Circular 6/2010 of the National Securities Market Commission on Derivative Instrument Operations by Collective Investment Institutions

OFFICIAL STATE GAZETTE No. 9 Tuesday, January 11, 2011 Sec. I. Page 2598 I. GENERAL PROVISIONS NATIONAL SECURITIES MARKET COMMISSION 551 Circular 6/2010, of December 21, of the National Securities Market Commission, on operations with derivative instruments by collective investment institutions. The publication of Order EHA/888/2008, of March 27, on operations of Collective Investment Institutions (hereinafter, IICs) of a financial nature with derivative instruments and clarifying certain concepts of the Regulation of Law 35/2003, of November 4, on Collective Investment Institutions, approved by Royal Decree 1309/2005, of November 4 (hereinafter, Order EHA 888/2008), expands the scope of action of IICs regarding investment in this type of product, especially with respect to the underlying assets considered suitable and the operation in products not traded on organized markets as well as other financial instruments, incorporating into our legal order Directive 2007/16/EC of the Commission, of March 19, 2007, which establishes, among others, certain definitions and requirements applicable to assets suitable for investment. In July, Directive 2010/43/EU on organizational requirements, conflicts of interest, conduct rules, risk management, and content of the manager-depositary agreement was approved, along with a Level 3 development on risk measures and calculation of global exposure and counterparty risk for UCITS (CESR/10-788). The contents of the Circular are in line with these developments. Considering now the content of the Circular, it consists of 27 rules distributed in four chapters, plus five additional provisions, one transitional, one repealing, and one final. Chapter I collects the definitions of certain concepts, the general rules for determining the limits on operations with derivative instruments established in article 39 of the Royal Decree that develops Law 35/2003 on IICs, as well as specific requirements that certain financial instruments must meet, either to be considered suitable or to define whether they incorporate an implicit derivative or not. Chapter II consists of two sections, where the content of the methodologies that the IIC may apply to measure the limit for market risk is detailed, specifically, the commitment methodology and the Value at Risk (or "VAR") methodology, ensuring that the one applied is the most appropriate to the investment and risk policy established in its prospectus as well as for measuring risk based on the complexity of investments and management strategies. Section 1 details the commitment methodology, which is similar to that established by Circular 3/1998 of the CNMV (formerly called the "standard" methodology), introducing certain modifications in line with the Level 3 work developed within the Committee of European Securities Regulators (CESR), which aims to concretize the harmonization initiatives of market risk calculation methodologies initiated with the European Commission Recommendation on the use of derivative instruments by UCITS (2004/383/EC). Section 2 develops the Value at Risk (or "VAR") methodology, admitting two methodological alternatives, one based on limiting the leverage of the IIC through the calculation of a "VAR" relative to a reference portfolio (or "benchmark"), and another based on determining a "VAR" limit in absolute terms. Additionally, precise qualitative and quantitative conditions are established for the application of the VAR methodology, as well as other risk tests and measures that must be implemented to complement said methodology. cve: BOE-A-2011-551

