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ESMA’s Advice on the Eligible Assets Directive

• Dechert LLP

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Published earlier this year, ESMA’s Advice on the Eligible Assets Directive seeks to tackle long-standing divergences across EU member states on what UCITS can and cannot invest in. In this episode of On Reg, host Angelo Lercara is joined by Dechert’s Doireann O'Daly and Mark Dillon to discuss whether the proposal has been successful in clarifying the two foundational concepts of the UCITS regime – what qualifies as a transferable security and what counts as liquid.


Angelo Lercara:

Hello everyone, and welcome to Dechert On Reg, the podcast where we explore the ever-changing landscape of financial regulations and the key issues that are shaping the future of asset management. I'm Angelo Lercara, partner at Dechert and co-head of our regulatory product line. And in each episode, we'll be joined by expert colleagues and guests to explore the most pressing issues in financial regulation. In today's episode, we're looking into the Eligible Assets Directive that is getting a makeover. But the question is, is it a facelift or a fundamental reconstruction? So whether you're an industry insider or simply interested in the world of financial regulation, you don't want to miss this episode of Dechert On Reg. I'm excited to have two experts joining us. My colleagues, Doireann O'Daly and Mark Dillon are here today to discuss with us. Let's dive in. Hi Doireann, hi Mark, good to see you.

Mark Dillon:

Hi Angelo.

Doireann O'Daly:

Hi Angelo.

Angelo Lercara:

Earlier this year, ESMA published its final report with detailed technical advice to the European Commission trying to tackle long-standing divergences across member states on what UCITS can and cannot invest in. And at the center of the report are proposed clarifications to two foundational concepts of the UCITS regime: what qualifies as a transferable security and what counts as liquid. The report also addresses some of the most challenging asset classes for supervisors and managers, including crypto assets, commodities and complex securitizations such as ABS and CLOs, all of which have pushed the boundaries of the existing framework. The overarching aim is clear - to reinforce investor protection, ensure genuine supervisory convergence across Europe, and safeguard the consistently conservative risk profile that defines the UCITS brand. Doireann, before we dive into the details, can you set the stage for us please? I mean, what is the Eligible Assets Directive? Why is it back on the agenda? And why now?

Doireann O'Daly:

Yeah, of course, Angelo, thanks very much. So since the UCITS Directive came into force in 1985 - so it's 40 years ago now, if you can believe it - financial markets have obviously developed considerably, and the range of financial instruments traded on financial markets has also significantly developed. And the UCITS Directive has been amended multiple times since 1985. As many in our audience will be aware, UCITS 2 was actually shelled, but UCITS 3 came into force, and its primary impact was to extend the range of eligible investments for UCITS by permitting investments in, for example, in market instruments, derivatives, bank deposits. It also permitted UCITS to employ fund to fund strategies. So while UCITS 3 extended the scope of eligible assets for UCITS, the Eligible Assets Directive was published in 2007 and I suppose, really helped to develop a common understanding of asset eligibility under the UCITS framework. However, there remains a lot of inconsistencies, I think it's fair to say, amongst national competent authorities in the EU in the application of the Eligible Assets Directive, or the EAD as we'll refer to it as during the podcast. I think specifically we see inconsistencies in determining whether certain categories of financial instruments are actually an eligible investment for UCITS. And this has given rise to divergent interpretations of the UCITS rules across EU member states. And really the impact of this is that it increases the risk that retail investors won't actually understand the UCITS product. So for example, and this is just one of a few, Luxembourg-domiciled UCITS loans have been considered an ineligible asset class since 2020. However, unsecuritized loans can be an eligible investment for Irish domiciled UCITS, provided they comply with the definition of money market instrument under UCITS rules and provided an application passes the Central Bank's enhanced scrutiny authorization process. And so I think this brings us up to the point where the Commission considered that a comprehensive review of the Eligible Assets Directive was required.

Angelo Lercara:

Yeah, and what did the, let's call it European regulator, ESMA, actually issue in June in relation to the Eligible Assets Directive? Mark, can you tell us about it?

