Corrigendum to Commission Recommendation 2004/383/EC of 27 April 2004 on the use of financial derivative instruments for undertakings for collective investment in transferable securities (UCITS) (OJ L 144, 30.4.2004)
Date: 2004-06-07
Institutions: European Commission
Subjects: application of EU law, approximation of laws, financial instrument, investment company, securities

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Corrigendum to Commission Recommendation 2004/383/EC of 27 April 2004 on the use of financial derivative
instruments for undertakings for collective investment in transferable securities (UCITS)

(Official Journal of the European Union L 144 of 30 April 2004)

Recommendation 2004/383/EC should read as follows:

COMMISSION RECOMMENDATION

of 27 April 2004

on the use of financial derivative instruments for undertakings for collective investment in trans-
ferable securities (UCITS)

(notified under document number C(2004) 1541/1)

(Text with EEA relevance)

(2004/383/EC)

THE COMMISSION OF THE EUROPEAN COMMUNITIES,

Having regard to the Treaty establishing the European Com-
munity, and in particular Article 211, second indent, thereof,

Whereas:

employ processes for the accurate and independent
assessment of the value of over-the-counter (OTC)-deri-
vative instruments. These requirements of Directive
85/611/EEC call for the establishment of an adequate
framework for the risk-measurement and -management
of a UCITS by Member States. In order to facilitate the
development of such a framework and to ensure a
is desirable to recommend
it
harmonised approach,
some common basic principles for risk-measurement.

(1)

(2)

laws,

regulations

One of the aims of the amendments to Council Directive
85/611/EEC of 20 December 1985 on the coordination
and administrative provisions
of
relating to undertakings for collective investment
in
transferable securities (UCITS) (1), introduced by Directive
2001/108/EC (1), was to widen the scope of financial
instruments in which a UCITS can invest and to enable
UCITS to make use of modern investment techniques.
This extension of permissible investments does not only
include money market instruments, bank deposits, units
of UCITS and other collective investments undertakings:
UCITS are now also permitted to employ financial deri-
vative instruments as part of their general
investment
policy, and not only for the purposes of hedging posi-
tions.

those amendments was

Another aim of
to ensure
investor protection. Directive 85/611/EEC, as amended,
therefore establishes an extensive system of risk-limita-
tion: In order to ensure that the risks related to the new
classes of financial instruments, in particularly regarding
derivatives, are duly and accurately monitored, measured
and managed, management companies or investment
companies are required to apply sound risk measure-
ment processes under the supervision of the competent
authorities.
risk measurement
processes should enable them to monitor, measure and
manage at any time the risks of the positions and their
contribution to the overall risk-profile of the portfolio.
Management or investment companies have also to

In particular,

these

(1) OJ L 375, 31.12.1985, p. 3; Directive as last amended by Directive
2001/108/EC of the European Parliament and of the Council (OJ L
41, 13.2.2002, p. 35).
(1) OJ L 41, 13.1.2002, p. 35.

(3)

reached

Agreement was
in the UCITS Contact
Committee on the benefits of formulating basic princi-
ples, which should be taken into account by Member
States. Those principles should help Member States to
ensure an equivalent and effective protection of investors
throughout the Community and level the playing field
for UCITS operators and products
regulated under
different jurisdictions.

(4) With regard to the limit to global exposure relating to
derivatives set out in the first subparagraph of Article
21(3) of Directive 85/611/EEC and the maximum limit
to borrowing transactions laid down in Article 36(2) of
that Directive, it should be made clear which maximum
exposure in total may be incurred by a UCITS.

(5)

The total exposure of a UCITS needs to be assessed on
the basis of both default risk of the UCITS and leverage
produced by the use of financial derivative instruments.
It should therefore be ensured that the market risk of a
UCITS is adequately measured. It is therefore necessary
to recommend possible approaches of market
risk
measurement, by clarifying the conditions for the use of
the following types of methodologies: the commitment
approach;
the Value-at-risk approach (VaR-approach)
and stress tests.

(6)

(7)

(8)

(9)

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For the same reasons it is useful to recommend some
elements for the method of assessing the leverage of a
UCITS portfolio produced by the use of financial deriva-
tive instruments.

