AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

New Regulation on the use of Derivatives by Collective Investments Schemes

Jesus Mardomingo

Cuatrecasas

Q4 2008

The Spanish funds market has undergone significant changes in recent months with the approval on 2 April 2008 of Order EHA/888/2008 27 March, on financial transactions by undertakings of collective investment institutions involving derivative financial instruments, which clarifies certain aspects of the Regulation of Law 35/2003, 4 November, (the MO).

Up to the enactment of this new regulation, the UCITS Directive was not fully implemented in Spain for the use of derivatives by undertakings of collective investment institutions, so Spanish funds could not benefit from the increased flexibility of this type of financial instrument granted by the modification of the UCITS Directive in 2001.

The prior regulation on the use of derivatives enacted in 1997, limited the use of unlisted derivatives to hedging or seeking a specific yield objective or for its configuration as a guaranteed capital product. This non-implementation of the UCITS Directive put Spanish funds at a competitive disadvantage with UCITS from other EU countries that had greater investment possibilities and opportunities to carry out more sophisticated investment strategies.

This modification is important now, since funds benefiting from the European UCTIS passport are becoming increasingly popular in the EU due to their beneficial regulatory and tax regime.

At the end of 2005, Royal Decree 1309/2005 on Collective Investment Schemes had already increased the number of financial derivates considered eligible for UCITS investment. The Decree recognised the possibility of netting positions in derivatives for calculating the investment limits in these products and allowed the use of financial derivatives with an investment objective. The previous regulation only allowed the use of derivatives for hedging or seeking a specific yield objective or for its configuration as a guaranteed capital product.

As the 1997 regulation remained in force, further regulatory development was necessary for Spanish undertakings of collective investment institutions to benefit from these new investment possibilities. This has been carried out through the approval of the MO (which does not apply to hedge funds because they have no limitations on the use of any type of financial instrument, including financial derivatives), although it is necessary for the CNMV Circulars to clarify further certain technical aspects.

Regarding the use of derivatives by Spanish UCITS, Spain has not opted to create two “types” of UCITS, sophisticated and unsophisticated, as other EU countries have, but to establish the same limits on the use of derivatives for all Spanish UCITS. This approach might place Spanish funds at a disadvantage with other EU UCITS, especially regarding the possibilities of alternative measures for calculating market exposure using derivatives.

Additionally, this opportunity has been taken to implement the Definitions Directive for suitable assets. March 2008 was the deadline for implementing this Directive, which involves substantiation of the criteria issued by the Committee of European Securities Regulators (CESR). It will change the classification of certain assets as listed financial instruments or securities.

The MO also eases restrictions on the use of Over the Counter (OTC) derivatives for investment and extends the list of eligible underlying assets, including derivatives of loans, volatility, commodities and hedge funds. It also introduces additional requirements when the underlying consist of determining assets as “credit risk”, a “financial index” or “volatility of another asset” and when financial instruments not listed in an organised derivative market were used.

In general, for OTC derivative financial instruments, the MO distinguishes between “sophisticated” and “unsophisticated” instruments. Depending on the type of derivative financial instrument, Spanish funds may use the assets for hedging purposes or as an investment for more effective management.

According to the above, the classification between sophisticated and unsophisticated instruments depends on the calculation method used:

• For sophisticated derivatives instruments, an example would be the Black-Scholes method - an analytic model in which the derivative's price is calculated with a formula (stochastic process).
• For unsophisticated derivatives instruments, the example would be the Montecarlo simulation model, which uses samples of numbers and the probability to resolve problems.

The unsophisticated derivatives used with an investment objective are, among others; futures, forwards and deferred sale/purchase contracts, swaps and financial options.

However, Spanish funds may only use these derivative financial instruments according to their investment policy and as long as their underlying assets are:

• Financial instruments and securities traded on stock markets,
• Shares or units of UCITS, credit risk, volatility, financial indices, interest and exchange rates, currencies, commodities for which there is a secondary market,
• Shares or units of hedge funds, country or geographical zone inflation, on the condition that the rules for calculation, transparency and dissemination are equivalent to those established for the European inflation indicator,
• Any other underlying assets authorised by the Spanish regulator.

On the other hand, Spanish funds may only operate with sophisticated unlisted derivatives for the purpose of hedging or seeking a specific yield objective, except in transactions involving financial instruments or securities that include an embedded sophisticated derivative that guarantees the principal. Moreover, for the use of listed sophisticated derivatives, for an investment purpose, just “listing” the derivative is not enough because, under the law, these instruments must be “traded on a market that publishes a daily market price based on the purchase and sale transactions made on that day”.

The MO establishes general limits for the use of derivative instruments based on market risk or counterparty risk and establishes internal control obligations for the use of derivatives and the information obligations with the regulator, the unit holders and shareholders, regarding operations with derivatives.

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