Mark Dillon:

Thanks, Angelo. On the 26th of June of this year, ESMA issued its final report that included technical advice to the European Commission in relation to its review of the Eligible Assets Directive. As Doireann pointed out, the report itself highlights important divergences that have emerged in the implementation of the Eligible Assets Directive across member states. And Doireann's given a few examples there. But given the age of the Eligible Assets Directive, it was due or is due, and overall, I mean, we all know, we're people in the industry, how quickly asset classes or the instruments in which exposure to asset classes develop, and how outpaced regulation can become. So that leads to divergences from jurisdiction to jurisdiction, as regulators try to interpret based on the guidance from the very skilled lawyers and investment managers that try and convince them of the eligibility of certain assets. Certain regulators can take different views on what actually is eligible, and their views can change. But in terms of that Eligible Assets Directive report, which was very useful and gathered a lot of data and was able to give out of the respondents a lot of information in terms of the breakdown of asset classes within UCITS funds, the actual findings are relatively narrow. And I would say, from the perspective of how you thought this was going to go, there would have been those contributing to the consultation that would have hoped that the asset classes that were eligible for UCITS would have expanded. But actually, we've seen that actually the review itself could be considered relatively conservative, and has said it does not have the ability to change the asset classes that are eligible, but simply interpret the existing rules that are there at Level 1. So I think the most important thing you'll see, and what's the biggest impact, is that now it's enforcing a look-through approach on any funds or instruments to which you might get access to a relevant asset class, and depending on the jurisdiction we'd seen that there had been investment in certain instruments, provided there was no leverage or wasn't considered to be a derivative, where you may have been able to get access to assets that would not otherwise be eligible. So that's potentially restricted the exposure that UCITS can get to certain asset classes. But then, and we'll touch on this in a little bit more detail, there has been an expansion of what the "trash bucket" is, which may, I suppose, mitigate somewhat the impact on UCITS to get access to those investments, but that will be limited to the 10% of the trash bucket. The other thing, Angelo, in your introduction, you mentioned liquidity, and there has tended to be a presumption of liquidity negotiability around listed instruments. The proposal is that that will no longer be the case, and that you'll actually have to be able to justify or consider the liquidity of each instrument, even where it is a listed instrument. In terms of where we're at, this is just a proposal, so the Commission hasn't considered this it. There is a suspicion that has been somewhat de-prioritized, but the Commission in its recent communications have said that they will be looking at this and moving forward with it in their review in 2026 so there's a bit, a little bit to run on it. But that's the the update from June.

Angelo Lercara:

Right. Thanks, Mark. So with that in mind, Doireann, let's move into maybe one of the most closely watched areas of the review. What does report say about UCITS' exposure to alternative assets?

Doireann O'Daly:

Yeah, and this is, this is getting a lot of attention, Angelo. So for the first time, the EAD report proposes to explicitly permit users to gain indirect exposure to alternative assets, so for example, commodities or crypto, and provided it complies with the 10% trash bucket. So this devout might have afforded certain managers the flexibility to diversify portfolios and an opportunity to improve risk diversification, but managers will still need to be mindful of increased compliance requirements in managing funds seeking to gain indirect exposure to alternative assets. So currently, users can gain indirect exposure to alternative assets, for example, by investing in structured financial instruments or SFIs, as we, as we call them. SFIs are eligible, provided they qualify as transferable securities under the UCITS rules and are backed by, are linked to the performance of another asset. I think it's worth pointing out that there are currently certain quirks in the UCITS rules regarding the ability of UCITS to gain indirect exposure to alternative assets. For example, indirect exposure is permitted by investing in an SFI, but not by way of a derivative, i.e. commodity, future. So in the EAD report, ESMA proposes to apply a look-through approach, as Mark was saying, to a minimum of 90% of a UCITS' portfolio, which means that at least 90% of the portfolio must be comprised of UCITS-eligible securities, so transferable securities, shares of other regulated funds, cash, cash equivalents, money market instruments and derivatives. The impact of this is that 10% of a UCITS' portfolio can be indirectly exposed to alternative assets. This is a fairly significant expansion of the trash ratio, I think it's fair to say, to include alternative investment funds and derivatives. And I suppose the whole idea here is to prevent UCITS from gaining significant indirect exposure to alternative assets, but allows enough limited exposure for them to improve risk diversification for fund managers seeking alpha. And I suppose importantly, the report includes a grandfathering proposal to allow managers impacted by this proposal an opportunity to rebalance their portfolios in line with the so called 90% rule.

Angelo Lercara:

And I assume that could have an impact on fund of fund strategies. Mark, what do you think?

