ESMA’s UCITS Overhaul: Major Reforms Proposed in Final EAD Report

Background and mandate

Since the adoption of the UCITS I Directive in 1985, the UCITS framework has evolved to address market developments and ensure supervisory convergence. The UCITS EAD, published in 2007, aimed to develop a common understanding of asset eligibility under the UCITS framework. In June 2023, ESMA received a mandate from the European Commission (EC) to review the UCITS EAD, considering market and regulatory developments over the past decades.

In May 2024, ESMA published a Call for Evidence to gather stakeholders feedback on the matters raised in the mandate. The Call for Evidence closed in August 2024. The Final Report summarises the feedback received to the Call for Evidence (Annex II), the main areas where Member State divergences have been identified (Annexes II and III) and sets out policy proposals to be addressed via legislative amendments (Annex VI).

Key issues and proposals

Divergences in implementation: ESMA identified significant divergences in Member State practices regarding the UCITS eligibility of various asset classes, including procedural aspects and interpretations of eligibility criteria. In particular, the treatment of delta-one instruments proved to be a source of divergence as was financial indices and index-tracking UCITS. In addition, the term ‘asset segregation’ was reportedly translated incorrectly in the context of the rules on UCITS investments in alternative investment funds (AIFs) which led to instances where UCITS management companies assessed only the ‘risk diversification’ (not asset segregation) requirements set out in the UCITS Directive.

ESMA recommends using directly applicable EU regulations to ensure greater harmonisation and reduce compliance burdens.

Liquidity: The Final Report emphasises the importance of liquidity in the UCITS framework, noting that the large majority of respondents to the Call for Evidence felt that there was no merit in introducing additional provisions on the concept of liquidity under the UCITS framework. However, ESMA sets out proposals on both the liquidity criteria and liquidity assessments at the asset and portfolio level.

ESMA wants to draw on the criteria included in its predecessor’s guidelines² to provide further clarity on the criteria to be taken into account by UCITS management companies when assessing the liquidity of assets. It wants to incorporate these criteria in the legal text of the UCITS EAD.

ESMA also wants to amend the legal text so as to clarify that the eligibility assessment on liquidity is performed at the asset level whereas liquidity risk management occurs at the portfolio level. ESMA asserts that the former is a criterion to assess that an asset has the necessary qualities or satisfies the necessary conditions to be deemed investible for UCITS whilst the latter represents the overall system put in place by the UCITS management company to ensure on an ongoing basis the ability to redeem investors at their request.

Transferable securities: ESMA proposes clarifications to the definition of transferable securities with the intention of providing greater clarity and supervisory convergence.

As for the definition of transferable securities, which was introduced by the UCITS III Directive, ESMA wants to link the term “any other negotiable securities which carry the right to acquire any such transferable securities by subscription or exchange” with the requirements on risk management set out in Commission Directive 2010/43/EU. This means that to be eligible for UCITS, the risks of this asset class must be fully understood, managed and incorporated into the risk management procedures as described in the Commission Directive.

The requirements on risk management in Commission Directive 2010/43/EU include an obligation on the risk management company “to take into account the nature of a foreseen investment, to formulate forecasts and perform analyses concerning the investment’s contribution to the UCITS portfolio composition, liquidity and risk and reward profile before carrying out the investment. The analyses must only be carried out on the basis of reliable and up-to-date information, both in quantitative and qualitative terms.” ESMA wants to update the “reliable valuation” criterion by specifying that the valuation assessment is supported by adequate liquidity of the market and adequate sources of information (e.g. multiple broker quotes).

Alternative assets: Whilst ESMA has refrained from putting forward policy proposals for larger-scale Level 1 changes for any possible expansion or restriction of the list of directly eligible asset classes set in the UCITS IV Directive it has made certain proposals including applying a look-through approach to determine the UCITS eligibility of assets.

ESMA proposes a look-through approach in the UCITS EAD which it believes will impact a relatively small number of UCITS that are significantly (i.e. beyond 10%) or even predominantly indirectly invested in alternative assets. It stresses that the approach would not affect investments in traditional company shares or bonds but rather seeks to limit the use of instruments (e.g. certain delta-one instruments, ETNs, ETCs, AIFs etc.) that provide for exposures to alternative assets. The Final Report suggests allowing limited indirect exposures (up to 10%) to alternative assets to improve risk diversification. The approach would mean that asset classes should not be backed by, or linked to the performance of, other assets which may differ from those referred to in Article 50(1) of the UCITS IV Directive. To avoid any circumventions, the approach would be performed to the level of the final underlying of the investment. To alleviate the impact of the approach on the relatively small number of UCITS, ESMA advises the EC to ensure there is an appropriate transitional period.

ESMA invites the EC to consider two policy options that are intended to alleviate certain concerns regarding the look-through approach. The first concerns whether consideration should be given as regards to harmonising Member State rules on the marketing of AIFs to retail investors. The second concerns exploring the creation of a new EU harmonised AIF product (next to EuVECA, EuSEF and ELTIF) which would be dedicated to investments in those asset classes that would be deemed not eligible under the proposed revised UCITS framework.

