December 11, 2023

We understand that the European Commission has directed the financial regulator, the European Securities and Markets Authority (ESMA), to examine eligible assets for UCITS investment fund strategies to ensure their applicability, with explicit reference to catastrophe bonds.

esma-securities-ucits-catastrophe-catastrophe bondsBack in April we reported that ESMA was rumored to have started exploring cat bonds and whether they should be eligible assets for UCITS investment funds.

We are told that the broad topic of eligible assets for UCITS funds is on the agenda of the European Commission this year and that catastrophe bond liquidity may come under review.

As we reported at the time, ESMA told us there was no information to share at the time, but confirmed that the EC was interested in eligible assets for UCITS fund strategies, furthermore, our sources indicated that there were no active discussions on catastrophe bonds, but there had been There are items of discussion related to cat bonds raised by European regulators.

Fast-forward to June, and it now appears that those rumors we’re hearing may be the early developments of a broader plan to revisit UCITS asset eligibility.

We now understand that the European Commission (EC) wrote directly to ESMA earlier this month requesting a study on UCITS asset eligibility and listed cat bonds as one of the potential areas of focus.

The EC has emphasized the importance of UCITS funds investing in assets that can meet all of their portfolio obligations, so liquidity, NAV calculations and limit monitoring are seen as critical.

They also want to implement asset eligibility rules in a uniform manner, taking into account all regulatory developments that have occurred over the past 16 years since the initial scope of UCITS eligible assets was established in 2007.

Therefore, the European Community has authorized ESMA to assess the implementation of the Qualified Assets Directive in all member states to see if there are differences in practice, and to make recommendations to keep eligible assets that comply with UCITS rules in line with market development.

Part of ESMA’s mandate will involve looking at how UCITS fund strategies are directly or indirectly exposed to certain classes of assets, which it says could give rise to “different interpretations” or pose undue risk to retail investors.

Here, cat bonds are considered an asset class worth analyzing, along with structured and leveraged loans, crypto assets, emission allowances, unlisted stocks, and more.

ESMA should gather empirical evidence and data, working with national authorities and market participants, to assess the suitability of these assets for UCITS investment strategies, the EC said, taking into account valuations, liquidity, availability of custody, etc. in these particular asset class markets.

The EC also wishes to understand the relative size of these asset classes in the context of the UCITS market and asks ESMA to also bear in mind how any proposed regulatory adjustments to the rules for appropriate assets will affect the future development of these asset classes.

ESMA will now conduct a long-term study covering much more than the above (which appears to be most relevant to cat bond funds), but all efforts are focused on the suitability of assets for UCITS funds, and it seems likely that the cat bond market will Subject to some review results.

The EC said its objective is to “maintain and enhance the sound functioning of the UCITS framework and the operations of UCITS management companies in order to safeguard the best interests of investors and the quality of investment products offered to retail clients.”

ESMA has been tasked with providing technical advice on this until October 2024, so it now looks like more than a year of research will be underway.

The catastrophe bond fund market is an important user of UCITS fund strategies, with the primary UCITS catastrophe bond fund having grown to $9.76 billion in total assets under management at the end of May 2023.

The managers of UCITS cat bond funds will therefore closely monitor this development and the progress of ESMA’s work on assessing UCITS eligible asset classes and wish to remain in touch with the regulator as needed or requested.

Of course, UCITS catastrophe bond funds are not aimed at real retail investors, that is, ordinary people. In contrast, UCITS catastrophe bond funds are primarily allocated by institutional investors who appreciate the more liquid nature of the fund structure, as well as by more sophisticated retail investors (such as high net worth investors, etc.).

Therefore, if there is any suggestion that the EC and ESMA could tighten the rules on eligibility for UCITS cat bonds, we would expect managers to quickly engage and perhaps seek alternative fund structures to accommodate these strategies.

In terms of liquidity, cat bonds have repeatedly proven themselves to have the liquidity they need when it matters most, and while investors are believed to hold their assets at times, some may expect more liquidity in the market.

As we have previously reported, some European regulators are concerned that the catastrophe bond market is not perceived to be particularly liquid after Hurricane Ian hits in 2022, as that storm again raised concerns about catastrophes. Knowledge of bond fund strategies.

But, as our readers will be aware, the post-storm recovery in cat bond positions suggests that cat bond managers made the right decision to hold rather than sell heavily their cat bond positions.

So the absence of a live catastrophe trading boom in the cat bond market, or trading immediately after Hurricane Ian made landfall, is actually a sign of a maturing market, as managers know they should hold out and believe that cat bonds will lose no will be particularly important, which is exactly the result of that period.

So if this worries some European countries they should look at the facts and talk to a manager of a cat bond fund and they can clearly explain that liquidity in the cat bond market is there when it is needed but sometimes the market knows best Liquidity is not as obvious as some might think.

We will update you as we hear more information on this issue and the ESMA and EC studies on qualifying assets and related rules.

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