A December regulation change was the last in a series under which French managers have been given an increasing capacity to trade over-the-counter derivatives, well in advance of the implementation of the "UCITS III" directive, which is due to be implemented by member states within a year.
Conditions Applicable To OTC Derivatives Generally
The regulatory framework applicable to French FCPS and SICAVS, has acknowledged the ability of managers to use these instruments, while providing for certain safeguards. Both SICAVs (sociétés d'investissement à capital variable) and FCPs (fonds communs de placement) are collective investment schemes, the first are incorporated as a corporation whereas FCPs are non-corporate investment funds similar to unit trusts.
The following is a summary of the key conditions that must be complied with in respect of all derivatives traded on behalf of a French SICAV or FCP. It is worth noting that there are varied forms of FCPS and SICAVS under French law, which are adapted to certain specialized contexts or investments and that the rules outlined below are rules applicable to general purpose SICAVS or FCPS.
Types Of Instruments: There is no exhaustive list of the types of OTC derivatives that may be used in the management of a SICAV or FCP. These may be swaps, options, forwards or other instruments that qualify as forward financial instruments for the purposes of French law. There is however an overriding requirement that the use of OTC derivatives should be consistent with the management policies of the relevant SICAV or FCP. In fact, the Commission des Opérations de Bourse requires the information memorandum specifically describe the contemplated use of derivatives and detail their foreseeable impact on the investment.
Eligible Underlying: Because derivatives should not be used to circumvent investment rules which are applicable to direct investments, the underlying used in an OTC derivative should be an instrument which is itself eligible to be physically held by the relevant SICAV or FCP. Interest and currency exchange rates are eligible underlying references, as well as equity indices that are computed and published in a manner satisfactory to the COB. Finally, by explicitly allowing credit derivatives, the December reform implicitly recognized credit risk as an eligible underlying reference.
Termination Option: OTC instruments do not afford the liquidity available in respect of exchange-traded products, so French regulations require that the SICAV or FCP should have at all times the ability to unwind the transaction. The reform makes it clear that termination can be made "at market value or at a pre-determined value". In practice, the documentation for tailored structured transactions which do not afford sufficient liquidity, often goes beyond the "all-or-nothing" mechanism required by the regulations and gives to the manager the ability to increase (within specified limits) or decrease the size of the transaction to match new issues of units or shares to investors or, as the case may be, redemption requests received from them.
Exposure Limit: Consistent with the requirements of the UCITS III Directive, French regulations limit the exposure of the relevant SICAV or FCP to a single counterparty to OTC derivatives to 10% of its assets. The regulations provide that the exposure is computed on a net mark-to-market basis, taking into account any collateral received by the SICAV or FCP. It is worth noting that guaranteed funds which involve an OECD credit institution issuing a formal guarantee to the scheme or to its investors are exempt.
Specific Conditions Applicable
To Credit Derivatives
Despite the increased sophistication of the regulatory framework, the French regulators felt that specific safeguards should be adopted with respect to credit derivatives. After some uncertainty as to whether credit derivatives should be permitted at all in the context of collective investment schemes, the group focused more on operational issues and the elaboration of rules which would be designed to prevent conflicts of interests and to ensure these complex products would be handled with adequate care and resources. The result of this exercise was the inclusion in the decree of a specific section dealing with credit derivatives. In fact, the additional conditions relating to the products are limited and most of the effort was devoted to special management rules applicable to the relevant managers.
What Credit Derivatives? Credit derivatives are defined in the December decree by reference to standard market documentation, as "forward financial instruments meeting the characteristics of credit derivatives defined in national or international market master agreements". Earlier drafts had attempted to give a substantial definition of the instruments but these attempts created uncertainty as to whether the full range of products covered by the International Swaps and Derivatives Association's credit derivatives definitions was covered. Although the final wording is not entirely satisfactory--in the sense that credit derivatives are not defined in the master agreements themselves--the intention of the draftsmen clearly appears to be to allow all varieties of credit derivatives transactions documented under the ISDA definitions or the French domestic documentation published by FBF in the form of its credit derivatives "Technical Schedules". There is however an overriding requirement that the instruments used constitute forward financial instruments under French law, which would exclude instruments which, because of their specific terms, might be characterized as insurance contracts or guarantees.