Mark Dillon:

Yeah, it definitely could and and will. And I suppose the one thing is to distinguish between fund to fund strategies that, for the most part, invest in other UCITS, which will continue to be largely unaffected - except for potentially some, well relatively small, exposure on the underlying UCITS that may have previously had some exposure indirectly - to now considered in UCITS and eligible assets. But for the most part, we're probably looking at what those fund of funds, the exposure they got through non-UCITS entities, so potentially AIFs that would have gone through an assessment that the UCITS considered them to comply in all material respects with the UCITS regulations and Central Bank requirements - so including the existence of an independent depository, requirements for spreading of investment risk, including concentration limits, ownership restrictions, leverage, borrowing restrictions, availability of pricing information, reporting requirements, redemption of facilities and frequency and restrictions in relation to dealing with related parties. So they were some of the considerations that were required to be taken into account in terms of assessing whether an AIF was an eligible investment for UCITS that could be a somewhat complex assessment in itself, but it didn't have the same look-through that is being applied now, and even beyond those open-ended AIFs without assessment to say that they complied with the UCITS requirement, or in all material respects, complied with the UCITS requirements. Certain UCITS would have also invested in closed-ended funds which were listed on an exchange, and they could be treated almost well, essentially, as transferable securities in terms of the assessment. And there wouldn't be a look-through, through to the underlying investments. That is going to change, where now they're going to simplify somewhat the assessment of the eligibility of an AIF where they're an EU AIF managed by an EU AIFM. You can assume that there is equivalence between them and a UCITS. However, the counterbalance to that is that the AIFs' underlying investments need to be eligible investments for a UCITS. So it somewhat narrows the scope of the AIFs that can be invested into, but potentially can alleviate some of the heavy burden in terms of the analysis that would need to be done in terms of investing in a fund that was not a UCITS. So there is definitely going to be an impact, but they'll see a common theme in terms of all of these. What they're looking to do with this consultation ESMA is to simplify the process. So you'll see a common theme in terms of removing some of the onerous assessments, but applying this constant rule of look-through, which will somewhat simplify it, but will ultimately narrow the scope to taking an interpretation and get indirect access to ineligible assets through that, because obviously some of those AIFs could have previously had ineligible assets in their portfolio, And the UCITS could obviously get exposure to that indirectly, right?

Angelo Lercara:

And I guess when reading through the report, I think ESMA wanted to make it very clear to create a separation between the UCITS, so what they do, and AIFs. I think they also mentioned ELTIF at some point, they mentioned maybe the Commission should consider creating a new type of fund as well. I think they wanted to be very transparent to say, okay, look, we need to separate the different funds for different purposes, in particular when we consider all of the retail money going into alternative strategies. And we need to make sure that, you know, UCITS is not the vehicle that is now going to invest heavily in private assets. Okay, another topic was financial indices. Are there any impacts on UCITS using financial indices?

Doireann O'Daly:

Yeah, absolutely. And following on from, from what Mark said, there's a look-through theme here too. So currently, the EAD permits UCITS to use financial indicies for a variety of reasons, so to investment strategies or for index tracking purposes, etc. The EAD report clarifies that UCITS will only be permitted to invest in financial indices provided that, on a look-through basis, the constituents of the index are UCITS-eligible. This means that UCITS' exposure to indices comprising of ineligible assets must comply with the 10% trash ratio, as we've touched on. The EAD report also includes proposals to more closely align the UCITS framework with the Benchmarks Regulation. For example, where UCITS has exposure to an index that's in scope of the Benchmarks Regulation, managers wouldn't be required to separately assess the adequacy of that index or its publication criteria. So that's just a neat summary of the impact of the report and UCITS' use of financial indices, right.

Angelo Lercara:

We've mentioned it's not a nice term. It's also not fair to call it "trash." What is in that quota, the"trash bucket," Mark? What is it? And what does ESMA think about it?

Mark Dillon:

It's interesting. I mean, certainly I think calling it the "trash bucket" has actually led to some misinterpretation, particularly for those that aren't very familiar with dealing with the UCITS on a day-to-day basis. And I've sometimes spoken to potential clients or talking about putting things in the trash bucket, and think that it is just for an eligible assets, which is kind of funny. I mean, really, it is for any transferable securities or money market instruments which do not meet the requirements that were set out, so essentially in Paragraph 1 of the Directive, which essentially means that they're not listed on a recognized exchange. And that has been clarified over the number of years, where previously someone had interpreted that collective investment schemes could fit into that that trash bucket, even though it wasn't specifically mentioned as a transferable security or money market instrument, people were trying to look at, particularly, close-ended funds to say, well, could they be treated technically as transferable securities and fall within the trash bucket allowance? And there was an opinion issued by ESMA where they categorically said that collective investment schemes are separate from transferable securities, and the trash bucket is narrowly meant for transferable securities and money market instruments. Now I think, and we'll see the theme, it's a common one. There is some sympathy, sometimes from ESMA saying this is potentially something that can be looked at in the future, but it's not within our gift to change this. We have to interpret the law that's in front of us.

