CELEX: 32004H0383
Language: en
Date: 2004-04-27 00:00:00
Title: 2004/383/EC:Commission Recommendation of 27 April 2004 on the use of financial derivative instruments for undertakings for collective investment in transferable securities (UCITS)(Text with EEA relevance)(notified under document number C(2004) 1541/1)

30.4.2004         EN                  Official Journal of the European Union                       L 144/33
                               COMMISSION RECOMMENDATION
                                               of 27 April 2004
 on the use of financial derivative instruments for undertakings for collective investment
                                  in transferable 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 Community, and in particular Article
211, second indent, thereof,
Whereas
(1)     One of the aims of the amendments to Council Directive 85/611/EEC of 20 December
        1985 on the coordination of laws, regulations and administrative provisions relating to
        undertakings for collective investment in transferable securities (UCITS)1, introduced
        by Directive 2001/108/EC, 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 derivative
        instruments as part of their general investment policy, and not only for the purposes of
        hedging positions.
(2)     Another aim of those amendments was to ensure investor protection. Directive
        85/611/EEC, as amended, therefore establishes an extensive system of risk-limitation:
        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 measurement processes under the supervision of the competent authorities.
        In particular, these 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
        employ processes for the accurate and independent assessment of the value of over-
        the-counter (OTC)-derivative instruments. These requirements of Directive
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).
 ---pagebreak--- L 144/34           EN              Official Journal of the European Union                   30.4.2004
         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 harmonised approach, it is
         desirable to recommend some common basic principles for risk-measurement.
(3)      Agreement was reached in the UCITS Contact Committee on the benefits of
         formulating basic principles, 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)      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
         derivative instruments.
(7)      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 liquidate 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 institutions2.
(8)      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 therefore
         appropriate to recommend standards for the application of issuer concentration limits
         with regard to financial derivative instruments.
2
  OJ L 126, 26.5.2000, p.1
 ---pagebreak--- 30.4.2004        EN               Official Journal of the European Union                   L 144/35
(9)     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
        transaction. 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 derivatives 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 appropriate to clarify the concept of uncovered sales with regard to financial
        derivative instruments and to recommend criteria applicable to the cover of a
        derivatives transaction in order to facilitate compliance with Article 42.
(10)    This Recommendation is a first step towards a uniform understanding of risk
        measurement methodologies in the UCITS area. However, risk-measurement
        methodologies are submitted to a permanent progress. Further steps may therefore be
        necessary taking into account further developments such as the Basle Capital Accord
        (Basel II) and the future corresponding Community Directive on capital requirements
        for banks and investment firms.
(11)    This Recommendation provides some basic elements which should be taken into
        consideration by Member States for their implementation of Directive 85/611/EEC as
        amended by Directive 2001/108/EC. It should be noted that this Recommendation is
        not intended to 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,
HEREBY RECOMMENDS:
In the framework of implementing Directive 85/611/EEC Member States should apply the
following:
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 investment 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.
 ---pagebreak--- L 144/36         EN               Official Journal of the European Union               30.4.2004
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 categories 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 authorities to ensure that, in the
case of non-sophisticated 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
application of the commitment approach, Member States’ competent authorities should also
take into account criteria such as the UCITS’ overall exposure deriving from the employment
of financial derivative instruments, the nature, aim, number and frequency of the contracts
entered into by the UCITS and the management techniques adopted.
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 instruments. 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 safeguards are requested in the
context of the use of the commitment approach, such as an appropriate cap to the global
exposure relating to financial derivative instruments below 100% of NAV for non-
sophisticated UCITS.
 ---pagebreak--- 30.4.2004        EN              Official Journal of the European Union                 L 144/37
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 recommended 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 confidence 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 parameters: 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
appropriate 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
safeguards, including those set out in this recommendation. The models concerned should be
subject to appropriate examination 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.
3.4 Recommendation to carry out further work
Considering that these risk-measurement methodologies need further refinement, Member
States are recommended to encourage 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 assets
        and the netting of positions underlying the financial derivative instruments in case of
        the application of the commitment approach;
" c) best practices in the area of VaR and stress tests;
" d) the standards which internal models must meet in order to be used by UCITS.
4. Appropriately calibrated standards to assess leverage
 ---pagebreak--- L 144/38         EN                Official Journal of the European Union               30.4.2004
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.
4.2 Invitation to allow the use of further advanced methodologies
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
investment 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.
4.3 Recommendation to carry out further work
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 competent 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
5.1 Criteria for the limitation of counterparty risk exposure to OTC derivatives
Member States are recommended to ensure that all the derivatives 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.
5.3 Invitation to use the standards laid down in Directive 2000/12/EC as a first reference
 ---pagebreak--- 30.4.2004          EN            Official Journal of the European Union                   L 144/39
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 Council3, notwithstanding 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.
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 of collateral in order to reduce a
UCITS’ counterparty risk 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 individual level, under the second
sub-paragraph of Article 22(2) and at group level, under Article 22(5) of that Directive.
5.5 Recognition of netting
Member States are recommended to allow UCITS to net their OTC-derivative positions vis-à-
vis the same counterparty, provided that the netting procedures comply with the conditions
laid down in Directive 2000/12/EC and that they are based on legally binding agreements.
6. Using adequate methodologies when applying limitations 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 financial derivative instruments into the issuer concentration limits
foreseen by Article 22, they should be converted into equivalent underlying positions,
Member States are recommended to require the use of methodologies adequate to the type of
instrument 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
3
  OJ L 126, 26.5.2000, p.1
 ---pagebreak--- L 144/40         EN               Official Journal of the European Union                30.4.2004
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 derivative instrument meets the
requirements of Article 22a of that Directive. For the application of Article 21(2) and the third
subparagraph 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 subparagraph 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
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.
7.2 Exceptional substitution with an alternative underlying 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 automatically 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 recommended to consider the
following categories as acceptable cover:
 ---pagebreak--- 30.4.2004        EN                Official Journal of the European Union                   L 144/41
–         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 derivative
                instruments, 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 the financial
instrument on its own market. Member States are recommended to ensure that the respective
cash amount be at the UCITS’ disposal at the maturity/expiry or exercise date of the financial
derivative instrument.
7.4 Calculation of the level of cover
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
Member States are recommended to require that the underlying financial instrument of
financial derivative instruments, whether they provide for cash-settlement or physical
delivery, as well as the financial instruments held for cover have to be compliant with the
Directive and the individual investment policy of the UCITS.
7.6 Recommendation to undertake further common work
As regards cover of transactions with financial derivative instruments, Member States are
recommended to encourage their competent authorities to identify a common typology of
transactions with financial derivative instruments in which the risk profile of an uncovered
sale may be identified.
8. The Member States are requested to inform the Commission, 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