countries, since they want to avoid any reputational risk.

That said, the last probe of the ESMA on securities lending unveiled that some countries have rather weak rules pertaining to securities lending or the use of derivatives as efficient portfolio management techniques. Germany and Luxembourg especially came under scrutiny with regard to the models asset managers use to share revenues from securities lending. While ESMA wants all revenues from securities lending to be passed over to the funds and therefore to the investors, it is common that funds domiciled in Germany or Luxembourg share the revenues between the provider of the lending service, the asset manager, and the fund, which leads to significantly lower returns for investors.

From my perspective it is also hard for an investor to understand why funds domiciled in France are allowed to charge an extra fee for transactions, the  so-called Commission de Mouvement, in addition to the transaction fee charged by the broker.

All these little bits and pieces need to be aligned to keep the reputation of the UCITS brand, thereby encouraging European fund domiciles as places for international fund promoters. Even though I am not a big fan of excessive regulation, I think the E.U. will need a strong ESMA to harmonize the markets further, but this should happen without interfering with the needs of local investors.

The views expressed are the views of the author, not necessarily those of Lipper or Refinitiv.

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