ESMA proposes to broaden the applicable wording covering the 10% limit for indirect UCITS exposures to alternative assets so that it is extended to all eligible asset classes listed in the UCITS IV Directive, including financial derivative instruments and units or shares of open-ended AIFs.

Money market instruments: ESMA proposes recalibrating the criteria for money market instruments, including risk assessments and liquidity criteria, to provide greater legal clarity and convergence.

ESMA has concerns regarding the notion of money market instruments citing that the qualification or reclassification of securities as money market instruments needs to be carefully assessed. As such it is proposing certain recalibrations of the criteria set out in the UCITS EAD (notably the risk management criterion and liquidity assessments).

Among other things ESMA is of the view that the relevant provision in the UCITS EAD should not be viewed as an obligation to automatically classify an instrument with a maturity of no more than 397 days as a money market instrument. Rather, other elements should be taken into account including: the liquidity of the instrument; the risk profile of the instrument, including the credit quality of the issuer and of the instrument as well as the interest rate risks.

Financial derivative instruments: The Final Report discusses the treatment of financial instruments embedding derivatives, proposing criteria to assess whether a transferable security or money market instrument embeds a derivative.

ESMA has set out legislative proposals which include certain criteria that a UCITS should consider in order to assess if a transferable security or money market instrument shall be regarded as embedding a derivative or if the derivative component shall be deemed to be a separate financial instrument. The criteria are partly based on ESMA’s predecessor’s guidelines concerning eligible assets for investment by UCITS³ which provided a non-exhaustive list of financial instruments embedding a derivative. The criteria focus on the possibility that the derivative component can contractually or economically be considered an independent financial instrument from the host transferable security or money market instrument.

Financial indices: ESMA recommends clarifying the eligibility of financial indices, ensuring they are sufficiently diversified and meet the criteria set out in the UCITS IV Directive.

ESMA proposes that the look through approach mentioned above should include financial indices. UCITS would be able to invest in financial derivative instruments providing exposures to financial indices comprising assets that are not eligible for direct investment within the 10% limit. However, these indices would need to be sufficiently diversified. The 10% limit set out in the UCITS IV Directive is an aggregate figure meaning that all possible forms of exposures need to be combined and not exceed 10%, this includes any exposures to financial indices comprised of assets other than those referred to in the UCITS IV Directive.

ESMA is also aware that some divergences between Member States stem from certain requirements in the UCITS IV Directive providing for national discretion⁴. Where the index refers to regulated markets or multi-lateral trading facilities (MTFs) where certain transferable securities or money market instruments are highly dominant and the concentration limit is raised to 35%, ESMA is proposing that such derogation be included in the fund rules or instruments of incorporation and shall be approved by the home competent authority of the UCITS.

UCITS investments in AIFs: ESMA proposes to update the terminology and criteria for UCITS investments in AIFs, ensuring these investments do not circumvent UCITS restrictions and investor protection standards.

ESMA’s legislative proposals include those that:

• Aim to ensure that UCITS investments in AIFs do not result in a circumvention of the investment restrictions and investor protection standards set out in the UCITS IV Directive. This includes the application of the look-through approach (see above), while granting some level of flexibility to invest in AIFs without the application of the look-through within the 10% limit.
• Distinguish between open-ended AIFs and closed-ended AIFs which is consistent with the approach already set out in the UCITS IV Directive and the UCITS EAD. For example:

• The UCITS IV Directive provides that open-ended AIFs are eligible where, among other things, they are authorised under laws which provide that they are subject to a supervision considered equivalent by Member States. ESMA is of the view that where authorised EU AIFs are managed by authorised AIFMs under the Alternative Investment Fund Managers Directive (AIFMD), this condition related to the supervision can be presumed, unless the UCITS is aware of information that may lead to a different conclusion.
• ESMA is of the view that investments in units or shares of closed-ended AIFs, coherently with investments in open-ended AIFs, need to adhere to certain investor protection safeguards. The legislative proposals contemplate a reference to criteria where closed-ended AIFs shall be subject to an equivalent level of supervision and no more than 10% of the portfolio of the targeted UCITS or AIFs can be invested in units of other UCITS or AIFs, in accordance with their fund rules or instruments of incorporation.

• Clarify the eligibility regime with respect to units or shares of AIFs which do not meet all the requirements set out in the UCITS IV Directive. However, a UCITS may invest in these units or shares of AIFs within the 10% limit, subject to certain requirements specified in its legislative proposals.

Ancillary liquid assets: ESMA suggests clarifying that ancillary liquid assets are subject to counterparty limits, without prescribing a maximum amount, to address current divergences and provide regulatory flexibility.

UCITS are permitted to hold ancillary liquid assets and the UCITS IV Directive does not provide for any explicit limits concerning the amount of ancillary liquid assets that can be held. ESMA sees no major need for an exhaustive definition of ancillary liquid assets. It does, however, see that holding ancillary liquid assets may expose UCITS to similar or even the same counterparty risks that are associated with investments in bank deposits. As such ESMA recommends that the EC clarifies in the legal text of the UCITS IV Directive that the 20% counterparty limit for deposits made with the same body also applies to ancillary liquid assets. Conversely, ESMA does not see merit in prescribing a maximum amount of ancillary liquid assets that UCITS may hold, bearing in mind that they might be required to cover for exceptional payments and unfavourable market conditions.