Pursuant to the second subparagraph of Article 21(3) of
Directive 85/611/EEC, the exposure of a UCITS must be
calculated taking into account not only the current value
of the underlying assets, but also the counterparty risk,
future market movements and the time available to liqui-
date the positions. As regards counterparty risk related
to OTC-derivatives, specific requirements are laid down
in the second subparagraph of Article 22(1) of that
Directive. In view of these requirements it is desirable to
clarify the method of calculating the counterparty risk
associated with financial derivative instruments and the
way in which it relates to the methods and criteria
provided for in Directive 2000/12/EC of the European
Parliament and of
the Council of 20 March 2000
relating to the taking up and pursuit of the business of
credit institutions (1).

(10)

(11)

appropriate to clarify the concept of uncovered sales
with regard to financial derivative instruments and to
recommend criteria applicable to the cover of a deriva-
tives transaction in order to facilitate compliance with
Article 42.

This Recommendation is a first step towards a uniform
understanding of risk measurement methodologies in
the UCITS area. However, risk-measurement methodolo-
gies are submitted to a permanent progress. Further
steps may therefore be necessary taking into account
further developments such as the Basel Capital Accord
(Basel
II) and the future corresponding Community
Directive on capital requirements for banks and invest-
ment firms.

This Recommendation provides some basic elements
which should be taken into consideration by Member
States for their implementation of Directive 85/611/EEC
It should be
as amended by Directive 2001/108/EC.
noted that
intended to
this Recommendation is not
provide exhaustive guidelines on the use of financial
derivative instruments for UCITS but to outline some
principles which can be considered as an essential basis
of a common risk-measurement approach for UCITS,

Pursuant to the third subparagraph of Article 21(3) of
Directive 85/611/EEC, the exposure to the underlying of
the financial derivative instrument has to be included
into the calculation of the issuer concentration limits
laid down in Article 22 of that Directive. According to
that same provision, Member States may allow that,
when a UCITS invests in index-based derivatives, these
investments do not have to be combined to the issuer
concentration limits laid down in Article 22. It is there-
fore appropriate to recommend standards for the appli-
cation of
issuer concentration limits with regard to
financial derivative instruments.

Uncovered sales are all transactions in which the UCITS
is exposed to the risk of having to buy securities at a
higher price than the price at which the securities are
delivered and thus making a loss and the risk of not
being able to deliver the underlying financial instrument
for settlement at the time of the maturity of the transac-
tion. These risks are always relevant for those operations
in which the UCITS is forced to buy securities in the
market to meet its obligations. In those cases the UCITS
is exposed to the risk that it cannot meet all or a part of
its commitments under the terms of a financial deriva-
tives operation. Article 42 of Directive 85/611/EEC
therefore generally prohibits the execution of uncovered
sales in order to avoid heavy losses for UCITS. However,
in the context of an operation with financial derivative
instruments having the financial profile of an uncovered
sale, the risks typically associated with uncovered sales
may not always have the same relevance. It is therefore

(1) OJ L 41, 13.1.2002, p. 35.

HEREBY RECOMMENDS:

In the framework of
Member States should apply the following:

implementing Directive 85/611/EEC

1. Risk-measurement systems adapted to the relevant risk-

profile of the UCITS

In applying Article 21(1) of Directive 85/611/EEC, Member
States are recommended to ensure that management or invest-
ment companies employ risk measurement systems which are
adapted to the relevant risk-profile of a UCITS in order to
make sure that
they accurately measure all material risks
related to the UCITS under the supervision of the competent
authorities.

2. A harmonised interpretation of

limitations to the

UCITS' risk- exposure

2.1. Limitation to a UCITS' global exposure on derivatives

and overall risk exposure

Member States are recommended to ensure that the global
exposure relating to financial derivative instruments may not
exceed 100 % of the UCITS' net asset value (NAV), and hence
that the UCITS' overall risk exposure may not exceed 200 % of
the NAV on a permanent basis.

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2.2. Limitation to possible temporary borrowing

Member States are recommended to ensure that the UCITS'
overall risk exposure may not be increased by more than 10 %
by means of temporary borrowing, so that the UCITS' overall
risk exposure may not exceed 210 % of the NAV under any
circumstances.

2.3. Joint application of points 3 and 4

For the application of the 100 % global exposure limit relating
to derivatives, Member States are recommended to ensure that
both points 3 and 4 are respected.

