Wednesday, April 24, 2013

EU UCITS Directive – Rationale, Scope of Application, and Regulation

Imagine you collect money from people to invest it first and then distribute the returns. If you would like to do this in the EU, you must deal with two types of regulation:

  • If you keep things simple, you will create a UCITS to receive and invest the funds. UCITS is a shortcut for “undertakings for collective investment in transferable securities”. A more cumbersome designation is probably difficult to imagine.
  • If you want to make it more sophisticated, you will set up an AIF. AIF means ”alternative investment fund”. This term is pretty meaningless. We will come to this in a later post.

What is simple and what is sophisticated? Let’s try to make it as easy as possible:

  • Simple means collecting money from the general public, investing it in liquid financial securities, and allowing investors to withdraw it at any time.
  • Sophisticated is everything which is not simple. This includes namely borrowing money in addition to the funds you collect (If you invest well, your return will be higher.) and collecting funds privately.

This post is only about UCITS. We will look at three questions – Why does the EU regulate? (Rationale), When does the respective regulation apply? (Scope of Application), and What do you have to respect? (Regulation).

You can find a schematic overview of the UCITS directive here.


The UCITS directive pursues four objectives:

  • Protect investors, namely through the solvency of the management company
  • Enhance free movement of capital
  • Approximate conditions of competition among investment funds and secure a level playing field in the European market
  • Safeguard the stability of the financial system

These objectives are somewhat contradictory: For example, protecting investors usually means imposing operating conditions on fund managers and this restricts the free movement of capital.

Scope of application

Let’s define a UCITS here. Cumulative conditions are

  • Capital raised from the public (as opposed to private fund raising) in Europe
  • Collective investment in liquid financial assets
  • Application of the principle of risk spreading
  • Fund units are redeemable at the request of holders. (This is called an open ended fund as opposed to a closed ended funds.)

Consequences of application

Fund structure

The EU directive allows three possible forms for UCITS structures:

  • Common fund under contractual law
  • Unit trust under trust law
  • Investment company under corporate law

The details are set by the national law of each member state.

A UCITS fund can have different investment compartments. More specifically, this means that investment strategies and returns can differ among compartments.

Finally, multiple UCITS funds can be set up as a master-feeder structure. This simply means that one or more UCITS funds (the feeder funds) invest at least 85 % of their assets in another UCITS fund (the master fund). The EU directive also allows cross-border master-feeder structures.
To protect unit-holders in the feeder UCITS, feeder and master fund must sign a binding agreement providing for exchange of information. In addition, the marketing documentation of the UCITS must reflect the master/feeder structure.

Management company

In case of a common fund, the most common fund structure, a management company administers the UCITS. How a management company looks like and what it can do is closely regulated. For example, it must meet minimum capital requirements and specific corporate governance and risk management mechanisms.
If your UCITS is organized as an investment company, it may or may not designate a management company.

One of the main features of the UCITS directive is the mutual recognition of management companies’ authorizations. In short, once you are authorized in a member state, you can operate and distribute your funds’ units in any other member state. This obviously entails the exchange of information among member states’ authorities which is deepened by the UCITS regulation.

The UCITS directive covers additional specific activities of a management company such as

  • a possible combination of collective and individual portfolio management activities if conflicts of interest are avoided;
  • a possible outsourcing of specifics tasks and functions under the premiss that the management company remains ultimately liable.


The depositary issues, sells, repurchases, cancels, and values UCITS units. A management company or investment company cannot be depositary; the depositary functions must necessarily be exercised by a third party established in an EU member state. The depositary acts in the sole interest of the unit-holders.

Marketing of fund units

As outlined above, EU wide marketing of fund units is possible. The EU directive contains two sets of regulation: First, you must provide a document called “key investor information” to your clients. Second, your additional marketing documentation must comply with specific conditions.


Investments by UCITS funds are limited. The stipulations of the EU directive are quite complex and relate to the type of financial asset (debt, equity, derivatives, bank deposits, other UCITS units etc.) as well as concentration limits for each asset class.

Merger of UCITS

Cross-border mergers of UCITS are possible. However, to protect investors, they are subject to detailed material and procedural conditions such as drafting the terms of merger and administrative clearance. For example, investors are granted exit rights in case of a merger.


Sunday, April 14, 2013

The Status of China’s Securities’ Markets – What have Shanghai's Taxis in common with Financial Innovation?

Imagine, you are a farmer. One autumn, your apple harvest turns out much bigger than expected. What to do about your apples, knowing that they will perish soon? As you cannot pick them all by yourself on time, you might ask your neighbors for help. Perhaps one could even bring his harvester and pick the apples much faster than than you could do with your hands...