OFFICIAL STATE GAZETTE No. 9 Tuesday, January 11, 2011 Sec. I. Page 2599 After finishing the description of the methods for determining the commitment, Chapters III and IV establish another series of rules related to the calculation of counterparty limits, diversification, the framework applicable to IICs with a specific profitability objective, and an enumeration of criteria for the valuation of derivative instruments and their underlying assets. Regarding counterparty limits, the solvency requirements established in Order EHA 888/2008 are specified, as well as a detail of the balances that must be taken into account for their calculation. Likewise, the functioning of guarantees received for such operations is developed, highlighting the expansion in the range of suitable assets (compared to cash, deposits, and public debt allowed by Circular 3/1998), as well as the possibility of reinvesting said assets to generate additional profitability for the IIC. As for diversification limits, greater detail is provided on how positions must be calculated under the commitment methodology, and some specific calculation rules are established for certain financial instruments. Additionally, the regime applicable to IICs with a specific profitability objective is developed, establishing, first, a detailed definition of the characteristics these institutions must meet as well as the regime applicable to them regarding the non-temporal valuation of positions and the exceeding of limits established in current regulations, both for those that have or do not have a guarantee granted by a third party to the IIC. Chapter IV concludes with a rule in which a series of guidelines and specific criteria are provided to be taken into account in the valuation of derivative instruments, both regarding possible generally accepted models, as well as the procedures and controls that entities must have established to carry out an adequate valuation of such investments. Finally, the first additional provision modifies certain confidential information models that IICs and management entities must submit to the CNMV, and three new models are incorporated, two for those institutions that apply any of the VAR methodologies for the calculation of global exposure, and an additional auxiliary information model. These models are included as an annex to this Circular. The second additional provision introduces into Circular 4/2008 of the CNMV on the periodic public information of IICs a new model for quoted index SICAVs. For its part, the third additional provision modifies the calculation of the debt limit as established in Circular 6/2008 of the CNMV, on the determination of the liquidation value and operational aspects of collective investment institutions, both for financial and real estate IICs. The fourth additional provision modifies Circular 6/2009 of the CNMV on internal control of CNMV management companies to include intermediary selection procedures when they provide analysis services. Finally, the fifth additional provision modifies Circular 1/2006 of the CNMV, on free investment collective investment institutions, so that the commissions obtained by the management of foreign institutions similar to those contemplated in the aforementioned Circular are taken into account in the calculation of the required resources of SGIICs. By virtue thereof, the Council of the National Securities Market Commission, after a report from the Advisory Committee, in its meeting of December 21, 2010, has ordered: CHAPTER I General definitions, suitable investments, and general limits for market risk Rule 1. General Definitions. For the purposes of this Circular, the following shall be understood:

1. Derivative Instrument: Any of the operations cited in article 2 of Ministerial Order EHA/888/2008 (hereinafter OM EHA/888/2008) of March 27, on cve: BOE-A-2011-551

OFFICIAL STATE GAZETTE No. 9 Tuesday, January 11, 2011 Sec. I. Page 2600 operations of collective investment institutions of a financial nature with financial derivative instruments and clarifying certain concepts of the Regulation of Law 35/2003, of November 4, on collective investment institutions, approved by Royal Decree 1309/2005, of November 4. 2. Underlying: Asset that is the object of actual or theoretical acquisition or disposal in the settlement of the derivative instrument and always consisting of: a) Assets or instruments mentioned in paragraphs a), b), c), and d) of article 36.1 of the Regulation of Law 35/2003. b) Dividends on shares mentioned in paragraph a) of article 36.1 of the Regulation of Law 35/2003 or on stock indices that meet the requirements established in current regulations. c) Credit risk. d) Volatility and variance. e) Financial indices. f) Interest rates. g) Exchange rates or currencies. h) Commodities for which there is a secondary trading market. i) Shares or participations in free investment IICs, as well as in foreign institutions similar to those provided for in article 36.1.j) of the Regulation of Law 35/2003. j) Inflation of countries or geographic zones provided that their calculation, transparency, and dissemination rules are equivalent to those established for the harmonized consumer price index of the European Union. k) Any other underlying asset whose use has been authorized by the National Securities Market Commission, or l) Any combination of those mentioned in the preceding letters. In no case shall the settlement of a derivative instrument result in the incorporation into the assets of the IIC of a non-financial asset. In these cases, the contractual clauses of the contract must expressly establish that the settlement will be made in cash or, the management entity must ensure, prior to making the investment, that in said markets there are other standardized mechanisms that guarantee that in no case will the incorporation into the assets of the IIC of a non-financial asset occur. 3. Financial Instrument: The set of contracts or securities that coincide in all and each of their characteristics regarding their issuer or counterparty, payment flows, maturity, denomination currency, underlying, and exercise price. A financial instrument may be both a derivative instrument and a covered financial asset. 4. Covered Financial Asset: Any value or instrument suitable for investment by IICs, which is covered by a financial derivative instrument, according to the admissible hedging rules in this Circular. 5. Long Position in a Financial Instrument: Any operation that may result in the actual or theoretical acquisition of the financial instrument. Specifically, long positions will be: Spot and forward purchases, bought futures, options, including "warrants", "CAPs", and "FLOORs", acquired as calls ("CALL" purchases) and sold as puts ("PUT" sales). 6. Short Position in a Financial Instrument: Any operation that results in the actual or theoretical disposal of the financial instrument. Specifically, short positions will be: Forward sales, sold financial futures, options, including "warrants", "CAPs", and "FLOORs", acquired as puts ("PUT" purchases) and sold as calls ("CALL" sales), and short sales. 7. Primary Net Position in a Financial Instrument: The difference between the sum of long positions and the sum of short positions in the same financial instrument. When this difference is positive, the net position will be long, while when it is negative, it will be short. cve: BOE-A-2011-551