3. Appropriately calibrated standards to measure market

risk

3.1. Adaptation of risk-measurement methodologies to the

risk-profile of a UCITS

In conformity with the overarching principle mentioned under
point 1 and established in Article 21(1) of Directive
85/611/EEC, Member States are recommended to allow a
differentiated methodological approach for the respective cate-
gories of 'non-sophisticated UCITS', which have overall less and
simpler derivative positions by using e.g. a few plain vanilla
options, and ‘sophisticated UCITS’. The distinction between,
and exact definition of, these categories requires further work
in accordance with point 3.4. Pending completion of such
work, Member States should move towards a more calibrated
approach for measuring market risk in accordance with points
3.2 and 3.3.

3.2. Non-sophisticated UCITS

3.2.1. Use of the commitment approach

Member States are recommended to request their competent
in the case of non-sophisticated
authorities to ensure that,
UCITS, they are satisfied that market risk is adequately assessed
by using the commitment approach, whereby the derivative
positions of a UCITS are converted into the equivalent position
in the underlying assets embedded in those derivatives. For the
the commitment approach, Member States'
application of
competent authorities should also take into account criteria
such as the UCITS' overall exposure deriving from the employ-
ment of
the nature, aim,
number and frequency of the contracts entered into by the
UCITS and the management techniques adopted.

financial derivative instruments,

3.2.2. Technical precisions

In the case of options, Member States are recommended to
allow the application of the delta approach, which is derived
from the sensitivity of the change in the option's price to
marginal changes in the price of the underlying financial instru-
ments. The conversion of forwards, futures and swaps positions

should depend on the precise nature of
the underlying
contracts. In the case of simple contracts, the marked-to-market
value of the contracts will usually be relevant.

3.2.3. Invitation to consider further additional safeguards

Member States are required to consider whether additional safe-
guards are requested in the context of the use of the commit-
ment approach, such as an appropriate cap to the global expo-
sure relating to financial derivative instruments below 100 % of
NAV for non-sophisticated UCITS.

3.3. Sophisticated UCITS

3.3.1. Standard use of value-at-risk (VaR) approach with stress tests

In the case of ‘sophisticated UCITS’, Member States are recom-
mended to require management or investment companies to
apply regularly VaR approaches. In the VaR-approaches, the
maximum potential
loss that a UCITS portfolio could suffer
within a certain time horizon and a certain degree of confi-
dence is estimated. Member States are recommended to require
management or investment companies also to apply stress tests
in order to help manage risks related to possible abnormal
market movements. Stress tests measure how extreme financial
or economic events affect the value of the portfolio at a specific
point of time.

3.3.2. Invitation to develop common reference standards as a further

step

For the application of VaR-approaches, Member States are
recommended to require the use of appropriate standards in
conformity with point 3.1. For this purpose, Member States
should consider, as a possible reference the following para-
meters: a 99 % confidence interval, a holding period of one
month and 'recent' volatilities, i.e. no more than one year from
the calculation date without prejudice to further testing by the
competent authorities. Once common standards have been
developed by further work undertaken by Member States in
accordance with point 3.4, Member States
should allow
management or investment companies to deviate from these
standards only on a case-by-case basis, subject to the appro-
priate examination of the competent authorities in accordance
with what is provided for in point 3.3.3.

3.3.3. Internal risk-measurement models

Member States are recommended to accept only those internal
risk-measurement models proposed by a management or
investment company which are subject to appropriate safe-
guards, including those set out in this recommendation. The
models concerned should be subject to appropriate examina-
tion by the competent national authorities. Member States are
also recommended to disclose a list of models recognised by
the competent national authorities, and make them publicly
available by appropriate means.

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3.4. Recommendation to carry out further work

4.3. Recommendation to carry out further work

Considering that these risk-measurement methodologies need
further refinement, Member States are recommended to encou-
rage their competent authorities to undertake further work
with a view to elaborating more advanced and elaborated
methods of risk-measurement and thus develop a convergent
Community-wide approach. This concerns in particular:

(a) the criteria to identify sophisticated and non-sophisticated

UCITS;

(b) the conversion of

financial derivative instruments into
equivalent underlying assetsand the netting of positions
underlying the financial derivative instruments in case ofthe
application of the commitment approach;

(c) best practices in the area of VaR and stress tests;

Member States are recommended to take into account that the
methods for assessing the leverage of a UCITS need further
refinement, in particular with respect to the maximum VaR/
stress-test value corresponding to a total exposure of 200 % of
a UCITS' NAV. Therefore they should encourage their compe-
tent national authorities to undertake further work to develop
more advanced and sophisticated methods of assessing leverage
aiming at the development of a convergent Community-wide
approach.

5. Applying appropriate standards and recognised risk-

mitigation techniques to limit counterparty risk

(d) the standards which internal models must meet in order to

be used by UCITS.