Angelo Lercara:

And that's actually, actually, actually a good point, Mark. I mean, what ESMA does is they interpret the existing law. They're not creating any new rules. They're just telling okay, this is the way we interpret the rules. Of course, I mean, it's a clear sign how the industry should apply the rules. Because if the ESMA says, you know, it's the interpretation, it's the regulators, I think it's, although it's non-binding, it's then, by fact, probably binding, but it's a fair point, yeah, yeah.

Mark Dillon:

I mean, sometimes they would hope they would give clearer recommendations that are to commission, but, but they are right in that they are not in a position to recreate the law, certainly on their on their own. And Darren actually, I mean, given funny talking about the narrowing of the trash bucket, or certainly the narrowing of the interpretation of the trash bucket, Esma are now looking at it with fresh eyes again.

Doireann O'Daly:

Yeah, and I think maybe just to summarize the proposal to expand the trash bucket and report we've touched on a few times during the podcast, but maybe just to summarize it for the audience, the report proposes to expand the scope of the trash ratio, or trash bucket, as we refer to it as, by including alternative investment funds and derivatives. So Mark, as you mentioned, the trash ratio is currently used by UCITS looking to invest in unlisted securities and money market instruments. The EAD report notes that ESMA proposes to expand this to, and I quote, "with a view to improving risk diversification and generating rich concerns from uncorrelated asset classes." And while the proposed expansion of the trash ratio may be a welcome development for some managers, it is difficult, I think it's fair to say, to rationalize this expansion of the trash bucket with the tightening of the look-through approach to 90% of UCITS portfolio. So I think it'd be interesting to see where the Commission lands on this one in particular, right?

Angelo Lercara:

Thanks, maybe let's zoom out again and look at the broader picture, because some of these proposals go directly to the investable universe for UCITS. So if you look across the report, how would these proposals actually impact UCITS' ability to invest in, in specific or in certain asset classes? Mark.

Mark Dillon:

Yeah, I think overall, if you are a typical UCITS manager that has had the same strategy for a number of years, and you do it well, you're a stock picker, you know the bond market well, and maybe you avail of certain instruments that allow you to get access to that, those particular asset classes and allow a certain level of leverage, there'll be very little change to you. There's no change in terms of what the eligible assets are. But for managers that had looked to be, maybe interpret the eligible assets or what could qualify a little bit more broadly, had invested in intermediary companies that could get you access to asset classes, and probably for good reason - there's not necessarily any reason why, or anything untoward in terms of what was being done - but the industry was developing where UCITS were investing in a broader set of asset classes. For those that were getting exposure to those asset classes previously, this is something they need to look at closely at this stage, because they need to consider - and we're only dealing with proposals at this stage - there is a suggestion that the Commission is going to disagree with some of this. We don't know that yet, so there is a bit to go. We encourage anyone that's going to be impacted by this to feed into the Commission's consultation, which we think will happen next year. But it is definitely going to restrict the ability for those UCITS managers to operate in a UCITS environment, and this is for some of the commentary that was in the report, was that they felt there was some blurring of the lines between UCITS and AIF investments through the use of things particularly that called out Delta one instruments, exchange traded notes and exchange traded commodities, which had become common means of getting exposure to asset classes that wouldn't have otherwise been eligible. So for those that were investing significantly in those, we know some that, that has set up cap bond usage, which you know now potentially could be impacted. It's when you get into the more niche asset classes where UCITS had been investing into, gonna have to have a careful look at this and consider whether UCITS is still an appropriate product. When we get close to knowing with certainty where the rules are going to land, and if you were somebody that only got access to a small proportion of what we might call alternative asset classes, perhaps the trash bucket might be welcome in terms of, you know, well, I only needed a small amount of exposure to diversify my holdings, so actually the 10% threshold is actually useful for me, and I can get this additional exposure without having to interpret potentially whether an asset is eligible. I have now some certainty that this asset classes is suitable within the 10% threshold. So there will be additional certainty, but for those that were investing indirectly in alternative asset classes, there will definitely be a potential impact here, and you'll need to see whether you need to have access. Is it something you can rebalance a portfolio, or is the whole point of the portfolio to be invested in those asset classes? And if so, whether the portfolio is more suited to an AIFM other than a UCITS.

Angelo Lercara:

Yeah, thanks, Mark. Doireann, I'm sure there are other aspects beyond the headline issues that are maybe notable and that managers should have on their radar.