OFFICIAL STATE GAZETTE No. 9 Tuesday, January 11, 2011 Sec. I. Page 2601 8. Secondary Net Position in a Financial Instrument: The difference between long and short Primary Net Positions, that is, the result of offsetting different Financial Instruments, provided that such offsetting is admissible according to the hedging requirements established in section 1 of chapter II of this Circular. 9. General Risk: Risk of a loss occurring in a certain financial instrument due to a general movement recorded in the level of interest rates, exchange rates, or asset prices and not attributable to specific characteristics of the financial instrument. 10. Specific Risk: Risk that the value movements of a financial instrument are greater or less than market movements, for causes explicitly related to its issuer, or in the case of a derivative instrument, with the issuer of its underlying, and among others, would include the risk of a credit event, bankruptcy, or default of said issuer. Rule 2. Instruments incorporating an implicit derivative and liquidity requirements for short sales.

1. In application of what is established in article 8.4 of OM EHA/888/2008, the management entity must analyze and evaluate whether a financial instrument whose profitability is referenced or linked to others meets the requirements established in said article to determine whether it incorporates an implicit derivative or not. Said analysis must be carried out for all financial investments regulated under letters a), b), c), d), e), h) and paragraphs 1, 2, 3, 4, and 6 of letter j) of article 36.1 of Royal Decree 1309/2005.
2. Regarding the requirement established in letter b) of said article 8.4, it will be understood that the characteristics and economic risks inherent to the derivative are closely related to the main contract when in a fixed-income operation the underlying of the derivative instrument is an interest rate or an interest rate index that does not produce a substantial alteration of the payment flows that would result from the operation in the absence of said derivative instrument. In any case, it is understood that a substantial alteration of payment flows occurs when the buying counterparty of the structured operation is exposed to not recovering its initial investment or when the accrual of interest can generate negative flows for said part of the contract.
3. In any case, it is considered that, for the purposes of complying with the limits established in this Circular, the following types of securities or financial instruments do not incorporate an implicit derivative: Those that incorporate exclusively early amortization clauses linked to interest rates. Those that are linked to inflation and have been issued by any of the issuers regulated in letter b) of article 38.2 of the Regulation of Law 35/2003. Those that incorporate exclusively clauses by which profitability is increased in the event of a deterioration of the credit quality of the issuer of the asset. As well as those in which equivalent situations occur in the event of non-early amortization of the financial instrument. Investments in Spanish non-subordinated securitization funds and equivalent foreign funds, in terms of applicable regulatory requirements, advertising, and transparency, that have a credit rating at the time of their issuance of maximum or extremely strong strength to meet the payment of their obligations, that is, that have been rated as "AAA" by Standard & Poor's, Moody's, Fitch, or similar by other ECAIs. Additionally, any other Spanish or equivalent foreign securitization fund will not be considered to incorporate an implicit derivative for which there is a trading market that offers liquidity and representative daily quotation. Any of the instruments regulated under letter c) of article 15.2 of OM EHA/888/2008. cve: BOE-A-2011-551

OFFICIAL STATE GAZETTE No. 9 Tuesday, January 11, 2011 Sec. I. Page 2602 4. Regarding the additional liquidity requirement applicable to short sales established in article 41.3 of Royal Decree 1309/2005, it must be taken into account that: a) It will only be exigible when the purpose of this operation is investment to manage the portfolio more effectively, and it is not included under a specific profitability objective that has been guaranteed to the institution itself by a third party. b) It may be materialized in any liquid asset regulated in rule 22 of this Circular on guarantees. c) These requirements will be applicable to any short position in derivative instruments in which the IIC is exposed to the risk of having to buy any of the assets established in article 36.1 of Royal Decree 1309/2005, at a price higher than that initially contracted or agreed in the sale operation, and regardless of whether the settlement is made with physical delivery of the asset or in cash. Short sales of the financial assets referred to in article 36.1 b), c), d), h), and j) of Royal Decree 1309/2005 cannot be carried out. d) The entity must have internal control procedures that allow ensuring that: In the case of derivative instruments that settle by physical delivery, the IIC, automatically or at the choice of the counterparty, must maintain said financial asset in the portfolio, or sufficient liquid assets that allow being used at any time to acquire the underlying to which the derivative instrument is linked, provided that the latter is also sufficiently liquid. In the case of derivative instruments settled in cash, automatically or at the discretion of the IIC, the IIC must maintain sufficient liquid assets that allow meeting any payment commitments that may arise from said operations at any time. Additionally, for the purpose of determining the amount of assets to be maintained in the portfolio, interest or any other additional payment commitment related to said operation must be taken into account. Likewise, guarantees that have been deposited in the realization of said operations may be deducted from said amount. Rule 3. Limits on operations with derivative instruments for market risk: Paid premiums and global exposure.