Replace your apple farm with Chinese financial markets and your apples with money and you touch upon one of China's urgent economic problems.

The following is based on a series of speeches from Guo Shuqing, former Chairman of the China Securities Regulatory Commission, held between May 2012 and January 2013.

China has a high savings rate

Today, China has one of the highest savings rates in the world. At the end of 2011, it stands at 51 % which is twice as high as Germany's savings rate and four times the US savings rate.

This means that China has money. More politely, China's financial resources do not encounter any problem of scarcity.

Capital allocation in China is sub-optimal

However, despite the abundance of funds, capital allocation doesn't work. As a matter of fact, savers simply lack appropriate investment opportunities which could re-inject the money in the real economy. In addition, capital allocation among industrial sectors is unbalanced: Some sectors (manufacturing, chemicals, mining, and infrastructure) are provided with excess funds whereas other sectors (SMEs, agriculture, education, health-care, and culture) lack sufficient financial resources.

As Guo Shuqing says, this China's financial service industry has become a “bottleneck sector”.

China's financial sector lacks innovation

What are the roots of sub-optimal capital allocation? Guo Shuqing is not prude with his fellow countrymen: “There is a crippling economic and financial problem, which is incompetence.”

To counter this incompetence, the former Chairman first trusts his fellowmen: “Employees of investment banks are known to be the smartest people and should be able to come up with smart solutions.” As this is obviously contradictory to the above statement about incompetence, he also suggests to stick to innovation: “It is unsustainable to always follow the footsteps of others. This is exactly why we are calling for innovation-driven growth of the real economy.”

Additional issues that China’s financial sector faces include

  • unreasonable valuation (namely P/E ratio) of equities;
  • insufficient diversification of listed companies’ shareholders;
  • lack of market integrity and legal awareness among market participants (for example insider trading and market manipulation);
  • substantial volatility;
  • over-dependence on indirect financing (80 %) as opposed to direct financing (20 %);
  • slow development of Chinese bond markets (Stock markets are 4.5 times bigger.);
  • underdeveloped derivatives market;
  • abundance of financial resources for large and government-backed firms and lack of financing for small and middle-sized enterprises.

But what does innovation actually mean for the Chinese financial industry? It means to

  • focus on the needs of the real economy;
  • introduce market-oriented reforms of interest and exchange rates to allow suitable pricing of financial products;
  • decrease market entry regulation and, at the same time, increase business activity regulation once you have entered the market;
  • open up Chinese financial sectors to the outside world to enhance efficient control of profitability by foreign competitors.
  • encourage long-term investment through appropriate tax policies;
  • deepen IPO and delisting reforms to curb speculation and allow a good interplay between primary and secondary markets;
  • create incentives for listed companies to pay out dividends;
  • strengthen law enforcement in securities markets.

Furthermore, Guo Shuqing's speeches are filled with moral appeals:

Always refrain from offering products that are not well understood!”

Never seek unjustified profits!”

Keep risk exposure within a controllable range!”

Always prepare for worst and make counter-cyclical provisioning!”

Face up your responsibilities!”

Keep a strong sense of social responsibility and foster your sense of honesty, compliance, patriotism, caring for the people, poverty relief and environmental protection!”

To conclude, the China Securities Regulatory Commission intends to develop Shanghai’s position as a financial hub. In this context, Guo Shuqing praises the high level of credibility that Shanghai offers:

For example, taxis in the city are well managed and they seldom take detours.”


Sunday, April 7, 2013

Virtual Currency Schemes – Why they don’t (yet) affect the real economy

Bitcoin bubble grows and grows”, the Financial Times has written a few days ago about the virtual currency created in 2009 for a peer-to-peer network. Should we care? In a recent research paper, the ECB has examined precisely this question.

Definition and Typology

A currency is called virtual if it is created by and applicable within a virtual community to exchange virtual or real goods and services and to serve as a unit of account. Its characteristics are:

  • It is virtual money.
  • It is digital money.
  • It is not regulated by official Government agencies but only created and controlled by its developers
  • Traditional financial actors such as central banks are not involved.

Depending on their interaction with the real world, the ECB differentiates 3 types of virtual currencies:

Opportunities and Threats

From a commercial perspective, issuing virtual currency can first of all lock-in customers by providing a financial incentive to keep on participating in the virtual community. Second, as the developer controls the creation of virtual currency, a virtual currency program enhances the issuer’s business model flexibility and his strategic control over the business. Finally, a virtually currency can simply generate revenue.
Beyond, virtual currencies can contribute to financial innovation and provide additional payment alternatives to consumers.

