Irish Fund Focus: Oversight of Use of Derivatives - Key Issues
This article was first published in The Hedge Fund Journal in July 2012
There are intricate and fast-changing economic and other risks associated with the use of derivatives. In the context of Irish regulated investment funds (“Funds”), there are also a range of legal, regulatory and tax considerations to be taken into account when investing through derivatives. As a Fund’s investment manager has day-to-day responsibility for implementing, monitoring and testing the investment strategy in this area, the role of a Fund’s directors is to monitor and oversee the investment manager’s use of derivatives.
Why use derivatives in a Fund portfolio?
Some of the key reasons to use derivatives in a Fund portfolio include: (i) gaining access to a broader set of investment opportunities; (ii) the ability to implement investment views with minimal portfolio disruption; (iii) the ability to avoid or hedge against unwanted risks; and (iv) optimising capital through minimal upfront cash outlay. For example, total return swaps and credit-linked notes may be traded to gain synthetic exposure to foreign markets where local settlement can be difficult and costly, e.g. a market with underdeveloped infrastructure, high taxes and tariffs and/or onerous regulatory registration requirements.
Fund directors should be conscious that derivatives raise additional risk management issues including:
- Leverage: Unlike cash securities, derivatives enable investors to purchase or sell exposure without committing cash in an amount equal to the economic exposure (the notional value) of the position. This ability could result in leverage, or magnification, of the risk position, on the long or short side;
- Illiquidity: Some derivatives, particularly complex over-the-counter (“OTC”) derivatives, may be illiquid and some previously liquid derivatives may become illiquid during periods of market stress; and
- Counterparty risk: Because the satisfaction of an OTC derivative depends on the creditworthiness of the counterparty, OTC derivatives carry counterparty risk.
Regulatory regime applicable to a Fund’s use of derivatives
With these risks in mind, it is important to note, in this time of market stress, that OTC trading counterparties (each, a “Counterparty”) engaged by an Irish UCITS or an Irish qualifying investor fund (“QIF”) are required to meet certain eligibility criteria.
OTC counterparty - UCITS
A Counterparty engaged by a UCITS must be a credit institution (in which case a counterparty exposure limit of 10% of UCITS net asset value applies) or an entity with a minimum credit rating as prescribed by the Central Bank of Ireland (the “Central Bank”). Where a Counterparty is not a credit institution, an exposure limit of 5% of UCITS net asset value applies. Eligible collateral may be posted by a Counterparty to reduce the counterparty risk exposure.
The onus is on the Fund’s directors, in conjunction with the investment manager, to monitor compliance by a Counterparty with these eligibility criteria and take corrective action if necessary.
As part of the risk management process required to be employed by the investment manager of a UCITS in relation to its use of derivatives, a risk management process (“RMP”) policy document is required to be put in place which details the following:
- All derivatives to be used by the investment manager with a summary of their commercial purpose;
- The risks involved to the UCITS from using derivatives;
- A description of the valuation rules for derivatives (these rules are prescribed by the Central Bank); and
- Details on global exposure and leverage. This area covers: (a) the risk measurement methodology to be used to calculate the UCITS’ global exposure and leverage; (b) the policy in relation to asset cover; (c) the policy for issuer concentration risk; and (d) controls and systems in respect of counterparty exposure.
The RMP may be a useful roadmap for Fund directors in monitoring and overseeing the investment manager’s use of derivatives.
OTC counterparty - QIF
Turning to the non-UCITS regulatory regime, a Counterparty engaged by a QIF must have a minimum credit rating as prescribed by the Central Bank and Counterparty exposure is limited to 40% of the QIF’s net asset value, above which the Counterparty must be appointed in accordance with the Central Bank prime broker requirements.
The Central Bank does not currently require a QIF to have an RMP in place for the trading of derivatives by its investment manager. Interestingly, the Alternative Investment Fund Managers Directive (“AIFMD”), which sets out the rules which investment managers providing services to QIFs will be required to comply with upon its implementation in July 2013, provides, in Article 15(2), that:
“AIFMs shall implement adequate risk management systems in order to identify, measure, manage and monitor appropriately all risks relevant to each AIF investment strategy and to which each AIF is or may be exposed.”
ESMA’s advice, dated 16 November 2011, on the Level 2 measures which will detail the implementing measures of AIFMD, states that: “AIFMs shall establish, implement and maintain an adequate and documented risk management policy which identifies all the relevant risks to which the AIFs they manage are or might be exposed to.”
On the basis of ESMA’s advice, it seems that the RMP will become something that investment managers managing QIFs will require to familiarise themselves with.
Oversight of use of derivatives
Ultimately, the directors of a Fund are responsible for overseeing its operations. As, typically, a Fund operates on a delegated model basis (i.e. investment management is delegated by the directors to an eligible investment manager), the directors are not expected to be derivatives specialists or micromanage a Fund’s use of derivatives.
During board meetings it is recommended that Fund directors focus on the following derivatives oversight principles in discussions with the investment manager on its Funds derivatives report:
- Enquire whether the internal controls are effective in monitoring risk and complying with investment restrictions and regulatory requirements;
- Ask about the investment rationale for using the chosen derivatives to determine their potential benefits and assess their associated risks;
- Enquire about failures and successes to understand the reasons for each and focus on error reports;
- Be alert to pricing and valuation difficulties focussing, in particular, on counterparty valuations and their verification by appropriately approved persons and follow prescribed rules in this area;
- Consider any tax ramifications of adding a derivative to a Fund portfolio and ask whether this issue has been discussed with the Fund’s tax adviser;
- Understand the custody arrangements in place in respect of collateral with key considerations such being the ability of a Counterparty to reuse a Fund’s collateral and planning for upcoming changes as a result of AIFMD; and
- Ask about any contentious issues which arose in the negotiation of the ISDA trading documentation.
Some derivatives are widely used, save money in achieving an investment strategy and have deep liquidity. However, as derivatives use by investment managers of Funds evolve, Fund directors should take the time to understand how derivatives work and how a Fund’s investment manager is using them. In addition, directors should assess the risks involved, scrutinise the quality of disclosure to investors in the Fund prospectus, be alive to the potential exposure of investors through the use of derivatives and be aware of the mitigants available to reduce risk in using them.