Doireann O'Daly:

Yeah, absolutely. Angelo, I think there's some really interesting and important recommendations in the report that we'll just touch on here. So for example, there's a proposal in the report to make elements of the Eligible Assets Directive directly binding across member states by EU regulations, instead of by way of a directive. I think the idea here is that a regulation obviously has direct effect in EU member states, whereas a directive must be transposed into national law, which then gives rise to potential divergence in the application of the directive across member states. The EAD report also advocates for the harmonization of the EU regime for marketing AIFs to retail investors. And to touch on something that both of you raised earlier, it also suggests for the creation of a new type of AIF to facilitate retail investors looking to gain greater exposure to alternative assets. And I think the whole idea here is that ESMA believes that UCITS were designed to invest in liquid assets, and then if a manager wants a product to invest in alternative assets, this shouldn't be done in any UCITS product. And with the Commission's current focus on enhancing retail participation in financial markets, I think this could actually be really interesting space to monitor.

Angelo Lercara:

It's actually an interesting aspect because I think we know a number of alternatives already, the ELTIF, the EUVECA, and apparently, ESMA is of the opinion that, you know, maybe a further vehicle would be good. So it's interesting to see how it develops. So curious to see whether, you know, they come up with something meaningful. I think they've been still looking for the UCITS type, you know, gold standard for private funds. I think that's what the Europeans are still trying to create, would be good. But let's see how it goes

Doireann O'Daly:

Watch this space, yeah.

Angelo Lercara:

this all means in practical terms, I guess. And

Mark Dillon:

Yeah, I think, well, if we're looking to be more proactive, then I suggest just wait and see. I think what you should be doing is having a look at your existing portfolio, examining it, seeing what would be no longer eligible within the portfolio. Can you rebalance the portfolio within an acceptable margin and comply with the new requirements? If you can, maybe you'll just see this report as being somewhat underwhelming, in that there was some hope that there'll be an expansion to the asset classes, or potentially means of getting exposure to things like crypto. I think a lot of UCITS managers that won't see themselves impacted by this or can make adjustments to their so what should managers do now in response to the report? portfolio have seen this being deprioritized, and it seems to be somewhat out of sight, out of mind. This will come up again in 2026, and certainly for those and I think UCITS generally, will feed into the Commission consultation. There was a lot of engagement around the ESMA consultation, a lot of useful data was provided. It didn't necessarily go the way some UCITS managers would have liked, but there is another opportunity. And I think, as you said, some of the whispers are that the Commission doesn't necessarily agree with everything that ESMA has put forward. So I think there is an opportunity to engage directly, engage with your local industry representatives, with Irish funds in Ireland, EFAMA, to just make sure that you have a voice. In terms of what the ultimate outcome is going to be, but actually in terms of whether there will be some of the musings around this makes you think that actually this could end up being part of a broader discussion. So it may be that the Eligible Assets Directive in itself is postponed, and this is speculation, but postponed to be considered in the wider context, and some of the feedback in the consultation really related to the brand that UCITS had. And while there may be some positives of expanding the scope of what UCITS can do, there was some consideration of protecting a kind of very recognized, dependable brand that's been through a lot of crisis and come out the other end, and that people feel they can rely on as a properly liquid product. So that's where the scope is. Do we end up where AIFs and UCITS meet in the middle? And I know we've helped AIFs as well. But is there another product, and is there space for one? And do they say that? Well, UCITS is actually something completely on its own, and we will come up with a more flexible retail product to kind of mirror, maybe a more protective version of an AIF, but doesn't necessarily have to be as liquid, and will allow investments in alternative products. So that's something that might happen also, I mean, and this is not necessarily related to the Eligible Assets Directive, but obviously technology is going to play a role in this. And as real assets potentially and tokenization become more liquid, then we could potentially look at, are there actually going to be a growth in the scope of assets that can be invested in to buy UCITS, and then potentially there will be an overhaul of UCITS, maybe a UCITS 7, and we'll see, you know, an additional look at what asset classes can be invested into.

Angelo Lercara:

Thank you, Doireann, Mark. A big thank you for joining us and sharing your insights with us. We really appreciate your expertise, and it's been great having you in this conversation. Thanks a lot.

Doireann O'Daly:

Thank you.

Mark Dillon:

Thank you, Angelo.

Angelo Lercara:

As we wrap up today's episode, I'd like to extend my thanks to our incredible production team. It is their dedication and hard work behind the scenes that make this podcast possible. So here's to our talented producers, sound engineers and everyone else involved in bringing this show to life. To our listeners, thank you for tuning in to our financial regulatory podcast. We hope that you found today's episode informative and engaging. If you enjoyed the show, please consider subscribing, rating and reviewing us on your favorite podcast platform. See you next time you.