Europe directs ESMA to study eligible assets for UCITS (including cat bonds)

We’ve learned that the European Commission has now directed financial regulator the European Securities & Markets Authority (ESMA) to study eligible assets for UCITS investment fund strategies, to ensure their suitability, with catastrophe bonds explicitly mentioned.

Back in April we reported that there had been rumours circulating that ESMA had started an exploration of catastrophe bonds and whether they should qualify as an eligible asset for UCITS investment funds.

We had been told that the broad subject of eligible assets for UCITS funds was on the European Commission’s agenda this year, with catastrophe bond liquidity likely to come under scrutiny.

As we reported at the time, ESMA told us there was no information to share then, but confirmed the EC’s interest in eligible assets for UCITS fund strategies and in addition our sources said no active discussion on cat bonds was ongoing, but there had been a discussion item related to cat bonds raised among European regulators.

Fast-forward to June and it now seems those rumours we’d heard may have been the early formulation of a wider plan to study UCITS assets eligibility again.

We’ve now learned that the European Commission (EC) has written directly to ESMA, earlier this month, requesting a study of UCITS asset eligibility, with catastrophe bonds called out as one area for potential focus.

The EC has highlighted the importance of UCITS funds investing in assets that can meet all of their portfolio obligations, so liquidity, net asset value calculation and limits monitoring and the like, are seen as critical.

They also want asset eligibility rules to be implemented in a uniform manner and take into account all regulatory developments that have occurred in the past 16 years, since the initial scope of UCITS eligible assets was laid out back in 2007.

As a result, the EC has mandated that ESMA carry out an assessment of the implementation of the eligible assets directive in all member states, to see if there are divergences in practice, and to come back with recommendations to keep the eligible assets for UCITS rules in-line with market developments.

Part of this task for ESMA will involve looking at how directly or indirectly exposed UCITS fund strategies are to some categories of assets that it says could give rise to “divergent interpretations” or lead to undue risk for retail investors.

Here, catastrophe bonds are cited as a type of asset deserving of some analysis, alongside other assets such as structured and leveraged loans, crypto assets, emission allowances, unlisted equities and more.

ESMA should collect empirical evidence and data, working with national competent authorities and market participants to assess these assets for suitability for UCITS investment strategies, the EC says, taking into consideration the availability of valuation, liquidity, safekeeping etc, for these specific asset class markets.

The EC also wants to understand the relative size of these asset classes in the context of the UCITS market, and mandates ESMA to also keep in mind how any proposed regulatory adjustments to the suitable assets rules could affect these asset classes going forwards.

ESMA will now enter into a prolonged study, covering off much more than the above (which seems most relevant to cat bond funds), but with all efforts focused on suitability of assets for UCITS funds and it seems the catastrophe bond market will come under some scrutiny as a result.

The EC says the goal is to “preserve and strengthen the well-functioning of the UCITS framework and the operation of the UCITS management companies in the best interest of investors, as well as the quality of investment products offered to retail clients.”

ESMA is being tasked with delivering technical advice on this by the end of October 2024, so more than one year of study will ensue it now seems.

The catastrophe bond fund market is a significant user of UCITS fund strategies, with the main UCITS cat bond funds having increased their overall assets under management to US $9.76 billion as of the end of May 2023.

As a result, managers of UCITS cat bond funds will be keeping a close eye on this development and how ESMA’s work to assess UCITS eligible asset classes progresses, hopefully liaising with the regulator as needed or requested as well.

Of course, the UCITS cat bond funds are not targeting the true retail investor, the average person. Rather, UCITS cat bond funds are largely allocated to by institutional investors that appreciate the more liquid nature of the fund structure, as well as more sophisticated retail, such as high-net worth investors and the like.

As a result, should there be any suggestion that the EC and ESMA could tighten the rules around cat bond eligibility for UCITS, we’d expect managers would be quick to engage and perhaps also look to alternative fund structures to house these strategies.

On liquidity, catastrophe bonds have repeatedly proven themselves to have the liquidity needed when it matters most, while investors have also been seen to hold onto their assets at times some might have expected to see more liquidity in the market.

As we had previously reported, it had been suggested that some European regulators were concerned that the cat bond market was not seen to be particularly liquid after hurricane Ian struck in 2022, as that storm raised awareness of cat bond fund strategies again.

But, as our readers will be aware, the recovery in cat bond positions after that storm showed that cat bond investment managers made the correct decision to hold, and not to sell their cat bond positions en masse.

So the fact the cat bond market did not see a rush of live-cat trading, or trading right after hurricane Ian made landfall, was actually a sign of the sophistication in the market, as managers knew they should hold on and believed cat bond losses would not be particularly significant, which is exactly how that period played out.

Hence, if that has driven concern in some European countries, they should study the facts and speak with the managers of cat bond funds, who can clearly explain that cat bond market liquidity is there when it’s needed, but sometimes the market knows best and liquidity is less apparent than some might feel it should be.

We will update you as and when we hear any more on this issue and the study of eligible assets and related rules by ESMA and the EC.