Eligible Reference Entities: The December decree gives a restrictive list of the reference entities as to which protection can be bought or sold by a French SICAV or FCP, limiting these to entities which are (i) sovereign states, international bodies whose membership includes EU member states and local authorities in the EU, (ii) entities whose equity instruments are listed in an EU regulated market or in an organized market which has not been excluded by COB, (iii) entities whose debt securities are rated in addition to being listed in an EU regulated market or in an organized market which has not been excluded by COB or (iv) any combination of several entities described in (i) to (iii) above.
Settlement Terms: French regulations do not heavily regulate the settlement terms of credit derivatives traded for a SICAV or FCP. The only substantial condition in fact results from the other applicable investment restrictions and lies in that the settlement of credit derivatives transactions can only be made by physical delivery of the underlying obligation if such obligation qualifies as an eligible asset for the relevant scheme.
Conditions Applicable To The Manager
The most interesting part of the decree relates to the additional constraints which must be complied with by the entity in charge of the management of the relevant SICAV or FCP, directly or by way of delegation from the primary manager. These requirements must be complied with before any credit derivative transaction can be entered into on behalf of the relevant SICAV or FCP.
Valuation: Firstly, the manager is required to set up a management system and an organization that allows for the daily valuation of the outstanding credit derivatives transactions. In addition, the valuation should be compared at least monthly with a valuation made externally. It is worth noting that FCPS and SICAVS are already under an obligation under Article 10 of the decree to be at all times in a position to accurately and independently value their assets and off-balance sheet commitments.
Risk Analysis: By the same token the manager is required to set up a management system and an organization which allows for risk analysis implemented by credit risk units which are independent from the manager's commercial and operational units. Again, this principle was already expressed in Article 10 of the decree, although it receives particular stress under the December decree, in particular by the requirement that the risk analysis should be presented to the board of the manager at least every six months.
Internal Controls: The manager is required to have internal control units independent from all other operational units, except for the executive office.
Prior Approval: Because credit derivatives are viewed by the relevant authorities as highly technical products which require special expertise and resources for their valuation and monitoring, the December decree requires the manager should have a specific program of activities approved by the COB. The purpose of this program is essentially to allow the COB to validate the manager has set up the internal systems, human resources and organization required to comply with the foregoing requirements with respect to valuation, risk analysis and compliance. For those managers which had already contracted credit derivative transactions before its entry into force, the decree provides that the program of activities should be submitted to the approval of the COB before March 12, a deadline which will probably need to be extended.
Transactions With Affiliates: Finally, in order to avoid conflicts of interests, the decree limits the capacity of the manager to enter into credit derivatives on behalf of a SICAV or FCP with one of its affiliated companies. Such transactions must not exceed 20% of the global volume of credit derivatives transactions traded by the relevant SICAV or FCP, a limitation that de facto prevents sponsor banks to structure schemes with which they would enter into the credit derivatives.
Conclusion
Beyond these specific rules, the application to credit derivatives of the general requirements for OTC transactions is likely to raise issues which will probably require further official interpretation from the COB, in particular the requirement that the underlying reference obligations should be taken into account for the purpose of computing diversification ratios. However, the December reform has solved the last residual uncertainties that existed as to whether credit derivatives were an adapted tool in the management of SICAVS and FCPS. No doubt that derivatives dealers will shortly be competing for proposing to managers imaginative ideas allowing SICAVS and FCPS to fully use the possibilities afforded by these synthetic investments.
This week's Learning Curve was written by Pierre Gissinger, partner at Allen & Overy in Paris.