On the other hand, virtual currencies also cause risks such as

  • lack of regulation and legal uncertainty;
  • counterparty and fraud risk;
  • alternative currency for drug dealing;
  • money laundering instrument;
  • price instability;
  • instability of the financial system and, especially, payment systems;
  • reputation risk for central banks;
  • undermining consumer protection laws.
    In addition, a type 3 virtual currency system might be interpreted as a Ponzi scheme in a sense that you always need additional investors to reconvert your virtual currency to real currency.

Appreciation of threats

In a nutshell, the ECB currently estimates the dangers as not substantial, given the small size of virtual currency schemes, compared to regulated currency schemes:

For the time being, [virtual currency schemes] do not jeopardize financial stability, given their limited connection to the real economy, the low volumes traded and the lack of wide user acceptance. However, developments should be carefully monitored as the situation could change substantially in the future.”

To illustrate ECB's position, the value of USD in circulation is currently more than 6,000 times the USD value of issued Bitcoins.

As a matter of fact, in the ECB’s view, type 1 virtual currency schemes are irrelevant as they are entirely disconnected from the real economy.

As regards type 2 schemes, they might have a negative impact if

  • they substantially modify the quantity of money;
  • they influence the velocity of money (how often a unit of currency is spent over a specific period of time) or the use of cash;
  • they can perturb the measurement of monetary aggregates;
  • there is an interaction between the virtual currency and the real economy.

Now, I feel comfortable again. Let the bitcoin bubble burst...


Monday, April 1, 2013

UK Banking Reform – A new structure for stability and growth?

With its banking reform proposal, the UK government pursues two overall objectives:

  • Curtail implicit guarantees enjoyed by “too big to fail” banks (“The government guarantees core banking services in the UK, not individual institutions.”)
  • Ensure that failing banks can be resolved without recourse to public funds and without risk to financial stability

The government suggests that an implicit state guarantee distorts incentives of managers and creditors, encourages them to take excessive risk and leverage. Moreover, the guarantee is said to distort competition in the banking sector to the detriment of small banks.

At the heart of current reform discussions is the government's intention to ring-fence core retail deposits from excluded wholesale and investment banking activities. The legislator expects such separation to

  • support financial stability;
  • reduce the risk to the taxpayer;
  • change the culture of banks for the better;
  • make banks simpler and easier to monitor.

Inside or outside the ring-fence?

The ring-fence is a nice illustration used by the UK legislator:

The ring fence must be robust against attempts by banks to subvert or undermine it.”

The ring fence cannot be susceptible to erosion over time.”

Banks may seek to test the strength of the ring-fence.”

In the absence of the Commission's proposals to electrify the ring-fence, the risk that the ring-fence will eventually fail will be much higher.”

The underlying message of this picture is clear: Inside the ring-fence are the good boys who need to be protected from the bad boys outside the ring-fence. This vision seems a bit simplistic but can certainly be sold very well to the general public.

More specifically, the UK reform wants ring-fenced banks to be legally, economically, and operationally independent of their wider corporate groups. This implies a distinct capitalization. As a consequence, non-ring-fenced banks cannot directly own ring-fenced banks and a sibling structure with a holding company between a ring-fenced and a non-ring-fenced bank is always required.

Directors of ring-fenced banks shall be held personally liable for preserving the integrity of the ring-fence.

Activities of ring-fenced banks

As can be seen in the above schema, a ring-fenced bank will no more carry trading assets on its balance sheet. With regards to derivatives, the regulation proposal says that ring-fenced banks can sell these instruments if

  • they constitute simple derivatives;
  • adequate safeguards to prevent mis-selling of derivative products within the ring-fence are in place;
  • they represent only a small portion of the bank’s equity capital;
  • they respect an absolute cap in terms of volume and total value;
  • they hedge underlying client risk; and
  • such trading activity is reported annually to the UK parliament.

However, it is not yet clear whether proprietary trading activities should be banned altogether from a group containing a ring-fenced bank: “The Government will consider carefully any further recommendation from the Parliamentary Commission on Banking Standards (PCBS) on this topic.”

Activities of non-ring-fenced banks

The current proposal advocates that proprietary trading activities may only be carried out in non-ring-fenced banks.

However, the above schema shows that these banks may still be allowed to carry out lending activities. Deposits with non-ring-fenced banks may also be allowed if

  • they are made by high-net-worth private banking customers or larger organizations;
  • they constitute an informed choice of the depositors;
  • they lie within (not yet specified) thresholds.