5.1. Criteria for the limitation of counterparty risk exposure

to OTC derivatives

4. Appropriately calibrated standards to assess leverage

4.1. Use of the commitment approach

In the absence of
the advanced methodologies mentioned
under point 4.2, Member States are recommended to request
the use of
the commitment approach to assess a UCITS'
leverage,
in combination with the VaR-approaches and the
stress-tests required for the purpose of measuring market risk
exposure of sophisticated UCITS under point 3.3.

Member States are also recommended to allow management or
investment companies which use the commitment approach
according to point 3.2 to also employ the commitment
approach for the assessment of leverage.

Member States are recommended to ensure that all the deriva-
tives transactions which are deemed to be free of counterparty
risk are performed on an exchange where the clearinghouse
meets the following conditions: it is backed by an appropriate
performance guarantee, and is characterised by a daily mark-to-
market valuation of the derivative positions and an at least
daily margining.

5.2. Recommendation to use maximum potential loss

Member States are recommended to require the exposure per
counterparty on an OTC-derivative transaction to be measured
on the maximum potential loss incurred by the UCITS if the
counterparty defaults and not on the basis of the notional value
of the OTC contract.

4.2. Invitation to allow the use of further advanced meth-

odologies

In the case of sophisticated UCITS under point 3.3, provided
that the supervisory authorities are fully convinced that a given
management or investment company has already developed
and tested an appropriate method of assessing leverage by the
means of VaR-approaches and stress tests and provided that
this method is duly documented by the management or invest-
ment company, Member States should consider recognising it
for the assessment of leverage. For this purpose, Member States
are specifically recommended to consider approaches relying
on a standard of comparison such as the VaR/stress test value
of an appropriate reference portfolio which complies with the
investment policy of a UCITS or the VaR/stress test value of an
adequate benchmark.

5.3. Invitation to use the standards laid down in Directive

2000/12/EC as a first reference

In compliance with the fixed quantitative prudential
limits
already imposed by Directive 2001/108/EC, Member States are
recommended to require the assessment of counterparty risk
with regard to OTC-derivatives
in accordance with the
marking-to-market method laid down in Directive 2000/12/EC
of the European Parliament and of the Council (1), notwith-
standing the need of appropriate pricing models when the
market price is not available. Member States should also
require the use of the full credit equivalent approach laid down
in Directive 2000/12/EC, including an add-on methodology to
reflect the potential future exposure.

(1) OJ L 375, 31.12.1985, p. 3; Directive as last amended by Directive
2001/108/EC of the European Parliament and of the Council (OJ L
41, 13.2.2002, p. 35).

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5.4. Recognition of collateral for the purpose of assessing a

UCITS' counterparty risk exposure

5.4.1. General criteria

Member States are recommended to allow for the recognition
in order to reduce a UCITS' counterparty risk
of collateral
provided that,
in accordance with the prudential rules laid
down in Directive 2000/12/EC and taking into account further
developments, the collateral:

(a) is marked-to-market on a daily basis and exceeds the value

of the amount at risk;

(b) is exposed only to negligible risks (e.g. government bonds

of first credit rating or cash) and is liquid;

(c) is held by a third part custodian not related to the provider
or is legally secured from the consequences of a failure of a
related party;

(d) can be fully enforced by the UCITS at any time.

5.4.2. Risk concentration limits

In accordance with the general principle of risk-spreading,
Member States are recommended to ensure that the exposure
to counterparty risk on a given entity, respectively group, after
taking into account any collateral received from that entity, or
group, may not be higher than the 20 % limit laid down in
Directive 85/611/EEC, both at
the
second sub-paragraph of Article 22(2) and at group level,
under Article 22(5) of that Directive.

level, under

individual

5.5. Recognition of netting

Member States are recommended to allow UCITS to net their
OTC-derivative positions vis-à-vis
counterparty,
provided that the netting procedures comply with the condi-
tions laid down in Directive 2000/12/EC and that they are
based on legally binding agreements.

same

the

require the use of methodologies adequate to the type of instru-
ment considered. For example, Member States may allow the
use of the delta approach for options.
In cases where this
approach is not relevant or technically impossible, due to the
complexity of the concerned financial derivative instrument,
Member States may then allow the use of an approach based
on the maximum potential loss linked to that derivative as a
maximum threshold assessment of the solvency risk.

