By Todd Zerega and Tom Watterson

In December of 2012, the European Securities and Markets Authority (“ESMA”) adopted Guidelines on ETFs and other UCITS issues (the “Guidelines”) that included a requirement regarding the diversification of collateral held for derivatives and repos. Section 43 e) of the Guidelines requires that UCITS diversify the collateral held under “financial derivative transactions,” including repos, by issuer and country. The maximum exposure to an issuer of collateral received from its repo counterparties (on an aggregate basis across counterparties) cannot exceed 20% of the UCITS’ NAV. However, the Guidelines do not include an exclusion from the collateral diversification requirement for governmental or sovereign issuers.

The Guidelines became effective in February of 2013, and, following the expiration of a transitional period, UCITS must comply with the collateral diversification requirements of the Guidelines by February 18, 2014.

Government money market funds (“Government MMFs”) principally hold obligations of governmental issuers as well as repurchase agreements collateralized by such securities. Government MMFs may limit their obligations to those issued by an individual country, such as the United Kingdom, Germany or United States. Repos are vital to the operation of most Government MMFs. Government MMFs use repos to provide liquidity for the fund that it then uses to facilitate shareholder redemptions. Repos are also used to generate attractive returns for Government MMFs.

Under the ESMA Guidelines, Government MMFs (particularly those limiting investments to an individual country) would likely be required to limit investing in repos to 20% of their NAVs or change their investment policies to permit the fund to take other securities as collateral. As a result, those Government MMFs would likely increase their investment in direct holdings of obligations of the government issuer. Therefore, the ESMA collateral diversification requirements would have the counter-intuitive effect of increasing a Government MMF’s exposure to direct holdings of obligations of the particular governmental issuer.

The European Commission’s recently released Proposal of the European Parliament and of the Council on Money Market Funds (the “MMF Reform”) presents diversification rules for MMFs with respect to collateral and direct holdings of securities. The MMF Reform, however, includes an exemption from the diversification rules with respect to holding treasuries and government bonds both directly and as collateral to repos, permitting MMFs to hold up to 100% of their assets in treasuries or government bonds from one issuer. A common sense solution would be for ESMA to implement a similar exception to its collateral diversification rules.

Good day. Good diversification? TSR