The Irish regulator’s decision to allow physical shorting through Ucits has been suspended pending a review by the European Commission. Nicholas Pratt examines the reasons for the Commission’s concerns and how they may be resolved.
For some, the decision by Ireland’s authorities to allow fund managers to launch hedge funds under the Ucits III label was just not palatable. They feared a hedge fund blow-up or scandal could dent the gold-plated Ucits brand internationally.
The decision to allow the physical shorting of stocks, which paved the way for Ucits hedge funds, was announced in November 2007 when the Irish Financial Services Regulatory Authority revised its Ucits III policy. The regulator had been asked to permit fund managers to engage in physical shorting rather than synthetic shorting through derivatives. Satisfied that its policy proposal was consistent with both Irish Ucits legislation and existing guidelines from CESR (the committee of European securities regulators) that deal with securities lending arrangements and repurchase agreements, the regulator pressed ahead with its changes to the Ucits III landscape.
The changes were widely welcomed in Ireland. Back in January, Gary Palmer, chief executive of industry body the Irish Funds Industry Association, heralded the move as “a demonstration of the strength of the financial regulator in that it is able to address innovation in the funds industry in an open and transparent way”.
He added: “It is a very sensible evolution that will allow funds to structure themselves in a way that will gain greater efficiencies.”
The ‘sensible’ part referred to the certain conditions that came with the revision that were designed to promote stability. Any provider of these new funds would have to demonstrate proven expertise and previous experience and no uncovered short selling would be allowed. “It’s so sensible that some people might say, ‘There’s got to be something wrong’!” said Palmer at the time.
And how prophetic his claim happened to be. Not long after the financial regulator issued its revised policies, certain unknown members of Europe’s fund industry raised the issue with the European Commission, requesting that it look into the move and commission CESR to conduct a thorough review of the situation to see whether the Irish market’s interpretation of the Ucits rules was consistent with its own.
According to Hilary Griffey, partner at Dublin-based law firm Maples & Calder, a formal response is expected from CESR by the end of the second quarter of the year and until the Irish regulator’s position is either confirmed or rejected by CESR and the EC, the Irish funds market must sit and wait.
“If the use of covered physical short sales is confirmed by CESR, managers and promoters may seek to establish funds which exploit this as part of their direct strategy but only where it is more cost effective to do so,” says Griffey. “If CESR does not confirm the financial regulator’s interpretation of the Directive which permits covered physical short sales, the financial regulator will discontinue authorising Ucits III funds which provide for this,” adds Griffey. The situation is less clear as regards those funds which may have already been given authorisation to engage in short selling.
From where did the objections arise and why? One fund promoter that is concerned about the allowance of short-selling though Ucits is HSBC Investments. Global head of product development Adam Fairhead is concerned that physical short selling will possibly erode what has become a respected standard, something that has helped make Ucits funds so exportable to funds centres outside of Europe.
“Ucits is a gold standard because it has clear and strong investment powers through the limits that it sets,” says Fairhead. “This made it very exportable to the likes of Switzerland, Asia and South America. You can also redeem a Ucits fund at notice, there is strong regulation on Ucits funds and, most importantly, there have been no significant scandals involving Ucits funds.”
Should the European Commission allow the Irish regulator to proceed with its interpretation of the Ucits III rules regarding the shorting of stocks, Fairhead believes that Ucits’ current reputation for strong investment powers could be at risk. He notes that certain countries, including within Asia, were initially uncomfortable with the idea that Ucits III funds would be allowed to use derivatives for short selling purposes in the first place. “The investment powers of Ucits funds could become very hedge fund-like. The danger is that by pushing the boundaries even further, it damages the exportability and credibility of that gold standard,” he says.
Understandably, this view is challenged. “I was surprised that people got so upset about it,” says Harley Murphy, head of offshore management at BNY Mellon Asset Servicing. “To me it was an over-reaction.” After all, he says, the synthetic shorting of Ucits funds is already allowed through the use of 130/30 funds, credit derivatives, hedge fund indices and commodity indices. But that final step from derivatives to fully physical shorting appeared to be a step too far for the Commission to immediately countenance.
A question of semantics
All of which suggests it is as much a question of semantics as it is about the operational detail of the changes. “I think it was the fact that it is a big step for Ucits in a philosophical sense,” adds Justin Egan of Dublin-based financial services provider Carne Global and also a board member of the IFIA. “In practical terms there is very little difference in risk between synthetic shorting and physical shorting.”
The only real difference, maintains Egan, is that those managers who have operational challenges in using derivatives and other sources of synthetic shorting would find it far easier to engage in physical shorting without incurring additional risk. “Ucits funds are still a highly regulated product – there are diversifaction rules, there must be evidence of robust risk management, and an independent custodian must be used,” says Egan. “Really it seems a logical extension of the current rules on synthetic shorting to allow physical shorting with conditions.”
The covering conditions that accompanied the financial regulator’s decision seem to have been largely ignored by the detractors, says Murphy, who have been perhaps overly biased by the unwelcome publicity that short-selling has attracted in recent years. “I think people saw the headline ‘Ireland allows short-selling’ but did not read the small print.”
Another concern from those outside Ireland is that the short-selling move will lead to fully-fledged hedge funds being launched through Ucits III, meaning that retail investors could find themselves wandering into investment areas they are not qualified to be in.
HSBC’s Fairhead says: “I think it is important that we do not blur the edges between Ucits retail funds and the more sophisticated institutional or high-net-worth funds. We have to be cautious over this development.”
“I understand that concern to some degree but provided there are the necessary restrictions and conditions in place I don’t know why this move on short-selling has been picked out,” argues BNY Mellon’s Murphy. “If I look at the Ucits funds that we administer at the moment, they have performance fees, they’re using prime brokers and they rely heavily on derivatives. If it was going to allow the use of lots of instruments that previously had not been allowed under Ucits, I could understand it, but to pick out this particular feature as something that was going to change the Ucits brand is unfair.”
There is another, more cynical interpretation of the objections that have been raised with the EC over the financial regulator’s policy revision. As one Irish fund manager says, “With any new development people have different agendas and a lot of the complaints come from other competing jurisdictions.”
A more legitimate-sounding description would be ‘regulatory aribtrage’; however, the likes of Ireland and Luxembourg have built their respective fund markets on a fast-moving and flexible regulatory base that exploits latest developments – as was shown by the adoption of the ‘qualified investor’ schemes and specialised investment funds by Ireland and Luxembourg respectively. Therefore it would seem inconsistent to declare the Irish market’s Ucits move as an act of arbitrage.
The most likely scenario is that the EC and CESR will spend the next two to three months completing their review before declaring that the Irish funds market is free to carry on as before. Meanwhile, Luxembourg will have had time to study the situation and work on developing a similar scheme of its own, thereby negating the advantage that Ireland would have gained by being first out of the blocks, no matter how momentary that advantage may have proved to be.
As Murphy, at BNY Mellon, says: “You can be sure that the Luxembourg regulators will be studying the situation and, as is often the case between Dublin and Luxembourg, when one comes out with something new, the other does something very similar soon afterwards.”
© 2008 funds europe