6.2. Case of index-based derivatives

Member States are advised,
in the use of their discretionary
powers for the application of the option foreseen by the third
subparagraph of Article 21(3) of Directive 85/611/EEC, to take
into account whether the underlying index of a financial deriva-
tive instrument meets the requirements of Article 22a of that
Directive. For the application of Article 21(2) and the third sub-
paragraph of Article 21(3) of that Directive, Member States are
recommended to consider that, a management or investment
company should generally be prevented from using financial
derivative instruments based on a self-composed index with the
intent to circumvent the issuer concentration limits of Article
22. Member States are also recommended to consider that a
management or investment company should be prevented from
using financial derivative instruments based on indices which
do not comply with the concentration limits set by Article 22a
of Directive 85/611/EEC.

6.3. Risk-concentration limits

Member States are recommended to require management
companies or investment companies to cumulate counterparty
risk with issuer risk versus the same entity or group for the
application of the 20 % NAV-limit pursuant to the second sub-
paragraph of Article 22(2)and Article 22(5) of Directive
85/611/EEC.

7. Applying relevant cover rules to transactions with both

listed, and OTC, financial derivative instruments

6. Using adequate methodologies when applying limita-

tions to issuer risk

6.1. Adaptation of the risk-measurement methodologies to

the derivatives typology

Considering that the fourth subparagraph of Article 21(3) of
Directive 85/611/EEC provides that, in order to include finan-
cial derivative instruments into the issuer concentration limits
foreseen by Article 22, they should be converted into equiva-
lent underlying positions, Member States are recommended to

7.1. Appropriate cover in the absence of cash-settlement

When the financial derivative instrument provides for, either
automatically or at the counterpart's choice, physical delivery
of the underlying financial instrument on maturity or exercise,
and provided that physical delivery is common practice on the
considered instrument, Member States are recommended to
require UCITS to hold this underlying financial instrument as
cover in their investment portfolios.

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7.2. Exceptional substitution with an alternative underlying

7.4. Calculation of the level of cover

cover in the absence of cash settlement

In cases where the risks of the underlying financial instrument
of a derivative can be appropriately represented by another
underlying financial
instrument and the underlying financial
instrument is highly liquid, Member States should consider
allowing UCITS to hold exceptionally other liquid assets as
cover provided that they can be used at any time to purchase
the underlying financial instrument to be delivered and that the
additional market risk which is associated with that type of
transaction is adequately measured.

7.3. Substitution with an alternative underlying cover in the

case of cash-settlement

Where the financial derivative instrument is cash-settled auto-
matically or at the UCITS discretion, Member States should
consider allowing the UCITS not to hold the specific underlying
instrument as cover. In this case, Member States are recom-
mended to consider the following categories as acceptable
cover:

(a) cash;

(b) liquid debt

instruments (e.g. government bonds of

first
credit rating) with appropriate safeguards (in particular,
haircuts);

(c) other highly liquid assets which are recognised by the
competent authorities considering their correlation with the
underlying of the financial derivativeinstruments, subject to
appropriate safeguards (e.g. haircuts where relevant).

In the context of the application of Article 42 of Directive
85/611/EEC, Member States should consider as ‘liquid’ those
instruments which can be converted into cash in no more than
seven business days at a price closely corresponding to the
current valuation of
instrument on its own
market. Member States are recommended to ensure that the
respective cash amount be at
the
maturity/expiry or exercise date of
the financial derivative
instrument.

the UCITS' disposal at

the financial

Member States are recommended to require the level of cover
to be calculated in line with the commitment approach.

7.5. Nature of the underlying financial instrument

instrument of

Member States are recommended to require that the underlying
financial
instruments,
financial
whether they provide for cash-settlement or physical delivery,
as well as the financial instruments held for cover have to be
investment
compliant with the Directive and the individual
policy of the UCITS.

derivative

7.6. Recommendation to undertake further common work

As regards cover of transactions with financial derivative instru-
ments, Member States are recommended to encourage their
competent authorities to identify a common typology of trans-
actions with financial derivative instruments in which the risk
profile of an uncovered sale may be identified.

The Member States are requested to inform the Commis-
8.
sion,
insofar as possible, by 30 September 2004 of any
measures they have taken further to this Recommendation and
to inform it of the first results of its implementation, in as far
as they are able, no later than 28 February 2005.

9.

This Recommendation is addressed to the Member States.

Done at Brussels, 27 April 2004.

For the Commission

Frederik BOLKESTEIN

Member of the Commission