No reuse of assets by depositary - UCITS V Provision
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UCITS V Anatomy™
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The market value of the collateral shall, at all times, amount to at least the market value of the reused assets plus a premium.
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The famous rule which rules out PB style rehypothecation for UCITS 5 funds.
“But I can still rehypothecate up to 100% of a UCITS fund’s indebtedness, right? Right?”
Wrong.
“But, I mean, the fund owes me, man. It owes me.”
Expect optimistic prime brokerage salesfolk to argue that the limited exception will cover PB rephypothecation as long as the PB limits itself to 100% of the fund’s indebtedness. Alas, this is wishful thinking. The permitted exception to the bar on reuse is designed to allow UCITS funds to participate in fully collateralised agent lending programmes. In that case a custodian lends client assets into the market on the client’s behalf (and as its agent) to earn a positive additional return for the fund. This is a very different thing to allowing a prime broker to play with the fund’s assets to defray its own financing costs from its margin lending on those very assets. To wit:
- “Reuse” is defined to include transfer, sale and loan
- “Reuse” is expressed to be “for the account of” the UCITS. This is consistent with the “reuser” depositary acting as agent — like, as an agent lender — on behalf of the fund, rather than as the fund’s counterparty or banker (in which case reuse would be “for the account of the counterparty”, not the fund). Agent lending is a very different kettle of fish: there, the custodian has not (necessarily) financed the asset — that is to say, an agent lending arrangement is in no sense a function of the principal’s indebtedness to the depositary — but rather is a custodian offering to generate some yield enhancement for its clients by lending their assets out into the market, for a fee, against collateral provided by those market borrowers.
- Agent lending “reuse” is, thus, explicitly for the benefit of the fund principal, in that the fund earns a positive return by doing it. The best you could say of PB-style rehypothecation is that the fund avoids a steeper financing charge from the PB that would be implied were the prime broker not allowed to rehypothecate the assets it has financed. In any case UCITS have fairly strict limits against leverage so generally shouldn't be financing assets in the first place.
- Likewise, the theory of rehypothecation is that it isn't collateralised, and certainly not with high-quality collateral: to the contrary, the prime broker’s right to take assets is dependent on the fund’s indebtedness to the PB, so that there is nothing to collateralise. Arguing that by effectively eliminating indebtedness is kind of like being collateralised (as long as you limit yourself to 100% of indebtedness) is a stretch.
What about assets posted as margin?
It’s one thing hocking off assets which your client bought with the proceeds of your loan and has asked you to look after: what about assets a client has posted to you explicitly by way of margin for unrelated exposures or liabilities? Surely you can use those, right? Here it depends what kind of margin it was (initial or variation) and how the UCITS transfers it to you in the first place. In a nutshell, variation margin is easy; initial margin a bit more of a trick.
- Title transfer: Needless to say[1] if a UCITS fund posts non-cash assets by title transfer, they are the broker’s to do with as it pleases. But variation margin, these days, tends to be cash, and initial margin presents a problem, because title transfer opens up an unsecured exposure to the broker for the return of the posted assets, and UCITS funds have tight concentration limits for counterparty exposure. So you may find title transfer is not really on the cards for initial margin.
- Pledge/security interest: Well, if you read literally, Art 22(7) makes this a non-starter too. Even for variation margin. Here's a legal opinion on use of assets in AIFMD and UCITS:
- The regime for UCITS assets is different [to AIFMD]: pursuant [Quotes Article as set out in the panel] It is worth recalling the above rules [in Article 22(7)], in particular to the extent that the ban on the reuse of the UCITS assets for the depositary account should be ensured throughout the chain as it is part of the depositary’s due diligence requirements. Indeed, Article 15(3) of the UCITS V Regulation 2 explicitly foresees that “A depositary shall exercise all due skill, care and diligence in the periodic review and ongoing monitoring to ensure that the third party continues to comply with the criteria provided for in paragraph 2 and the conditions set out in [...] Article 22a(3)(a)-(e) of UCITS V and shall at least: […] (d) monitor compliance with the prohibition laid down in [...] Article 22(7)”.
For Regulatory IM it is probably no biggie that you can’t do anything with it, since you are not meant to do anything with it anyway. The assets are meant to be immobilised, away from the clutches and rehypothecatory designs of your broker and the fragile, feather-weight, jacked-up-on-vega credit-quality of its client. But for ETD it’s a different story: your clearing broker will need to the margin you posted to it down the line to satisfy its own IM requirements to the clearing house and intermediate brokers. If it can’t freely reuse your initial margin, it will have to fund its own. And guess who’s going to pay for that.[2]