1. As established in article 8.5 of OM EHA/888/2008, in no case shall the premiums paid for the purchase of options that are contracted in isolation or incorporated in values or instruments that incorporate an implicit derivative exceed 10% of the assets of the IIC. For compliance with this limit: a) The IIC must value the options at their acquisition price. However, IICs must take as the reference price the market price or fair value of the options at the time of their acquisition, when it is significantly higher than the price effectively paid. b) The sum of the premiums paid will be calculated in gross terms. However, it will be possible to offset the amounts paid for the purchase of options with the premiums received for the sale of options, including "warrants", "CAPs", and "FLOORs", when the purchased and sold options to be offset are not incorporated in different structures and coincide in all and each of their characteristics, except for their contracting date, counterparty, or exercise price. c) This limit will be subject to review only when a new purchase of options occurs. cve: BOE-A-2011-551

OFFICIAL STATE GAZETTE No. 9 Tuesday, January 11, 2011 Sec. I. Page 2603 2. As established in point 1 of article 8 of OM EHA/888/2008 and in article 39.3 of Royal Decree 1309/2005, the total exposure to market risk associated with financial derivative instruments cannot exceed the net assets of the IIC. For compliance with this limit, the management entity may apply the following methodologies: a) Commitment Methodology, developed in section 1 of chapter II of this Circular, whose objective is the measurement of the excess leverage generated by investment in financial instruments, establishing for this purpose calculation rules for the equivalent spot exposure for each type of financial derivative instrument. b) Value at Risk Methodology (hereinafter "VAR" methodology) established in section 2 of chapter II of this Circular, based on limiting the global exposure of the IIC through the maximum probable loss that the IIC could incur in a time horizon and under a certain level of confidence. Additionally, the IIC may choose between the application of a: Relative "VAR" on a reference portfolio, or "VAR" in "Absolute" terms. 3. The management entity must be in a position to prove that the methodology applied for measuring exposure from operations with derivative instruments is adequate to the investment and risk policy established in the prospectus of the IIC, analyzing that said methodology adequately captures the complexity and risks of investment strategies as well as of the derivative instruments themselves and their impact on the assets of the IIC. The applied methodology (commitment, Relative VaR, or Absolute VaR) must be specified both in the prospectus of the IIC and in the first section (regarding derivative instrument operations) of the periodic public information model, included in the Annexes of Circular 4/2008 of the CNMV. 4. The management entity may apply these methodologies jointly to all or part of the managed IICs, as well as to all or part of the compartments of the same IIC. The methodology must be applied consistently, that is, once an IIC or compartment applies a certain methodology, it cannot apply a different one without prior communication to the CNMV and to the participants whenever it implies a substantial change in the investment and risk policy under the terms established in point 2 of article 14 of Royal Decree 1309/2005. 5. The IIC must calculate its global exposure at least daily. However, IICs that carry out, among others, active investment strategies in derivative instruments or on underlying assets that could present high volatility must calculate said exposure more frequently, in order to ensure compliance with these limits at all times. 6. The CNMV may require the management entity to compute intraday global exposure and even abandon the applied methodology either for not adequately capturing the exposures and risks assumed by the IIC or because the entity does not have sufficient means, procedures, and/or controls. cve: BOE-A-2011-551

CHAPTER II Methodologies for the calculation of market risk Section 1. Commitment Methodology Rule 4. Specific criteria for the calculation of exposure to market risk in operations with derivative instruments.

1. IICs