UCITS investments in foreign currencies: The UCITS IV Directive does not explicitly address the holding of foreign currencies for investment purposes, except for allowing the acquisition of foreign currency through back-to-back loans and as underlyings of financial derivatives.

ESMA’s view is that holding foreign currencies as ancillary liquid assets is permissible, and investments in foreign currencies are allowed if they fall within the categories of deposits, underlyings of derivatives, or ancillary liquid assets. All such exposures must comply with risk management, liquidity, and disclosure requirements set out in the UCITS framework.

As such ESMA concludes that there is no need for amendments to the UCITS EAD regarding foreign currencies, as the current framework is considered sufficient, provided that exposures are managed in line with existing rules

Efficient portfolio management techniques (EPMs): The Final Report addresses issues related to EPMs, including costs, collateral arrangements, and alignment with Securities Financing Transactions Regulation definitions, proposing clarifications to ensure legal certainty and convergence.

Among other things, ESMA notes that cost-related matters are beyond the Level 2 UCITS EAD and need to be addressed at the Level 1 UCITS IV Directive or in a separate legal act (such as the Retail Investment Strategy). ESMA recommends that the EC consider providing further legal clarity on EPM-related costs and fees including on the fee split models with a view to ensuring investor protection.

Securitisations: The Final Report briefly discusses respondents’ views on the pros and cons of UCITS investing in securitisations and concludes that this goes beyond the scope of the technical advice.

The Final Report notes the relevance of securitisations for the EU capital market and that UCITS can invest in securitisations that meet the requirements set out in the Securitisation Regulation and the UCITS Directive (including the 10% concentration limit for debt securities issued by the same body). With respect to the investment limits and requirements set out in the UCITS Directive, ESMA is of the view that this should be holistically discussed in the context of future amendments to the investment limits of UCITS on securitisations, provided that the current 10% limit is dedicated to the broad category of debt securities.

Alignment with MIFID II, DLT Pilot Regime Regulation and MiCA: The Final Report notes that a significant area for regulatory alignment or update concerns MTFs.

ESMA confirms that MTFs could be considered a regulated market in line with its Q&As on the application of the UCITS IV Directive. It is also of the view that EU MTFs can be considered an eligible trading venue for UCITS. As such, ESMA recommends to the EC to introduce the definition of regulated market and MTFs by way of adding a cross-reference to MIFID II and amending the UCITS Directive, together with the UCITS EAD, with the aim of including EU MTFs as an eligible trading venue for UCITS.

Referring to the Markets in Financial Instruments Directive II (MiFID II) and its concept of financial instruments which includes instruments that have been issued by means of distributed ledger technology, ESMA states the technology used and the characteristics of the issuance or the market infrastructure should not exclude the eligibility of assets, unless the assessment whether the instrument meets the criteria set out for the eligibility of financial instruments or other information available to the UCITS would concretely lead to a different conclusion.

Interestingly, ESMA notes that crypto-assets that qualify as financial instruments under MiFID II or as AIFs under AIFMD fall outside the scope of the Regulation in markets in crypto-assets (MiCA). It also notes that crypto-assets are not explicitly eligible for direct investments under the current UCITS framework. However, it then goes on to state that a case-by-case analysis may lead to a different conclusion taking into account the following: (1) the qualification as a financial instrument under MIFID II (and, where relevant, other EU acts such as the AIFMD); (2) the instrument meeting the criteria and conditions set out in the UCITS Directive and in the UCITS EAD for being an eligible asset; (3) the UCITS being able to comply with all the requirements set out in the UCITS Directive and other regulations applicable to it.

Short positions: UCITS may build up short positions through derivatives or other financial instruments or techniques only where all requirements and limits set out in the UCITS framework are met.

ESMA has not proposed any amendments to the UCITS EAD but highlights the need to ensure adequate disclosures to investors including on whether the UCITS intends to take long positions, short positions, or both and the associated risks.

Conclusion

The Final Report on UCITS EAD provides comprehensive technical advice to the EC, aiming to enhance the clarity, effectiveness, and supervisory convergence of the UCITS framework. The proposed amendments and clarifications seek to address divergences in Member States’ practices, improve investor protection, and ensure the continued success and resilience of the UCITS brand. In terms of next steps, whilst the EC is not obliged to take action in light of the Final Report it is expected to start holding stakeholder meetings with asset managers and open a consultation next year. ESMA will also cooperate closely with the EC in its review of the UCITS EAD.

Next steps

It may be slightly premature for firms to spend a lot of time thinking about the steps they may wish to take in light of the Final Report. Whilst it is likely that the UCITS EAD will be revised in the future it is only when the drafts amending Level 1 and Level 2 legislation are published does it make sense to think about restructuring the investments affected by the proposed new rules. In the meantime, an asset manager should perhaps conduct an analysis on which of the products it offers actually benefit from the rather liberal approaches taken by the current UCITS EAD on look-through, liquidity and transparency.