Ireland: Covered Short Selling By UCITS Funds – The Debate Continues

Last Updated: 21 August 2008
Article by Karen Jennings
Most Read Contributor in Ireland, September 2019

1. Introduction

In light of the current difficult market climate, pressure is mounting upon fund managers and pension funds to deliver ever-more important outperformance to their clients. As a result, the possibility of allowing UCITS funds to engage in short selling techniques is receiving more attention at local and European level. Karen Jennings of Dillon Eustace considers recent developments in relation to possible strategies available to UCITS funds.

2. Short Selling by UCITS Funds

Shorting is one of the most important strategic tools now available. Shorting provides added exposure to a given market, allowing the fund manager to take an overweight position (long) in securities they like, but also to go actively underweight (short) in those they do not. In selling a security they do not own, the manager anticipates that it will fall in value and can be bought back at a lower price. Whereas a hedge fund can physically short-sell a stock or bond, Regulation 72 of UCITS Regulations 2003, as amended, prohibits a UCITS from engaging in uncovered physical short sales.

Physical short selling involves the actual sale of the security and it may be covered or uncovered. In light of the prohibition on UCITS funds from engaging in uncovered physical short sales, an alternative strategy for achieving the effect of shorting has become increasingly popular for UCITS fund managers, namely, synthetic shorting. Through the use of financial derivative instruments, a short exposure to the price of a security can be created, rather than physically selling the actual security. To date, 130/30 UCITS funds in the Irish market have relied upon such synthetic short selling techniques in order to allow fund managers to exploit negative opinions on securities.

Whilst it has been clear that a UCITS fund cannot engage in uncovered physical short sales, doubts have remained as to whether or not a UCITS fund can engage in covered physical short sales. On 5 October, 2007 the Irish Financial Services Regulatory Authority issued a revised policy note in respect of covered physical short selling by UCITS. The revised policy note purported to allow UCITS to borrow stock before it entered into the physical short sale of that stock and to treat such borrowed stock as constituting cover for the short sale provided that certain conditions were met. The basis for this policy rested upon the fact that Regulation 72 only prohibits uncovered physical short sales (not covered physical short sales) and further that the guidelines issued by CESR concerning eligible assets for investment by UCITS (Ref: CESR/07-044) suggest that that stock borrowed under a stock borrowing arrangement will not constitute borrowing under the UCITS Regulations. This opened the way for Irish UCITS to engage in covered physical short selling strategies.

Following the issue of the Irish Financial Services Regulatory Authority's policy note, certain other Member States expressed an interest in the possibility of permitting UCITS to engage in uncovered physical short sales. In order to ensure even implementation and interpretation of the UCITS Directive across the EU, the European Commission was asked to consider this matter further. The Commission has now concluded that covered physical short selling is not UCITS compatible for a number of reasons.

  • Firstly, it was felt that the borrowing of stock to cover the sale would not protect a UCITS from unlimited market risk. This is because the price of the stocks sold short could rise without limit.
  • Secondly, concern was expressed over the absence of any express provisions governing the management of the risks generated from such physical short selling techniques in the UCITS Directive.
  • Thirdly, the European Commission concluded that covered physical short selling could expose a UCITS to additional risks or risks which are more acute to those to which it would be exposed by virtue of synthetic exposure.
  • The final, and possibly the most significant, reason behind the Commission's position is the wording of Article 36 of the UCITS Directive. Article 36 prohibits borrowing by UCITS except on a temporary and limited basis (i.e. up to 10% of assets). It was felt that the borrowing of stock in order to provide cover for a physical short sale was not compatible with this restriction.

3. Future Developments

The European Commission has indicated its position to the Committee of European Securities Regulators ("CESR") and it is expected that CESR will consider this matter further with the possibility of correcting its guidelines on this issue. However at the current time, Irish UCITS funds are not permitted to treat borrowed stock as constituting cover for a physical short sale. It remains to be seen whether or not the Commission, based on CESR opinion, will vary its initial conclusions or whether any proposal to amend the UCITS Directive will materialise in order to pave the way forward for the possibility of covered physical short selling by UCITS funds in the future. As UCITS III evolves, one can only expect increasing demand for new tools to be placed at the disposal of UCITS fund managers in order to employ techniques which are currently available to hedge fund managers.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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